Treasury has released exposure draft legislation to overhaul the thin capitalisation rules for non-financial entities. The proposal will replace the current asset-based 60% safe harbour test with a fixed ratio earnings limit (which will limit net debt deductions to 30% of EBITDA).
The proposals also include two alternative methods, being a group earnings limit (which allows the ratio, instead of being the fixed 30%, to instead be calculated based on the worldwide group’s net interest-EBITDA ratio) and an external third-party earnings limit (which effectively allows gearing to the extent of certain third party external borrowings). The rules are proposed to come into effect for income years starting on or after 1 July 2023 with no grandfathering or transitional rules. If implemented in their current form, the changes will have a significant impact on taxpayers that are members of multinational groups who have debt in Australia. Although the rules are not yet finalised, taxpayers should start considering how the changes will affect them and whether they need to consider restructuring their existing Australian financing arrangements.
What are the new rules about?
The new thin capitalisation rules will apply to entities other than financial entities and Authorised Deposit-taking Institutions (“ADIs”) (referred to as “general class investors”). The proposed rules will operate to limit a general class investor’s debt deductions for a year based on one of three tests:
- The fixed ratio test (“FRT”) (the default test).
- The group ratio test (“GRT”) (if the entity makes a choice to apply it).
- The external third party debt test (“ETPDT”) (if the entity and all of its associate entities choose to apply it).
Which entities are subject to the new rules?
The scope of the proposed new rules has largely remained unchanged. An entity will be subject to the thin capitalisation rules if they are either an inward or outward investing entity. That is, entities belonging to purely domestic groups should generally not be within the scope of the rules.
Further, no significant changes have been proposed to the existing $2 million de minimis, the 90% Australian asset exemption for outward investing entities or the exemption for insolvency-remote special purpose entities.
Fixed Ratio Test
The (default) FRT is a fairly straightforward test that limits an entity’s net debt deductions to 30% of its tax EBITDA for the year. Tax EBITDA is proposed to be calculated as an entity’s taxable income (or loss) for the year disregarding its net debt deductions, certain tax depreciation deductions and prior year tax losses deducted for the year. If the amount is calculated as a negative amount, it is taken to be zero. Debt deductions denied under the FRT can be carried forward for up to 15 years (subject to satisfying certain carry forward tests).
Assume an entity is established and acquires an asset for $1 million funded by $600,000 of debt and $400,000 of equity and the asset generates $80,000 of gross rental income for the year. If the only deductions were interest and depreciation (including the building allowance), the entity’s tax EBITDA would be $80,000. On that basis, the entity would only be able to deduct $24,000 of net debt deductions. If the interest costs for the year were $30,000, $6,000 would be denied under the proposed FRT. However, unlike the existing rules, the denial is not permanent: the amount denied may be carried forward for up to 15 years provided certain conditions were satisfied.
By way of comparison, the current asset-based safe harbour would result in no deductions being denied given the entity’s debt does not exceed the 60% safe harbour amount.
In order for the full $30,000 of interest to be deductible under the new test, the entity would need to have generated $100,000 of gross rental income for the year. Therefore, to maximise deductibility of interest expenses the entity may need to generate additional taxable income.
Net debt deductions
One major change under the new rules is that the FRT places a limit on net debt deductions rather than gross debt deductions. Any amounts of interest income or amounts in the nature of interest are taken into account to reduce the entity’s net debt deductions for the year.
Taking the example above, if the entity instead generated $70,000 of rental income and $10,000 of interest income for the year then its net debt deductions would be $20,000 which is below the $24,000 FRT limit for the year, so that the total interest expenses of $30,000 would be deductible that year.
The adoption of a net debt deduction test means that entities which are net lenders (that are not financial entities) may more easily be able to claim debt deductions in full where they make a profit for the year (i.e. irrespective of how thinly capitalised the entity may be).
Non-corporate entities (trusts and partnerships)
One important aspect for non-corporate entities is that no adjustments have been made for capital gains made by trusts, such that only the net amount of assessable income after the 50% discount counts towards tax EBITDA.
Further, where partnerships are subject to the new rules, no consideration has been given to the operation of the CGT rules which tax the partners on the capital gains instead of the partnership. As a result, capital gains made in relation to partnership assets will not count at all towards the partnership’s tax EBITDA.
We believe that these issues have not yet been considered by Treasury and hopefully will be addressed in the final legislation.
Group Ratio Test
The GRT allows an entity to use its worldwide group’s net interest expense-to-EBITDA ratio (“group ratio”) which may assist taxpayer by providing for a better outcome than the FRT. This test essentially replaces the existing worldwide gearing test for non-financial entities.
The group ratio must be calculated from the information in the audited consolidated financial statements of the group to which the entity belongs. Various adjustments are required to be made to determine the group’s net interest expenses, including adjustments to interest income and expenses and disregarding dealings between members of the group and certain related entities outside the group. Adjustments are also made to disregard group members who have a negative EBITDA for the year.
As many private groups with discretionary trusts are not structured in a way that lends itself to consolidation for accounting purposes, the GRT may not be practically available for many taxpayers in the middle market. This is a critical issue for middle market taxpayers, who currently have access to an “associate entity excess” provisions under the current thin capitalisation rules. As these groups are likely to have entities within the group that have excess borrowing capacity, it will be critical that some form of grouping is provided to middle market taxpayers in the final legislation.
