Following a lengthy consultation process, Treasury Laws Amendment (Making Multinationals Pay Their Fair Share - Integrity and Transparency) Bill 2023 (the Bill) was introduced into Parliament on 22 June, containing measures which will significantly change Australia’s thin capitalisation rules and which will reduce the scope for interest deductions for a wide range of taxpayers.
These changes are part of the Government’s multinational tax integrity package announced as part of their election campaign, which initially only proposed to replace the safe harbour debt amount to work out a taxpayer’s maximum allowable debt under the thin capitalisation rules (although there has been considerable discussion in relation to amending the Arm’s Length Debt Test (ALDT)), with an earnings-based test. Under this commonly used method, taxpayers are currently permitted to gear up to a debt-to-equity ratio approximating 1.5:1 but, from 1 July 2023, this method will be replaced with a cap on interest deductions for an income year up to 30% of EBITDA, which is based on the concept of “tax EBITDA” (fixed ratio test).
However, the proposed changes to the thin capitalisation rules have progressively morphed throughout the consultation process which commenced in August last year, culminating in the Bill which, in addition to the new fixed ratio test, introduces a new third party debt test to replace the current arm’s length debt test, and a new group ratio test which will replace the worldwide gearing debt test for most taxpayers.
Furthermore, a surprise addition in the Bill is the proposed introduction of a new “debt creation” rule as a separate measure to the thin capitalisation changes. There are two scenarios in which debt deductions can be denied under this rule:
- an entity borrows to acquire an asset (or an obligation) from an associate; and
- an entity borrows from an associate to fund a payment it will make to that entity or another associate.
The provisions are very broadly drafted. For example, if a company borrows to acquire shares in a subsidiary in the same corporate group, the interest expenses on that borrowing would not be deductible, or if a company debt funds a dividend by borrowing from a shareholder which sufficiently influences or controls the company, the interest deductions could also be denied.
The debt creation rule is supplemented by an anti-avoidance measure which applies to schemes which have a principal purpose of avoiding the application of the rule.
The debt creation rule only applies to entities that are subject to the thin capitalisation rules. However, we note that there are no transitional rules and that the debt creation rule may apply to deny interest deductions for arrangements that were in place before 1 July 2023. Given that there has been no previous consultation on this rule, it seems very inequitable to potentially deny taxpayers deductions for pre-1 July 2023 arrangement without providing them with an opportunity to restructure any affected arrangements.
Although the changes will take effect from 1 July 2023, it was not passed during the last sitting of Parliament. We also note that the Bill has been referred to the Senate Economics Legislation Committee who is due to report on 31 August 2023.
Notable changes since the previously announced exposure draft
Key aspects in relation to the changes to the thin capitalisation rules have been broadly maintained. However, there have been some notable changes since the previously released exposure draft, which we have summarised below.
For the fixed ratio test, EBITDA is 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 and deductions for capital works. However, some of the key changes from the exposure draft include:
- All capital allowance and capital works deductions are added back in working out tax EBITDA, except to the extent they are immediately deductible. For example, blackhole deductions spread over five years are now added in working out tax EBITDA, which is important in the context of mergers and acquisition activity and capital-intensive industries such as real estate and infrastructure;
- Deductions for utilisation of prior year tax losses are no longer added to the calculation of tax EBITDA;
- Amounts of franked credits and dividends are not included in calculating tax EBITDA;
- A regulation power will be introduced to ensure the rules surrounding tax EBITDA calculation can be readily updated if further adjustments are required.
Carry forward of denied deductions
As announced previously, taxpayers will be permitted to carry forward denied deductions for up to 15 years which can be used where there is an excess capacity available under the fixed ratio test in a subsequent year of income. This measure will address volatility concerns and will also ensure that entities engaging in projects which are initially loss making, e.g. start-ups, tech firms, construction projects or greenfield investments, will not permanently lose deductions for interest incurred during the initial capital-intensive stages.
In the exposure draft legislation, the carry forward of denied deductions was proposed to be subject to a modified continuity of ownership test without any scope to rely on the alternative business continuity test. The Bill now provides that taxpayers will be able to apply the business continuity test, similar to carried forward tax losses, where the continuity of ownership test is not passed. This will be relevant in the context of mergers and acquisitions where there may be a change in the majority ownership of an entity with carried forward denied deductions.
If a taxpayer entity chooses another test in a subsequent income year, the entity loses the ability to carry forward denied deductions. However, it has now been clarified that the mere fact that the thin capitalisation rules do not apply in a subsequent income year will not result in carry forward denied deductions being lost.
