The Federal Government has announced that it will pursue its reform of the thin capitalisation rules to limit interest deductions based on an earnings test rather than a balance sheet test.
Commencing on 1 July 2023 these measures are expected to have a significant impact on deductions available to inbound and outbound groups.
Reform of the thin capitalisation rules
Consistent with their pre-election commitments, the Federal Government will proceed with significant reforms to the thin capitalisation rules for non-financial entities from 1 July 2023. The measures will adopt OECD recommendations and apply to entities that are members of multinational groups (both inward and outward entities).
The proposed earnings-based test will limit debt deductions for an income year to 30% of an entity’s Earnings Before Interest, Taxes, Depreciation and Amortisation (EBITDA). This will replace the current asset-based safe harbour test which denies deductions where an entity’s average debt exceeds 60% of the average value of its assets for the year.
The alternative arm’s length debt test will be retained but will be limited so that it can only be relied on to support debt deductions on external (unrelated party) debt.
The proposal will also adopt an alternative group ratio rule allowing an entity to claim debt deductions above the 30% EBITDA ratio based on its worldwide group’s net interest expense ratio (as a share of earnings). This will replace the existing asset-based worldwide gearing test.
Unlike the current thin capitalisation rules which operate to permanently deny excessive debt deductions, the earnings-based rule will allow denied deductions to be carried forward up to 15 years.
This is an important feature which recognises the potential negative impact on taxpayers that experience long lead times between expenditure and earnings (such as start-up entities, property developers, taxpayers conducting infrastructure projects and those suffering temporary downturns and falls in earnings).
It is presently unknown whether subsequent utilisation of excess debt deductions will be subject to continuity of ownership testing. Further, it does not appear that the measure will allow the carry-forward of excess debt capacity as has been adopted in other jurisdictions that have implemented the equivalent OECD recommendation.
Impact on SMEs
While the measures are targeted at large multinational groups, the thin capitalisation rules apply to many entities in the middle market which are majority foreign-owned or have foreign operations. The main carveout is the $2 million de minimis which appears will not be uplifted, despite many calls for a higher de minimis in a higher interest rate environment.
The earnings-based test will particularly affect property developers and property funds which may incur debt deductions in the early years prior to generating income. In these projects, any change to the debt/equity mix may affect investor returns on equity and performance fees earned by fund managers.
No transitional rules
The Federal Government is silent on any grandfathering or transitional relief such that the measures will apply from 1 July 2023 to entities with pre-existing arrangements. Such entities may therefore be significantly affected where long-term borrowings have been committed and may not be easily renegotiated.
Entities who were funded to ensure that they complied with the current 60% safe harbour may now find that a significant portion of their interest costs will become non-deductible affecting projected returns.
Further clarity is required
The devil will be in the detail as many aspects of the measures are still unknown including what adjustments are required to the EBITDA (such as for tax losses and intra-group distributions), whether the measures will apply to net interest expenses (as per BEPS Action 4) or gross interest expenses, whether capital gains will form part of EBITDA (including the impact of the capital gains tax discount) and if and how the excess debt capacity of related entities will be factored into the calculations.
Pitcher Partners made a comprehensive submission on the proposed thin capitalisation reforms in the recent Treasury consultation paper and will continue to closely scrutinise any further consultation documents and exposure draft legislation to advocate for middle market taxpayers who will be unfairly impacted by these proposals.