As part of its commitment to ensure that multinational enterprises (MNEs) pay their fair share of tax in Australia, the Government announced a multinational tax integrity package in the lead up to the federal election earlier this year. A consultation paper was recently released by Treasury which seeks feedback on some of the measures contained in that package, namely, proposed changes to the thin capitalisation rules, a denial of deductions for royalties which are ultimately received by residents of tax havens, and enhanced tax transparency requirements (Consultation Paper).
In this article, we discuss what the proposed thin capitalisation changes are and what they practically mean for MNEs. The gist of the proposal is to replace the existing ‘safe harbour debt test’ (which is based on the value of a MNE’s Australian assets) with an ‘earnings-based’ test. We would expect sectors which typically may be highly leveraged, such as infrastructure, real estate, construction and private equity, to be most immediately affected by the changes.
Overview of Australia’s thin capitalisation rules
Australia’s thin capitalisation rules limit deductions for interest to the extent that debt exceeds the ‘maximum allowable debt’. The rules broadly apply to Australian entities which are foreign-controlled and/or which control foreign entities. Currently, there are three methods for working out maximum allowable debt for such entities. The most common method is to work out the ‘safe harbour debt amount’, which broadly allows an entity to gear up to 60% of the book value of a company’s Australian assets (or a debt-to-equity ratio of 1.5:1).
There is also an ‘arm’s length debt amount’, 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, and a ‘worldwide gearing debt amount’ pursuant to which an entity may gear its operations by reference to the level of gearing in its worldwide group.
There are some exceptions to the thin capitalisation rules. For example, they do not apply where an entity’s (and its associates) deductions for interest are A$2 million or less for a particular income year (otherwise known as the de minimus threshold).
What is the Government’s proposal?
As noted earlier, a commonly used method to work out an entity’s maximum allowable debt under the thin capitalisation rules is the calculation of the safe harbour debt amount, which currently allows gearing up to a debt-to-equity ratio of 1.5:1. Broadly, the Government is proposing to replace this calculation with a cap on interest deductions for an income year up to 30% of earnings before interest, taxes, depreciation and amortisation (EBITDA limit). No changes are proposed to the calculation of the arm’s length debt or the worldwide gearing debt amounts.
The OECD issued its final report in 2015 on Limiting Base Erosion Involving Interest Deductions and Other Financial Payments, and recommended an EBITDA limit for thin capitalisation purposes. A similar approach has been adopted by various jurisdictions, including the United States and the United Kingdom. This limit involves:
- Calculating earnings - EBITDA is calculated by adding back to taxable income the tax values for net interest expense, depreciation and amortisation. The OECD recommends that EBITDA should exclude non-taxable income such as branch profits or dividend income which benefits from a participation exemption. The Consultation Paper is currently seeking feedback as to whether the calculation of EBITDA should rely on accounting or tax figures, however notes that “tax EBITDA” is preferred.
- Applying the statutory benchmark fixed ratio to earnings - This is proposed to be 30% in Australia. The OECD recommends countries set their statutory benchmark fixed ratio within a corridor of 10% to 30%. A ratio of 30% proposed in Australia is aligned to international counterparts such as the United Kingdom.
- Comparing maximum deductible interest expense with actual interest expense - Any amounts in excess of the maximum deductible interest expense as calculated above would be denied (i.e. permanent or temporary add-back).
The policy behind the EBITDA limit is to ensure that an entity’s interest deductions are directly linked to its economic activity.
Specific design considerations
There are a range of considerations relevant to the design of the EBITDA limit. Some of the key considerations are discussed below.
A disadvantage of the proposed approach is the potential volatility in earnings, which is currently foreshadowed in the Consultation Paper. This may make it difficult for some groups to anticipate the level of the interest deduction that is available from year to year. One way of addressing this issue would be to allow for an average EBITDA based on the current year and the preceding two or three years. However, this would however only deal with short-term volatility and would also not help a group which incurs interest expenses in the early stages of a project and not expected to generate EBITDA until sometime in the future.
