In line with the amendments announced in the 2022-23 Federal Budget, the Treasury yesterday released the Exposure Draft and Explanatory Memorandum amending the thin capitalisation rules (available here).
These amendments represent a wholesale change to Division 820 of the Income Tax Assessment Act 1997 (Cth) (“1997 Act”). Like many recent changes to Australia’s taxation laws, the thin capitalisation amendments are intended to implement the OECD Base Erosion and Profit Shifting (BEPS) Action Items: in this case, Action Item 4, “Limitation on Interest Deductions”. Similar rules have been enacted in the UK, US and much of the European Union.
The amendments replace the current asset-based rules with debt deduction limitations based on “tax EBITDA” for all types of entities except for financial entities (the definition of which has been narrowed significantly) and authorised deposit-taking institutions (“ADIs”). They also replace the arm’s length debt test with a test limited to actual third party debt, applicable to all entities but ADIs.
These amendments have the potential to substantially curb the ability of taxpayers who are subject to the thin capitalisation rules to claim debt deductions in Australia.
There is no grandfathering for existing debt, no transitional period, and no significant exemptions for particular sectors or entity types other than financial entities and ADIs.
A previously unannounced measure included in the Exposure Draft is the removal of the deductions previously available under sections 25-90 and 230-15(3) of the 1997 Act for interest expenses incurred to derive certain foreign equity distributions (being those treated as non-assessable non-exempt income under section 768-5).
The new rules will apply to income years commencing on or after 1 July 2023.
Given the extensive changes to the rules (including the potential for entities to make irrevocable elections concerning which test they are subject to), all taxpayers subject to the thin capitalisation rules should familiarise themselves with the new rules and understand its impact on their business. The timeline for enactment means taxpayers will need to consider their position – including any necessary restructuring – very quickly. In the current economic environment of higher interest rates, the economic effect of denied debt deductions may be punitive.
General class investors
The amendments introduce the singular concept of a “general class investor”, which replaces the separate concepts of “outward investor (general)”, “inward investment vehicle (general)” and “inward investor (general)”. This categorisation covers all entities subject to the thin capitalisation rules except for “financial entities” and ADIs.
“General class investors” are intended to be Australian entities carrying on business in a foreign country via a PE or a controlled entity, Australian entities controlled by foreign residents, and foreign entities with investments in Australia
For general class investors, the amendments introduce the “fixed ratio test” (the default method), the “group ratio test” and the “external third party debt test”. Importantly and contrary to the current rules, general class investors now must make an irrevocable election to apply either the group ratio test or external third party debt test.
The default fixed ratio test disallows deductions to the extent that the general class investor’s net debt deductions exceed 30% of its tax EBITDA.
Tax EBITDA is worked out by calculating the entity’s taxable income or tax loss, then adding back net debt deductions, decline in value (only those amounts under the core provisions in Subdivision 40-B of the 1997 Act – not including, for example, balancing adjustments and project pools) and capital works deductions under Division 43, and prior year tax losses.
Importantly, the fixed ratio test is calculated using net debt deductions, rather than all debt deductions. An entity’s net debt deductions are worked out by taking its debt deductions, then subtracting all amounts included in the entity’s assessable income which are interest, in the nature of interest or otherwise calculated by reference to the time value of money.
To the extent debt deductions are disallowed, those amounts (known as “FRT disallowed amounts”) are carried forward for up to 15 years, provided the entity passes a modified version of the continuity of ownership test. This concession is intended to address concerns about earnings volatility, but is only available to general class investors using the fixed ratio test. Special rules have been introduced where an entity with FRT disallowed amounts joins a consolidated tax group.
If an election is made to apply the group ratio test, an entity’s debt deductions are disallowed to the extent its net debt deductions exceed the entity’s “group ratio earnings limit” for the income year.
The calculation of the “group ratio earnings limit” is complex, but is based on the third party interest expenses disclosed in the audited consolidated financial statements of the group parent for the period, with some adjustments.
