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Non-bank lenders: key issues in the thin capitalisation amendment bill

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We have been considering the implications for non-bank lenders of the recently released Treasury Laws Amendment (Making Multinationals Pay Their Fair Share—Integrity and Transparency) Bill 2023 (Bill). The first version of these reforms was released in the March 2023 Exposure Draft (ED). 

The Bill, among other things, includes significant reforms to the thin capitalisation regime in Division 820 of the Income Tax Assessment Act 1997 (Cth) (1997 Act). The changes are to operate with retrospective effect from 1 July 2023.

Key issues for non-bank lenders include:

  • Practical difficulties arising from the amended definition of ‘financial entity’.
  • Tips and traps in applying the ‘third party debt test’.
  • Extension of the exemption for special purpose insolvency remote vehicles to ‘general class investors’.

Amended definition of ‘financial entity’

Concerns were expressed about the impact of the proposed changes to the definition of ‘financial entity’ on non-bank securitisation industry participants.

The ED had wholesale deleted the category of ‘a registered corporation under the Financial Sector (Collection of Data) Act 2001’ (FSCODA), which would have resulted in many entities that were previously able to rely on the concessional thin capitalisation tests for ‘financial entities’ being classified as ‘general class investors’. The benefit of being a ‘financial entity’ is that an entity is able to access the existing asset-based rules, which are generally more favourable to taxpayers than the new earnings-based tests. General class investors must apply the ‘fixed ratio test’ unless they elect to apply the new ‘third party debt’ or the ‘group ratio’ tests.

The Bill restores the category of FSCODA registered entities in the definition of ‘financial entities’ but limits it to entities that carry on a business of providing finance, not predominantly directly or indirectly to or on behalf of their associates, where all or substantially all of their profits are derived from that business. While not helpful for entities that carry on hybrid financial businesses which also derive other types of profits and vague in parts, this is a middle ground which covers off on Treasury’s concerns about too many non-financial entities being registered under the FSCODA.

The ATO may need to provide guidance on what is meant by the new phrase ‘not predominantly for the purposes of providing finance directly or indirectly to, or on behalf of’ associates.

Third party debt test

The third party debt test replaces the arm’s length debt test for general class investors and financial entities. The new test is far narrower than the arm’s length debt test. The requirements of the test may need to be taken into consideration when negotiating loan agreements with certain borrowers.

In broad terms, a ‘debt interest’ satisfies the ‘third party debt conditions’ if:

  • it is issued by an Australian resident entity to an entity which is not an associate entity of the issuer;
  • the holder of the debt interest has recourse for payment of the debt only to the Australian assets of the entity that are not rights under or in relation to a guarantee, security or other form of credit support; and
  • the entity uses all, or substantially all, of the proceeds of issuing the debt interest to fund its commercial activities in connection with Australia.

The exclusion of debts of borrowers that have the benefit of a guarantee, security or other form of credit support significantly limits the types of borrowers that will be able to rely on the third party debt test which is likely to have other flow-on effects in the lending market.

Another potential side effect of this requirement may be that when a multinational buyer seeks to acquire a business that has assets in both Australia and other jurisdictions, the buyer may choose to use separate acquisition vehicles to acquire the Australian business on the one hand, and the foreign business on the other.

The expansion of the use limitation on funds raised from the issue of a relevant debt interest from ‘wholly’ funding Australian investments and operations in the ED to requiring that ‘substantially all’ of the proceeds fund commercial activities in connection with Australia is welcome and should provide flexibility for borrowed funds to be used in relation to some offshore operations and activities that do not constitute an offshore permanent establishment.

Extension of exemption for special purpose insolvency remote vehicles to ‘general class investors’

To the relief of participants in the securitisation industry, the current exemption from the thin capitalisation rules for special purpose insolvency remote vehicles in section 820-39 has now been extended to entities classed as ‘general class investors’.

This allays concerns expressed by the securitisation industry that many special purpose vehicles could inadvertently be subject to denials of debt deductions under the thin capitalisation rules despite a clear previous policy decision to exempt such entities from the regime.

Please do reach out to us to discuss any of the issues mentioned in this piece, particularly if you have any questions about how the current reforms apply to you, or if you want to explore the wider opportunities our non-bank lender team could present for you and your business.

KWM’s non-bank lender team is at the cutting edge of developments in the sector and are well placed to work with any client on their future needs from established players to new entrants from the fintech industry. 

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