The Australian Government is consulting on changes to the tax rules on allowable debt deductions (thin capitalisation) as part of its ‘crackdown’ on the alleged ‘tax avoidance practices of multinational enterprises’.
What is proposed is a significant change to the ‘safe harbour rules’ that most entities have traditionally used - from focusing on the level of debt (allowing deductions on levels of debt up to 60% of assets) to focusing on the amount of net interest (allowing deductions of up to an amount equal to 30% of EBITDA).
We explore some of the key issues and questions that are raised by the consultation and that we hope are addressed as the proposal develops.
What is proposed?
Currently, entities subject to the thin capitalisation rules (foreign controlled entities investing into Australia and Australian entities investing overseas) can generally deduct interest expenses based on rules focused on the level of debt (with transfer pricing to first adjust any excessive level of interest on that debt). There is currently a ‘safe harbour’ allowing an entity to deduct interest on debt provided the level of its debt does not exceed 60% of its assets. Alternative rules can allow interest deductions in excess of the safe harbour on a level of debt equal to what an arm’s length lender would lend to the entity and the entity would borrow (arm’s length debt test) or up to the same level as the worldwide group of which it is part (worldwide gearing test).
The new proposal would fundamentally change the ‘safe harbour’ part of the test so that it would look at the amount of net interest (that is, net interest expense in excess of interest income), and limit the interest that can be deducted to an amount equal to 30% of EBITDA (earnings before interest, tax, depreciation and amortisation). As alternatives to the safe harbour, it is proposed to keep (but potentially modify / restrict) the arm’s length debt test, introduce a new group ratio rule (allowing some higher level of deduction if the worldwide group has interest levels above 30% of group EBITDA) and possibly also retain the worldwide gearing test. It is also proposed that there would continue to be a de minimis exemption (under which the thin capitalisation rules don't apply), which is likely to be consistent with the current de minimis of $2 million. However, given it is at the consultation stage, exact details are limited – which also brings the opportunity for affected entities to input and potentially shape the outcomes.
There are no changes currently proposed to the rules applying to banks and other financial institutions (whilst the consultation does ask whether this is appropriate, we expect this will be the likely outcome).
The changes seek to implement the OECD Base Erosion and Profit Shifting (BEPS) Action Item 4 from 2015 and were foreshadowed by the now government during the 2022 Australian federal election campaign. Similar rules have already been adopted in the United Kingdom (since 2017), the United States (since roughly 2018) and the EU (generally from 2018-2019). Canada is also currently consulting on similar rules (although they may focus only on outward investing Canadian entities). Australia previously had rejected making changes to align with BEPS Action 4 as a result of our existing rules (which were often already stricter than international peers)!
Key issues / questions
Some of the key issues or questions arising from the consultation / proposal are as follows:
- Grandfathering: the consultation makes no mention of transitional rules or grandfathering for entities currently applying the safe harbour (other than for changes in the arm’s length debt test). This was also a big issue internationally, but despite efforts there was no transition in the UK or the US. The EU rules allowed it, but it hasn't generally been implemented. However, there may be significant commercial implications for entities that have adopted the existing ‘safe harbour’ and suddenly finds their debt deductions limited. Accordingly, the current safe harbour and its influence on debt levels may provide a stronger argument for transitional rules than existed overseas.
- Arm’s length debt test: retention of the arm’s length debt test is, at least theoretically, a welcome move not generally seen internationally. It may be particularly significant where high third-party gearing is normal (e.g. infrastructure / real estate). We have also recently seen more entities make use of this alternative test, despite the current rigorous evidence requirements set by the Australian Taxation Office (possibly reflecting that leverage of 60% was conservative in the former interest rate environment). However, whilst the consultation recognises the current difficulties in applying the test, it seems focused on limiting the application of the test (potentially to third party debt). This would reduce its utility. It also seems to want to address the perceived risk of inflated interest rates through the test, notwithstanding the transfer pricing rules. Finally, the arm’s length debt test is also currently difficult to apply to trusts, and this difficulty may be increasingly relevant if it is not addressed and the safe harbour is tightened.