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 the 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. This test largely remains unchanged since the exposure draft. Notably, it is clarified that the GR group cannot be comprised of just one entity.
Third party debt test
One of the other methods currently available to entities to work out maximum allowable debt is the ALDT, which enables an entity to claim interest deductions on debt up to the amount an independent third party lender would be willing to lend based on certain assumptions.
As announced previously, the ALDT will be replaced from 1 July 2023 for general class investors and financial entities (other than ADIs, which can continue to apply an arm’s length capital test) with a third party debt test. If the third party debt test applies for an income year, the amount of an entity’s debt deductions that is disallowed is the amount by which the entity’s debt deductions exceed the entity’s “third party earnings limit”, which is the sum of the debt deductions that satisfies the “third party debt conditions”.
We note however that the availability of the third party debt test is still restrictive. For example, a lender to the taxpayer must only have recourse to the “Australian assets” of the taxpayer and “all, or substantially all”, of the proceeds of the debt must be used by the taxpayer to fund commercial activities in Australia. As such, the intention is that the third party debt test only captures third party debt used to fund Australian business operations, not offshore operations.
The Explanatory Memorandum provides that the term “all, or substantially all” is to cover where proceeds are used for the relevant activities, but accommodating a minor or incidental use of the proceeds for other activities.
Recourse to assets of an entity that are rights under a guarantee, security or other form of credit support will be prohibited, with an exception being where the credit support relates to the creation or development of real property in Australia. Also, as an update against the exposure draft, a new requirement under the third party debt conditions is that the debt interest must be issued by an Australian resident (i.e. the third party debt test is now limited to Australian residents only).
If a taxpayer uses the third party debt test, it was previously proposed that all associate entities would be required to use it (i.e. certain taxpayers would be deemed to have made a choice to use the third party test if certain conditions were satisfied). For example, this would potentially have required all portfolio companies held by a fund vehicle to use that test. While there is still an associate entity requirement contained in the legislation (but with a 20% rather than a 10% threshold), it now only picks up associates entities in the same “obligor group” (which is a new concept) or entities that have entered into a cross staple arrangement together. An entity is a member of an obligor group if the creditor of the debt interest has recourse for payment of the debt to the assets of the entity. It is also intended to capture all members of consolidated groups and multiple entry consolidated groups. This is a welcome change, in particular, for private equity funds that hold independent and unrelated portfolio companies, in which it would have been potentially impractical to apply the previous rules proposed under the exposure draft.
Meaning of debt deduction and net debt deduction
The definition of debt deduction and net debt deduction is important in applying the thin cap rules. The legislation further broadens the definition, such as to include an amount that is economically equivalent to interest. It is intended that payments under interest rate swaps are captured in the definition. Consistent with the previously released exposure draft, a cost incurred by an entity does not need to be incurred in relation to a debt interest issued by the entity for the cost to be a debt deduction.
Denial for deductions to fund foreign subsidiaries
It was previously proposed that the ability of Australian corporate entities to deduct interest used to fund earnings from investments in foreign entities would be removed. Following submissions made by industry, the Government has deferred (but not necessarily abandoned) the proposed amendments to sections 25-90 and 230-15. However, the newly introduced debt creation rules may act as a brake because it may stop further debt funded investment in foreign entities in certain circumstances.
Other multinational tax integrity measures
The Bill also contains the new transparency rules requiring Australian public companies (listed and unlisted) to disclose information about subsidiaries in their annual financial reports, commencing for financial years on or after 1 July 2023. Such entities will be required to provide a “consolidated entity disclosure statement” as part of their annual financial reporting obligation. Information that will be required to be disclosed include names and tax residency of entities in the group, and their entity types.
Measures relating to the intangible deductions, country by country public reporting and the public register of beneficial ownership are not included in the Bill. We note however that Treasury has released revised exposure draft legislation in relation to the intangible deductions.
As we have highlighted previously, we consider the thin capitalisation changes to be of relevance to those sectors which typically may be highly leveraged, such as real estate, construction and private equity. In relation to the revised thin capitalisation methods and the proposed debt creation rule, given that there are no grandfathering or transitional rules and the changes take effect from 1 July 2023, taxpayers should take immediate steps to review the changes and model the impact of the changes as well as the level of debt that can be supported.
Please contact one of our tax experts if you would like to discuss how the proposed changes to the thin capitalisation rules, and more broadly, the multinational tax integrity changes, may impact you.