Treasury have released for consultation new exposure draft legislation (ED) to make various amendments to the thin capitalisation and debt creation measures that were tabled in Parliament on 23 June (Bill). These changes follow on from the recommendations of the Senate Economics Committee report released on 22 September (see our alert on the Committee report here and the original legislation here).
The changes in the ED address a number of the issues raised in the over 50 submissions made to the Senate Economics Committee (Committee). Although, the ED includes many welcome adjustments to the thin capitalisation measures, including transitional rules and adjustments to limit the scope of the debt deduction creation rules and some equitable (albeit limited) changes for trusts, the core elements of the changes remain the same. That is:
- The new rules 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.
The new rules still represent a dramatic shift in Australia’s thin capitalisation rules, will present many practical challenges for taxpayers and are expected to result significant denials of debt deductions (Treasury forecast new revenue from the changes of $370m and $350m in the 2025 and 2026 financial years), which will be of particular concern for foreign investors who may have been planning Australian investments but may now think twice. We consider below the key elements of the new rules and proposed amendments.
Start date and transitional relief
There is no change to the start date for the new thin capitalisation rules: they will still apply from 1 July 2023 and, therefore, already apply for the current year despite not being finalised. However, it is now proposed that there will be some transitional relief from the debt deduction creation rules (see below).
Significant changes to debt deduction creation rules
The ED includes significant changes to the debt deduction creation rules that were surprisingly included, without prior consultation, when the broader thin cap changes were introduced into Parliament in June. Under the original drafting, the rules were intended to deny debt deductions in two scenarios, where debt:
- is created to fund the acquisition of an asset / legal or equitable obligation from an associate (acquisition debt);
- is issued to an associate and the proceeds are predominantly used to fund payments/distributions to an associate (financial arrangement debt).
The debt deduction creation rules were ostensibly intended to address concerns raised in Chapter 9 of the BEPS Action 4 Report, which suggested that targeted debt deduction creation rules may be required to address a number of risks that could remain where the fixed/group ratio test does not apply or even if it does.
However, the risks identified, which are the basis for the inclusion of the debt deduction creation rules, would in any case have arguably been covered by existing rules such as transfer pricing, the general anti-avoidance rules or thin cap measures (as amended).
Following significant concern raised by stakeholders in submissions to the Committee, the proposed amendments in the ED introduce substantial changes to debt deduction creation rules including:
- The introduction of a new ‘related party debt deduction condition’ which effectively limits the denial of deductions under the debt creation rules to related party debt. This change is welcome and consistent with the OECD’s recommendations regarding debt creation rules. The purpose of this change is stated to ensure that the rules are ‘appropriately targeted’.
- The availability of transitional relief until 1 July 2024 for debt created before 22 June 2023 (the rules will apply from 1 July 2024 for all debt regardless of when it was created).
- The exclusion of ADIs, insolvency remote special purpose vehicles and securitisation vehicles from the debt deduction creation rules.
There are also three new exceptions from the rules in respect of ‘acquisition debt’ to carve out:
- new membership interests in Australian entities and foreign companies;
- new depreciating assets (excluding IP); and
- certain related party debt.
The ‘financial arrangement debt’ test has now been broadened (it was previously limited to ‘debt interests’) but now includes two limited exceptions dealing with mere on-lending of third party debt to associates (on the same terms in relation to costs) or payments/distributions referable to repayment of the principal amount of debt owed to an Australian entity.
However, issues remain in terms of the complexity and breadth of the rules. Although the proposed amendments do narrow application of the debt deduction creation rules, the drafting approach is still to cast a wide net with limited exceptions – so entities creating debt will be covered until they can prove otherwise.
The debt deduction creation rules, as proposed to be amended, will still cover many purely domestic arrangements where there is no overall net increase in interest deductions or no net loss to revenue. For example, where assets are transferred between members of a group of Australian trusts (e.g., as part of portfolio rebalancing) and the consideration is in the form of a debt, the debt deduction creation rules could apply to deny deductions for the interest on the outstanding debt, even though there is no net loss to revenue from the transaction because interest on the debt should be assessable to the transferor.