- Denied interest carry forward / capacity carry forwards or backs: The ability to carry forward denied interest deductions and carry forward (or back) unused interest capacity is important to partially address the greater potential for EBITDA volatility (and therefore volatility in interest deductibility) from year to year when compared to assets. Such provisions are also critical for sectors where interest costs arise from the beginning (e.g. projects, infrastructure and real estate), but where earnings only arise later (e.g. at construction completion). Otherwise, there may be a loss of deductions for interest in those early years and higher net taxes overall. Unfortunately, these issues are not specifically addressed in the consultation. Internationally, the UK rules allow carry forward of denied interest deductions for an unlimited period and of excess capacity for 5 years; the EU rules permit carry forwards up to those used in the UK (and the larger member states have adopted the same rules as the UK); and the Canadian proposals include the ability to carry forward denied interest for 20 years and unused capacity for 3 years. As such, this is a key area where the Australian rules should reflect the international consensus.
- “Public infrastructure” exemption: infrastructure is one sector in which debt leverage is often necessarily high and where interest begins being incurred significantly ahead of earnings. Accordingly, it is a key sector where the new rules could have a greater impact (depending on the ongoing application of the arm’s length debt test and any carry forward rules). Accordingly, the consultation discusses an exception for assets/ projects that provide ‘net public benefits’ or are ‘nationally significant’. However, the consultation seems focused on making use of existing concepts in the tax legislation. This might, for example, be the “approved economic infrastructure facility” exception in the MIT withholding tax rules (broadly transport, energy, communications and water infrastructure approved by the Treasurer). However, that definition is limited in scope and unlikely to practically provide relief for the range of infrastructure projects affected by the new rules. The UK has a similar exemption that is significantly broader in potential scope than, say, the MIT rules (and which is objective rather than requiring political input), although it can still be quite difficult to apply to groups. The US exempts certain regulated utilities from its rules and the EU allows exemptions for ‘long-term public infrastructure’ (and leaves member states to determine details).
- No real estate / REIT exemptions: another area where both high leverage and interest incurred before earnings are common is real estate. Unfortunately, unlike infrastructure this sector gets no particular focus in the consultation (beyond the general question about which types of entities might be particularly impacted). Again, some of the leverage challenges might be addressed by the arm’s length debt test retention (subject to tightening / practical issues). However, the lack of discussion of real estate is in contrast to the UK rules (which provide exemptions for REITS and UK property businesses) and the US rules (which exempt real property businesses). There may therefore be opportunities for real estate businesses / REITs to point to those international regimes to obtain changes that manage the potentially significant effects of the proposal.
- Tax or accounting EBITDA and grouping: what goes into calculating EBITDA, and particularly whether earnings reflect taxable or accounting income, is left open in the consultation. This choice can be significant for calculating earnings (whereas many of the other differences in the ‘ITDA’ part of EBITDA will follow appropriately): for example, they may affect whether capital gains, tax exempt dividends, capital distributions (particularly from trusts) and/or losses are taken into account in earnings. Also relevant is how grouping works – is it accounting consolidation or just tax consolidated groups. To take an example, imagine a ‘stack’ of trusts: if they are not ‘grouped’ and tax EBIDTA / grouping applies, borrowings in a trust that is ‘higher up’ in the structure than the operating trust (a common structure to allow for effective security) could see denial of interest deductibility if debt happens to be capitalised when pushed down to the operating trust and amounts flowing up are returns of non-assessable capital / tax deferred amounts. That is, there could be negative consequences because of pre-existing choices of commercial structure if the rules are not designed appropriately.
Consultation and making submissions
Responses to the consultation are due by 2 September 2022. The consultation document sets out a series of 18 questions on the proposed thin capitalisation changes (and also on two other proposals around limiting tax deductibility of intangibles and royalties and further tax transparency and reporting measures).
If you would like our assistance in preparing a submission, please contact the authors or another of your King & Wood Mallesons tax contacts.