The carry-forward concessions discussed above are not available for taxpayers electing to apply the group ratio test.
This test replaces the arm’s length debt test for both general class investors and financial entities. ADIs can still access the existing arm’s length debt test. The new test is far narrower than the arm’s length debt test.
If an election is made to apply the external third party debt test, an entity’s debt deductions are disallowed to the extent that they exceed the entity’s debt deductions attributable to third party debt. Notably, this is calculated by reference to all of the entity’s debt deductions, rather than the entity’s net debt deductions.
If a general class investor wishes to apply the external third party debt test, and it has associate entities which get the benefit of an thin capitalisation exemption under the de minimis threshold, asset threshold or as an insolvency-remote special purpose vehicle, all of those entities must also elect to apply this test. An entity’s “associate entities” are determined based on a modified version of section 820-905, with amendments for super funds.
Third party debt is included in the calculation if:
- it is issued to an entity which is not an associate entity of the issuer,
- it is not held by an associate entity at any time in the income year,
- the holder of the debt interest has recourse for payment of the debt only to the assets of the entity; and
- the entity uses the proceeds wholly to fund assets which are attributable to an Australian PE or that it holds for the purposes of producing assessable income, or its Australian operations.
This would appear to exclude external debt which has the benefit of a guarantee (potentially even including third party guarantees), as well as causing issues for Australian entities which borrow and lend to other group entities, though concessions are made for conduit financing. The conduit financing concessions appear to be too restrictive for most typical financing companies, and include the requirement that the funds are on-lent on identical terms apart from quantum.
The carry-forward concessions discussed above are not available for taxpayers electing to apply the external third party debt test.
While this test is very narrow, it could be suitable for entities which are expected by the market to be highly geared. For example, it may of interest to project finance vehicles, foreign-owned banks, entities with exposure to regulated assets, or other types of entities which only use external, non-guaranteed debt.
Financial entities and ADIs
Financial entities and ADIs remain able to access the existing thin capitalisation rules, except for the arm’s length debt test, which is being replaced by the external third party debt test (for financial entities only – discussed above).
The amendments narrow the concept of “financial entity” in section 995-1(1) by deleting paragraph (a) of that definition: a registered corporation under the Financial Sector (Collection of Data) Act 2001 (Cth).
Transfer pricing
A taxpayer’s associate entity debt still remains subject to the transfer pricing rules in Division 815 of the 1997 Act, though the associated debt deductions are now subject to the changed limits in the thin capitalisation rules. Importantly, the proposed amendments to Division 815 will now require general class investors to ascertain the arm’s length quantum of debt in addition to other arm’s length conditions such as price. Currently, section 815-140 applies such that the arm’s length interest rate ascertained for transfer pricing purposes is applied to the quantum of the debt interest actually issued by a taxpayer.
General comments
The concept of “debt deductions” in section 820-40 is significantly expanded. The amendments remove the existing requirement that the cost be incurred “in relation to a debt interest issued by the entity”, and make other amendments which include in the definition costs incurred under broader schemes giving rise to debt interests – not necessarily only schemes involving debt interests issued by the relevant taxpayer.
Some existing concessions appear unaffected: the section 820-35 de minimis $2 million threshold, the section 820-37 assets threshold, and the section 820-39 exemption for highly geared, insolvency-remote special purpose vehicles.
Conclusion
The amendments represent a substantial change to the thin capitalisation rules in Australia. Taxpayers have only been given a very short period of time for consultation and familiarisation with the rules before they are enacted. If taxpayers wish to restructure their affairs in light of these changes, they will need to move quickly.
Taxpayers may wish to consider replacing any existing related party debt with third party debt or equity.
Taxpayers may also need to reconsider their ownership structures in light of the amendments to sections 25-90 and 230-15(3)(c) of the 1997 Act, removing the deductions for interest expenses incurred to derive certain foreign equity distributions.
Stakeholders have until 13 April 2023 to make submissions to the Treasury.
Please contact us if you wish to discuss the potential impact of these new rules on your business.
