Legislation has been introduced into Parliament that significantly rewrites Australia’s thin capitalisation rules with effect from 1 July 2023, with no grandfathering or transitional relief.
The new thin capitalisation regime will limit net debt deductions to 30% of tax EBITDA. Two alternative methods are available on an opt-in basis, being the group ratio test and third party debt test. The legislation includes major changes from the March exposure draft, both favourable and unfavourable for taxpayers, including the introduction of a previously unannounced anti-avoidance provision regarding “debt creation schemes”. This new provision has extremely broad application and could apply to ordinary financing arrangements between related parties to permanently deny interest deductions. The legislation will have a significant impact on taxpayers that are subject to the thin capitalisation rules. These taxpayers will need to consider the legislation and review their existing Australian financing arrangements.
What are the rules about?
The Treasury Laws Amendment (Making Multinationals Pay Their Fair Share – Integrity and Transparency Bill) 2023 (the “Bill”) was introduced into the House of Representatives on 22 June 2023. The Bill contains new rules that will operate to limit the annual debt deductions of all entities subject to the thin capitalisation regime (other than financial entities and Authorised Deposit-taking Institutions (“ADIs”) based on one of three tests:
- The fixed ratio test (“FRT”) (default test);
- The group ratio test (“GRT”) (if the entity makes a choice to apply it for an income year); or
- The third party debt test (“TPDT”) (if the entity makes a choice to apply this test for an income year. In addition, entities can be deemed to have made a choice to use this test if certain conditions are satisfied).
Consistent with the existing rules, an entity must be part of a multinational group (i.e. either an inward investing entity, outward investing entity or associate entity of an outward investing entity). The new rules apply mostly to those entities that are not financial entities or ADIs, which are referred to as “general class investors”. As was the case in the exposure draft, no changes have been proposed to the existing $2 million de minimis, the 90% Australian assets exemption for outward investing entities or the exemption for insolvency-remote special purpose entities.
Summary of the fixed ratio test
The (default) FRT limits an entity’s net debt deductions to 30% of its tax EBITDA for the year. Broadly, tax EBITDA is calculated as an entity’s taxable income (or loss) for the year disregarding its net debt deductions, depreciation and capital works deductions for the year. In addition, assessable dividends (whether franked or unfranked) and any associated franking credit amounts are excluded from an entity’s tax EBITDA. An entity’s net debt deductions will be the difference between its gross debt deductions and amounts of interest income derived in the year.
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 capital works deductions), 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, this results in $6,000 being denied under FRT, which may be carried forward for up to 15 years.
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 calculating the tax EBITDA for partners of a partnership and beneficiaries of a trust in which a 10% or greater interest is held, further adjustments are made to ensure that amounts included in the net income of partnerships and trusts are not counted in the tax EBITDA more than once. Accordingly:
- For partners of partnerships – distributions of partnership net income (or loss) are excluded; and
- For beneficiaries of a trust – distributions of trust net income (including distributions of capital gains) are excluded.
The exclusion of distributions from an entity’s tax EBITDA is a significant change from the exposure draft legislation and results in entities that borrow to fund equity investments in a subsidiary or joint venture entity potentially being denied all debt deductions under the FRT.
Debt deductions denied under the FRT can be carried forward for up to 15 years subject to satisfying the usual tax loss carry forward tests for companies and trusts (with no testing required for partnerships). This is a change from the exposure draft legislation which did not provide an ability for companies to use the business continuity test and did not contain any testing for trusts.
Summary of the group ratio test
The GRT allows an entity to use a group ratio determined by reference to the level of net interest expenses of its worldwide group’s (“group ratio”) rather than 30%. Under this test, the entity’s net debt deductions for the year are limited to its group ratio multiplied by its tax EBITDA. This earnings-based test replaces the current asset-based worldwide gearing test for non-financial entities.
The group ratio must be calculated from the information in the audited consolidated financial statements of the worldwide 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 the EBITDA of individual group members that 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 practical for many taxpayers in the middle market. This is a critical issue for middle market taxpayers who (up until 30 June 2023) had access to “associate entity excess” provisions under the balance sheet safe harbour method. As many are likely to have entities that have excess borrowing capacity, the lack of appropriate grouping rules for middle market taxpayers may have serious adverse consequences for many private groups.
Deductions disallowed under the GRT are denied permanently and cannot be carried forward. An entity with carry forward FRT disallowed amounts that chooses to use the GRT in a later income year will permanently forfeit all FRT disallowed amounts for use in later years.
Summary of the third party debt test
The TPDT sets a limit on the entity’s gross debt deductions for the year equal to the amount of debt deductions incurred on debt funding from unrelated parties that is used to fund its commercial activities in connection with Australia. While the test permits more highly leveraged entities to claim debt deductions in excess of the 30% fixed ratio where they are funded by third parties, the test is designed to be narrow and will not assist in many genuine commercial borrowing arrangements in Australia.
Importantly, the external lender must only have recourse for payment of the debt, to the Australian assets of the borrowing entity that do not consist of rights in relation to a guarantee, security or other form of credit support unless these rights relate to the creation or development (but not holding) of Australian real property. The borrower must also use the borrowed funds in its Australian commercial activities.
Where these requirements are satisfied, a borrowing entity whose Australian operations are wholly financed by external third parties should be able to deduct their interest costs in full under the TDPT. 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 TPDT includes a conduit financer rule that allows loans between related parties to qualify as “external debt” where a central finance entity obtains third party debt and on-lends the amounts to related-party borrowers on essentially the same terms.