Carry forward of denied deductions
Although not specifically mentioned in the Consultation Paper, we consider that groups should have an ability to carry forward denied interest deductions. Provided the payment of interest does not have a purpose of base erosion or profit shifting, permanently denying interest deductions would be undesirable where an entity is funding a project which will generate future earnings, or where fluctuations in EBITDA were due to circumstances outside of the entity’s control. There have been various jurisdictions which have implemented this measure but with variations, such as timing and monetary limits.
Carry forward of excess capacity
Conversely, there may be some income years in which an entity’s deductions for interest fall below 30% of EBITDA. The OECD report provides that countries may choose to allow entities to carry forward or carry back unused interest capacity. Similarly, the Government should also consider the possibility for MNEs to carry forward such unused capacity for use in subsequent years of income as this would reduce the impact of volatility in group earnings on an entity’s ability to deduct interest expense.
In some countries which have already adopted an EBITDA limit, interest deductions on debt attributable to privately-owned public-benefit assets are excluded from the EBITDA limit since the nature of such assets and the close connection with the public sector means there is little or no base erosion or profit shifting risk.
Group ratio rule
Groups in different sectors may be leveraged differently. As such, if the EBITDA limit were applied in isolation, groups with net interest expenses in excess of the limit would suffer a denial of deductions for the excess. The OECD suggests that groups be permitted to work out their maximum interest by reference to a group ratio, for example, equity as a proportion of total assets or the group’s net third party interest expense as a proportion of the group’s EBITDA.
The changes are targeted at general entities as defined in the current thin capitalisation rules. Financial entities and authorised deposit-taking institutions are proposed to be excluded from the changes in the interim.
It is not evident in the Consultation Paper as to whether there would be any grandfathering or transitional periods to be implemented generally, in particular, in relation to the tax treatment of existing debt entered into before 1 July 2023. The Consultation Paper is however seeking feedback as to what should be considered a reasonable transition period to introduce any changes to the arm’s length debt test (in light of the overall proposed thin capitalisation changes).
The finer details of the proposed changes to the thin capitalisation rules are still to be developed. With long-term projects, groups may need to forecast expected profitability in order to estimate their tax payable after taking into account allowable interest deductions, although we would expect this to be conducted as part of their feasibility studies. Some groups will also need to explore the viability of relying on the arm’s length or worldwide gearing debt test where they are disadvantaged by the EBITDA test, which may lead to an increase in compliance costs. The arm’s length debt amount, in particular, is compliance intensive and requires an economic analysis from year to year. It has also been a compliance focus of the ATO in recent years and the Consultation Paper is currently seeking feedback as to whether changes are required for this alternative test.
As mentioned previously, 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. However, not all industries should be adversely affected, in particular, those entities that have high profitability and are less capital intensive (such as service and some technology-based companies).
The proposed change by the Government can broadly be seen as a move to align with market and commercial practice. For example, with cash flow-based lending, although there are several risk factors considered by lenders, the borrower’s EBITDA is often a significant consideration. There is usually not a specific limit imposed by lenders based on EBITDA, but the multiple applied would depend on the circumstances of the case (for example, a riskier lend could be a low multiple of 4.00x of EBITDA whereas for infrastructure it can be as high as 14.00x of EBITDA). As such, a “one-all fit size” rule to the EBITDA limit to be implemented by the proposed changes would not be appropriate across all industries, and additional mechanisms should be considered by the Government such as allowing a carry forward of disallowed interest deductions and unused interest capacity.
Given the proposed thin capitalisation changes are expected to apply from 1 July 2023, MNEs can commence modelling of the potential impact of the changes as well as the level of debt that can be supported under the alternative thin capitalisation methods.
The Consultation Paper complements the Government’s ongoing engagement in the OECD’s Two-Pillar Global Tax Agreement, which includes a global minimum tax. We would expect further information to be released on this in due course.
Please contact one of our tax experts if you would like to discuss how the proposed changes to the thin capitalisation rules, and any other proposed multinational tax integrity changes, may impact you.