The introduction of a simple overarching purpose test (i.e. transactions where the predominant purpose is to increase debt deductions in Australia or reduce assessable interest income in Australia) could have addressed some of these incongruous and, in some cases, inequitable outcomes and provided more certainty for taxpayers. This would also more closely align with what the OECD envisaged in the BEPS Action 4 Report.
As it stands, the debt deduction creation rules may still apply in many scenarios that are entirely commercially driven (and may have been entered into long ago) and do not include any offshore aspect that could be a threat to the revenue. Accordingly, the debt deduction creation rules will need to be considered:
- when any new debt arrangement is entered into;
- for all existing debts, however long ago the debt arrangements were entered into, during the current grace period which ends on 30 June 2024.
Changes to the third-party debt test
The third-party debt test is intended to replace 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.
Because the new third-party debt test is so narrow, borrowers which currently rely on the arm’s length debt test for existing debts may not comply with the third part debt test. Such borrowers may need to, for example, reconsider security arrangements to ensure compliance with the third-party debt test. These things need to be considered now because the new third-party debt test already applies from 1 July 2023.
If an election is made to apply the 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. In broad terms, the 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 Australian assets of the entity, but not in respect of rights under or in relation to guarantees, security or other forms of credit support; and
- the entity uses substantially all of the proceeds of the debt to fund commercial activities in connection with Australia.
The rules allow for conduit financing arrangements (which allow certain intergroup back-to-back debt arrangements to be effectively looked-though for the purposes of the third party debt test).
The proposed amendments only partially address the concerns raised by stakeholders.
- In a partial recognition of real-world financing arrangements, the proposed changes will permit a lender to hold security over shares or units in a borrower without falling outside of the third-party debt test requirements.
- Unfortunately, the proposed changes maintain the exclusion of debt in relation to which there is any form of credit support, except for in relation to certain investments in Australian real property.
- Minor amendments have been made to the broaden the scope of the conduit financier rules.
Ultimately, the third-party debt test is far narrower than the arm’s length debt test it is intended to replace (which is an intentional). Stakeholders raised many issues with the narrowness of the test on the basis that it will be unworkable in practice, particularly the strict requirements for on-lending within groups (conduit financier rules) and the limitations on recourse and security arrangements.
Debt capacity sharing for trusts
An important and welcome development is a provision to allow trust groups to share excess debt capacity, which is relevant to the fixed ratio test. Certain trusts will be able to access excess debt capacity for the purposes of applying the fixed ratio test (i.e., the default test) between members of the same trust group. In broad terms, these measures will apply to resident trusts that control other resident trusts via a greater than 50% interest in a 12-month period.
While this is a welcome development, because the provisions in the original Bill would have resulted in the inappropriate denial of debt deductions for groups of trusts that borrow at a holding trust, rather than an asset trust, level, it is unclear why there is a 50% requirement rather than a 10% requirement which would be more consistent with the broader operation of the provision (particularly given the exclusion from Tax EBITDA of distributions from 10% or more interests in sub trusts).
More broadly, it is important to note that the excess capacity sharing changes are only available to trust groups and not to other entities which may have trust or partner distributions excluded from Tax EBITDA as the same issue arises for any entity (broadly with a 10% or more interest) that derives income from a trust, partnership or a company (albeit changes have now been made to limit this to ‘associates’).
We consider the appropriate policy should be that where income is excluded from Tax EBITDA then excess capacity sharing should be available, regardless of the entity type.
Technical changes for trusts
The proposed amendments also include some important and sensible technical changes for trusts:
- Attribution managed investment trusts (AMITs) will be able to apply the fixed ratio test (an oversight in the original legislation).
- Trusts and partnerships are now entitled to access the third-party debt test (again, an oversight in the original drafting).
What next
The consultation period for these proposed changes is currently open and will conclude on 30 October.
If you would like to discuss the proposed reforms and how the new rules may impact your business, please contact one of the authors or your KWM contact.