The TPDT replaces the arm’s length debt test for both general class investors as well as financial entities (other than ADIs).
An election to use the TPDT may result in certain associate entities (on a 20% or greater ownership basis) that provide credit support also being deemed to have made a TPDT election, which may impact on the debt deductions available to those entities should they have borrowings of their own.
Introduction of new “debt creation rules”
The March exposure draft legislation proposed repealing section 25-90, which allows a company to claim debt deductions for costs incurred on funds borrowed to invest in foreign subsidiaries. While this proposed changed did not make its way into the Bill, there was instead a much nastier surprise inclusion of a new anti-avoidance rule intended to target related party transactions that result in the creation of debt deductions. While these are said to target schemes that seek to shift profits away from Australia and lack genuine commercial justification, the wording of the rules is extremely broad and apply to permanently deny deductions of entities within the thin capitalisation regime where:
- An entity borrows amounts (from any entity, whether related or not) to fund the acquisition of an asset (or obligation) from an associate; and
- An entity borrows amounts from an associate to fund payments or distributions to another associate.
Importantly, the debt creation rules do not contain a tax purpose test and can apply to wholly domestic and arm’s length arrangements. Additionally, there is no grandfathering such that debt deductions occurring on or after 1 July 2023 in relation to past transactions may be denied (e.g. loans used to fund acquisitions from associates before 1 July 2023).
These rules have the potential to result in substantial denials of debt deductions for common arrangements, particularly for non-consolidated groups where intra-group dealings are not ignored for income tax purposes.
Additionally, the “90% Australian assets exclusion” from thin capitalisation rules for outbound investors does not apply as an exclusion to the proposed new debt creation rules, with only the $2m de minimis exclusion being applicable. As such, Australian taxpayers with a minor foreign presence (e.g. a single foreign subsidiary with minimal assets) will be subject to these new rules if enacted.
What has changed from the exposure draft?
The Bill contains many changes from the exposure draft. While there were a few favourable changes, many of the changes are highly unfavourable and have the potential to have significant adverse implications for taxpayers.
In addition to the changes already outlined in this article, a summary of other key changes is outlined below:
- Calculation of tax EBITDA – An entity’s tax EBITDA will now exclude distributions from other entities (i.e. all dividends as well as trust and partnership distributions from certain associates). Additionally, tax losses will now not be added back in the calculation. These changes materially impact all taxpayers who borrow to fund equity investments in another entity. Such taxpayers may now have no ability to claim debt deductions under the FRT or GRT as they may have a nil tax EBITDA if their taxable income consists mainly of distributions from its subsidiaries. A favourable change is the expansion of tax depreciation items that could be added back so as to increase tax EBITDA (e.g. balancing adjustment deductions).
- Removal of mutual choice requirement for TDPT – Under the exposure draft, an entity wishing to make an election to use the TDPT was required to ensure all of its associate entities (on a 10% or greater ownership basis) also made the same election, a condition which would be impossible to satisfy in many group structures. Instead of this “mutual choice” requirement, the Bill introduces a concept of an “obligor group”, being a group of associate entities whose assets a lender has recourse to for the payment of debt. If an entity makes a TDPT election for a year, all members of the obligor group that are required to lodge income tax returns will also be deemed to have made a TPDT election such that any of their own related-party debt deductions will be denied in full.
- Requirement for entities to be “Australian residents” under TPDT – The TDPT now requires the borrowing entity to be an Australian resident, and in the case of the conduit financing rule, require lenders to have recourse only to the assets of Australian residents. The tax legislation defines “Australian resident” in a way that only covers individuals and companies. As such, in what we hope to be a drafting error, the Bill in its current form precludes trusts and partnerships from satisfying the relevant conditions to benefit from the TPDT. Given the significant impact on trusts and joint venture partnerships engaged in highly leveraged property development and/or investment activities, this change will have a significantly adverse impact on taxpayers if it is not corrected.
- Ability to revoke GRT and TPDT elections – The Bill provides for an entity to be able to revoke an election to use one of the two methods other than the default FRT, if the Commissioner allows, where it was reasonable for the taxpayer to believe that it would have obtained a better outcome at the time it made the original choice.
- Debt deduction and financial entity definitions – The meaning of debt deductions was proposed to be amended under the exposure draft to remove the requirement for a cost in the nature of interest to be incurred in relation to a debt interest, so as to capture a broader range of interest-like expenses within the scope of the thin capitalisation rules and subjecting them to denial. The Bill expands this even further by including costs associated with hedging (such as under interest rate swaps) within the meaning of debt deduction. The definition of a financial entity (which obtain more concessional treatment under the rules) was also updated to include certain registered corporations whose business predominantly consists of providing finance to unrelated parties.
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 relief. The Bill has been referred to the Senate Economics Legislation Committee with a report due by 31 August 2023. Over 40 submissions have been lodged with the Committee, including a submission by Pitcher Partners. The Bill contains many technical errors that prevent the rules from operating as intended. We anticipate that many of these errors are likely to be corrected and are hopeful other aspects are also refined, such as the lack of any associate entity excess rule and the overly broad scope of the debt creation rules.
Taxpayers need to be mindful of any legislative developments and re-consider the provisions in the Bill if, and when, any amendments are made before being passed into law.
What are the next steps?
All taxpayers subject to thin capitalisation rules (i.e. inward or outward investing entities) will be impacted by the new regime from 1 July 2023. Clients should contact their Pitcher Partners representative to review their existing arrangements and determine what action is required in light of the changes.