External Third Party Debt Test
The ETPDT sets a limit on the entity’s gross debt deductions for the year equal to the amount of debt deductions on debt funding from unrelated parties that is used to fund the entity’s Australian investments or operations. Importantly, the external lender must only have recourse to the assets of the borrowing entity for payment of the debt. Accordingly, a guarantee or other form of security provided by a party related to the borrower may prevent the relevant debt from satisfying this condition and therefore resulting in the debt not considered to be external third party debt for these purposes.
Essentially, an entity whose Australian operations are wholly financed by external third parties (which meet the recourse test) should be able to deduct their interest expense in full under this test. If an entity is financed by a mix of both external and related-party debt, choosing to use this test should result in all debt deductions paid to related parties being denied (with such income still potentially being assessable to the lender).
The ETPDT includes a conduit financer rule that allows loans between related parties to meet the external third-party conditions where a central finance entity obtains third party debt and on-lends the amounts to related-party borrowers on essentially the same terms.
This test replaces the arm’s length debt test for both general class investors as well as financial entities (other than ADIs).
While this new test may be somewhat simpler to apply than the arm’s length debt test, the requirement for all associate entities (determined on the basis of a control interest of at least 10%) to make a mutual choice to apply the test presents many practical challenges. This is particularly problematic for entities that have investments in joint venture vehicles as such joint venture entities (and all participants in the joint venture with a 10% or greater interest) may also need to make the same choice based on the current exposure draft. Additionally, the failure to satisfy one condition would result in the test setting a limit of debt deduction limit of nil for the entity for the year.
Carry forward of denied deductions
The current thin capitalisation rules permanently deny deductions where entities have excess debt. In recognition that earnings are volatile and may occur many years after interest costs are incurred, the new rules are proposed to allow deductions denied under the FRT (the “FRT disallowed amount”) to be carried forward for up to 15 years for use when the entity has sufficient earnings.
Importantly, the ability to carry forward denied amounts is not available under the other two tests. Further, although the rules allow entities to choose one of the two elective methods (GRT or ETPDT) on a year-by-year basis, an entity with FRT disallowed amounts that chooses to use either the GRT or ETPDT in a later income year will permanently forfeit all FRT disallowed amounts under the proposed carry forward provisions.
The rules also propose that companies wishing to use carry forward amounts in later years must pass the continuity of ownership test (“COT”). However, the same or similar business test is currently not being proposed as a back-up, should the COT be failed.
The exposure draft also provides for modifications to the tax consolidation rules governing whether carry forward amounts can be transferred by an entity that joins a tax consolidated group, and where they can so be transferred, provides for a negative adjustment to the entity’s allocable cost amount for tax cost setting purposes.
Under the current draft, no COT testing is required for trusts or partnerships that wish to utilise carry forward amounts in later income years.
The exposure draft also includes other items that are likely to significantly impact many taxpayers.
- Removal of section 25-90 – In a substantial policy shift that will affect taxpayers with outbound structures, Australian companies that borrow to fund equity investments in foreign subsidiaries will not be able to deduct those interest costs, regardless of whether they are subject to the thin capitalisation rules or not. This may also affect trusts and partnerships that are interposed between the Australian company and the foreign subsidiary. If the proposed repeal eventuates, entities that borrow to finance a mix of domestic operations and investments in foreign subsidiaries may be required to undertake complex tracing or apportionment calculations to determine which debt deductions are disallowed (or may be forced to restructure debt arrangements as equity).
- Limiting the scope of “financial entities” – Citing integrity concerns, the Government proposes to remove from the definition of financial entities those that are registered corporations under the Financial Sector (Collection of Data) Act 2001. Such entities may therefore become subject to the new rules as general class investors and not be able to continue to use the existing balance sheet test applicable to financial entities. However, if such entities are net lenders, they may obtain favourable outcomes under the new tests where their interest income exceeds their interest expenses as their net debt deductions would essentially be nil.
- Expanding the scope of “debt deductions” – In a change that will affect all taxpayers subject to the thin capitalisation rules, the meaning of debt deductions will not be limited to certain costs that are incurred in relation to debt interests and will instead cover all interest costs and economically equivalent amounts even if they are not incurred in relation to a financing arrangement that is considered a debt interest. This change may bring additional costs within the scope of the thin capitalisation rules.
When do the changes apply from?
The new rules will apply for income years commencing on or after 1 July 2023 with no grandfathering or transitional rules. While it is unlikely that the rules will make their way through Parliament before 1 July 2023, it is not expected that the start date will be deferred.
What are the next steps?
It is critical that affected taxpayers consider their position and how the current draft of the rules will apply as compared to the existing thin capitalisation rules and conduct relevant forecasts to understand the impact of the rules on their after-tax cost of financing.
Taxpayers should also consider whether one of the two elective methods may be suitable for their arrangements if the FRT is likely to result in a denial of deductions, as well as considering whether any changes need to be made to their financing arrangements. As financial arrangements can take significant time to change, it is critical that this analysis be conducted sooner rather than later.
Any restructuring undertaken to maximise an entity’s debt deductions in line with the new rules should be carefully considered in light of the application of the general anti-avoidance rule in Part IVA, with ATO guidance on its potential application to such restructures being critical.
Taxpayers should contact their Pitcher Partners representative to review their existing arrangements and determine what action is required in light of the forthcoming changes.