With just over three months before proposed changes to Australia’s thin capitalisation rules take effect on 1 July 2023, exposure draft legislation on the changes has finally been released for consultation.
In broad terms, the thin capitalisation rules apply to Australian entities which are foreign-controlled and/or which control foreign entities or have foreign branches. Such entities may be denied interest deductions to the extent that their debt exceeds “maximum allowable debt”. Currently, there are three methods for working out maximum allowable debt. The most common method is to work out the “safe harbour debt amount”. In our previous article on the proposed changes, Reassess your debt: proposed changes to Australia’s thin capitalisation rules, we provided an overview of the government’s proposal to change the calculation of the safe harbour debt amount from 60% of the value of Australian assets (or a debt-to-equity ratio of 1.5:1) to a cap on annual interest deductions at 30% of earnings before interest, taxes, depreciation and amortisation, and highlighted a range of issues to be addressed in the drafting of the changes.
Understanding Proposed Tax Law Changes: Key Features and Practical Implications for Taxpayers
The exposure draft now provides clarity on a number of the issues previously identified. In this article, we summarise the key features of the proposed changes and some of the practical implications for taxpayers. An unexpected inclusion in the draft legislation is the proposed denial of interest deductions on debt which fund investments in foreign subsidiaries. Under Australia’s tax laws, interest is ordinarily deductible when it is incurred in deriving assessable income. However, there are currently specific provisions which allow deductions for interest to fund investments in foreign entities notwithstanding that the returns on those investments may be exempt from tax. The exposure draft legislation proposes to repeal these provisions with effect from 1 July 2023.
At the outset, we highlight that the proposed changes are intended to take effect from 1 July 2023 with no grandfathering or transitional period. This means the changes may apply to existing debt, not just borrowings entered into on or after 1 July 2023. This is clearly potentially adverse to taxpayers who have borrowed on the basis of the existing safe harbour debt amount and may, for example, have modelled the viability of investments or projects based on interest deductions which may cease to be available in just over 90 days’ time.
Denial for deductions to fund foreign subsidiaries
As noted above, it is proposed that the ability of Australian entities to deduct interest used to fund investments in foreign entities where the distributions from those foreign entities are non-assessable non-exempt income will be removed. We do not believe this measure should be introduced. It was not previously announced and with the changes commencing from 1 July 2023, taxpayers will have very little time to restructure their financing (or restructuring may in fact not be commercially feasible).
If this measure is introduced, taxpayers will be required to trace the use of their borrowings, which could be a compliance-intensive and onerous exercise. Our view is that the Government should allow for additional consultation in relation to this proposed measure, for the measure to be omitted or for grandfathering to be allowed.
New thin capitalisation tests
The new thin capitalisation tests proposed by the draft legislation are the fixed ratio test, the group ratio test and the external third-party debt test. These tests will apply to “general class investors”. This new concept represents a consolidation of existing “general” classes of entities which are subject to the thin capitalisation rules (i.e. outward investors, inward investors or inward investment vehicles other than financial entities or approved deposit-taking institutions).
An entity chooses which test to apply for all of its debt deductions for an income year. The default test applicable to general class investors is the fixed ratio test, which is 30% of tax EBITDA.
Fixed ratio test
The key features of the fixed ratio test as set out in the draft legislation are summarised below.
Tax vs accounting EBITDA
One issue identified in our previous article was whether EBITDA would be based on accounting or tax figures. The draft legislation confirms that the fixed ratio test will be based on “tax EBITDA”, which is broadly an entity’s taxable income or loss for the income year (disregarding the operation of the thin capitalisation rules), and then adding back net debt deductions, deductions for depreciation, deductions for capital works and prior year tax losses deducted in the current year.
Carry forward of denied deductions
As recommended in our previous article and as foreshadowed in the Government’s Federal Budget of October 2022, taxpayers will be permitted to carry forward denied deductions for up to 15 years which can be used where there is an excess limit available under the fixed ratio test in subsequent years of income. This measure will address volatility concerns and will also ensure that entities engaging in projects which are initially loss making, e.g. construction projects or greenfield investments, will not permanently lose deductions for interest incurred during the early stages of those projects or investments.
However, the carry forward of denied deductions is subject to a modified continuity of ownership test. Generally speaking, companies can currently carry forward and recoup tax losses where they maintain the same majority underlying ownership. It is proposed that this continuity of ownership test would need to be satisfied in order to carry forward denied deductions under the thin capitalisation rules. Furthermore, unlike the loss recoupment rules, there is no scope to rely on the alternative business continuity test. This will be relevant in the context of mergers and acquisitions as a change in the majority ownership of an entity will result in a loss of these carried forward deductions (but subject to the provision for transfer of deductions into a consolidated group – see below).
Where a company with carry forward deductions joins a tax consolidated group, those deductions can be transferred to the group provided a modified continuity of ownership test is satisfied. Unlike losses which are transferred into a tax consolidated group, the availability of the deductions are not subject to a rate of utilisation.
Notably, if an entity does not use the fixed ratio test in a subsequent income year, the entity loses its ability to utilise any existing carry forward amounts.
Carry forward of excess capacity
There may be some income years in which an entity’s deductions for interest fall below 30% of tax EBITDA. In some countries, an entity is permitted to carry forward or carry back unused interest capacity. However, the exposure draft legislation does not, unfortunately allow for the carry forward (or carry back) of excess capacity.
Group ratio test
Currently, general class investors may be able to rely on the worldwide gearing debt test to determine their maximum allowable debt. This test will be replaced with a “group ratio test” which may allow an entity in a highly leveraged group to deduct net debt deductions in excess of the amount permitted under the fixed ratio.
The group ratio test is broadly available to entities which are members of a “GR group”, which is broadly a worldwide group with audited consolidated financial statements. The group ratio is based on the ratio of the worldwide group’s net third-party interest expense to the group’s EBITDA for an income year.
If an entity chooses to use the group ratio test, it will be required to keep specific records that are sufficient for a reasonable person to understand how the group ratio has been calculated. These records must be prepared by the time the entity is due to lodge its income tax return for the income year.
External third-party earnings limit
One of the other methods currently available to entities to work out maximum allowable debt is the arm’s length debt test (ALDT), which enables an entity to claim interest deductions on debt up to the amount a third-party lender would be willing to lend based on certain assumptions.
As previously announced by the Government, the ALDT is to be replaced for general class investors and financial entities (other than ADIs, which can continue to apply an arm’s length capital test) with an external third-party debt test. The explanatory materials to the draft legislation describe this test as a credit assessment test, in which an independent commercial lender determines the level and structure of debt finance it is prepared to provide an entity. Under this test, interest deductions will be denied to the extent that they exceed the entity’s external third-party earnings limit. The external third-party earnings limit is, broadly speaking, the interest deductions that would be available on debt that is issued by an entity to unrelated parties and which is used to fund Australian operations.
As such, these conditions aim to ensure that the external third-party debt test only captures genuine third-party debt which is used to wholly fund Australian operations, as opposed to offshore operations (i.e. deductions for related party debt will be entirely disallowed).
This test will be much narrower than the existing ALDT. This could have a significant impact for certain sectors such as private equity, which may fund their investments with related party debt.
Retention of Existing Exemptions in Thin Capitalisation
Existing exemptions such as the de minimis threshold for debt deductions of $2 million or less and the 90% Australian assets threshold exemption (for outward investing entities) will be retained.
In some countries which have introduced a fixed ratio test, there has been an exclusion from the application of the thin capitalisation rules to borrowings to fund the construction of public-benefit (e.g. public infrastructure) assets. The exposure draft legislation does not provide for any such exclusion.
Key takeaways: Plan Ahead for Proposed Tax Law Changes
As mentioned in our previous article, we would expect sectors which typically may be highly leveraged, such as real estate, construction and private equity, to be most immediately affected by the changes. Given that no grandfathering or transitional rules are proposed and the proposed changes are intended to take effect from 1 July 2023, taxpayers should be taking immediate steps to review the proposed changes and forecast their tax EBITDA in order to model the potential impact of the changes as well as the level of debt that can be supported under the revised thin capitalisation methods. As the carry forward of denied deductions only applies to the fixed ratio test, this should also be factored into the modelling.
Stakeholders have until 13 April 2023 to make a submission to Treasury.
Please contact one of our tax experts if you would like to discuss how the proposed changes to the thin capitalisation rules, may impact you.