The Australian Federal Government released Exposure Draft (ED) legislation on 16 March 2023, intending to implement thin capitalisation measures announced in the October 2022 Federal Budget. Primarily affecting multinational companies with high interest deductions, these measures will apply to income years starting from 1 July 2023.
Read more on Federal Budget Report 2023.
This Andersen Tax Brief sets out an analysis of the new ED and what businesses might look out for.
Introduction
Australia’s thin capitalisation regime is designed to limit debt deductions by restricting the amount of interest deductions a company can have based on its level of assets. The proposed amendments in the ED build on the OECD’s base erosion and profit shifting (BEPS) project which outlines using third party, related party, and intragroup debt to generate excessive deductions for interest and other financial payments as one of the simplest profit-shifting techniques available in international tax planning.
Proposed New Law
General Class Investors: New Definition and Rules
1. Who is a general class investor?
The ED introduces a new definition for ‘general class investors’, replacing the existing ‘general’ classes of entities. Entities falling under this new definition must apply one of the new thin capitalisation tests. Those not falling under it will continue to be subject to existing tests, except for the arm’s length debt test, which is being replaced.
An entity is considered a ‘general class investor’ if it meets specific criteria and is not a financial entity or an ADI for the entire income year. The new definition encompasses Australian entities conducting business in a foreign country or controlled by foreign residents, as well as foreign entities with investments in Australia. Thin capitalisation rules are generally more favourable for entities that are not general class investors.
- New Thin Capitalisation Tests
Under the ED, a general class investor may lose some or all of their debt deductions for a given year. The extent of the deduction disallowed is determined by applying one of the three new thin capitalisation tests:
- The Fixed Ratio Test (FRT)
- The Group Ratio Test (GRT)
- The External Third Party Debt Test
The entity can choose which test to apply to all of their debt deductions for that year.
you can read more on International tax.
The Fixed Ratio Test
- Limitations and Calculations
The FRT limits debt deductions to 30% of an entity’s “tax EBITDA” for the year. If an entity’s net debt deductions exceed this limit, the excess amount is disallowed and cannot be used to reduce the entity’s taxable income. “Tax EBITDA” is calculated by adding net debt deductions, decline in value and capital works deductions, and tax loss deductions to taxable income. Net debt deductions are calculated by subtracting the amount of interest income from the amount of debt deductions.
- Carry Forward Provisions
The FRT ensures that a portion of an entity’s profit remains subject to tax in Australia and cannot be reduced by excessive debt deductions. Where a debt deduction is denied under the FRT, it permits the debt deduction to be carried forward for up to 15 years, subject to modified Continuity of Ownership Test and tax consolidation rules, to be used in a future year where there is excess limit available under the FRT. This carry forward is not available for the alternative tests described below.
The Group Ratio Test (GRT)
- Limitations and Calculations
If the GRT is chosen, the amount of an entity’s debt deductions for an income year that are disallowed is the amount by which the entity’s net debt deductions exceed the entity’s group ratio earnings limit for the income year. An entity’s ‘group ratio earnings limit’ for an income year is its ‘group ratio’ for the income year multiplied by its tax EBITDA for the income year. The group ratio is calculated based on information contained in the audited consolidated financial statements for the GR group parent for the group for the period corresponding to the relevant income year. In certain circumstances, taxpayers will be required to make adjustments to the amounts disclosed in the audited consolidated financial statements to include amounts akin to interest and disregard specific payments to associate entities.
- Group Ratio Calculation Steps
To calculate the group ratio, the following steps must be taken:
a) Step 1: Determine the GR group net third party interest expense of the GR group.
b) Step 2: Determine the GR group EBITDA of the GR group.
c) Step 3: Divide the result of Step 1 by the result of Step 2. The result of this division is the entity’s group ratio for the income year, subject to Step 4.
d) Step 4: If the result of Step 2 is zero or less, the entity’s group ratio for the income year is zero.
- Record-Keeping Requirements
Entities are required to prepare and keep records of how they worked out their group ratio, including the particulars that have been taken into account in working out the group ratio. The entity must prepare the records by the time the entity is due to lodge its income tax return for the income year. The purpose of specific record-keeping rules is to ensure that entities may work out their group ratio using information that is not publicly available, or have made certain adjustments to their calculations on a self-assessment basis.
Financial Entity and ADI Definitions and Tests
The definition of ‘financial entity’ remains largely the same as the existing rules; however, there is a slight amendment to narrow the definition in section 995-1 to remove paragraph (a) as an integrity feature. The definition of ‘ADI’ (authorised deposit-taking institution) remains unchanged.
‘Financial entities’ and ADIs continue to have access to the existing thin capitalisation tests (with the exception of the arm’s length debt test, which is being replaced by the external third-party debt test for all entities previously subject to it).
External Third-Party Debt Test
- Overview and Test Scope
The External Third-Party Debt Test limits an entity’s debt deductions to those attributable to external third-party debt, replacing the previous arm’s length debt test for general class investors and financial entities.
The External Third-Party Debt Test is a simpler and more streamlined credit assessment test based on the determination of debt finance by independent commercial lenders. The test is specifically designed for Australian operations and investments and balances tax integrity policy with ensuring genuine commercial arrangements are not impeded. Authorised Deposit-taking Institutions (ADIs) will continue to have access to the arm’s length capital test.
- Calculating Disallowed Debt Deductions
If your entity chooses to use the External Third-Party Debt Test for an income year, any disallowed debt deductions for the year are determined by subtracting the entity’s external third-party earnings limit from its total debt deductions. An entity’s external third-party earnings limit is the sum of each debt deduction that satisfies the external third-party debt conditions.
- External Third-Party Debt Conditions
To meet the external third-party debt conditions, the debt interest must be issued to a non-associate entity, not be held by an associate entity, have recourse for payment only to the issuing entity’s assets, and be used solely to fund Australian operations or investments related to Australian permanent establishments. Conduit financer arrangements can also satisfy these conditions if certain criteria are met.
If a conduit financer satisfies the criteria, it can issue a debt interest to an ultimate lender that satisfies the external third-party debt conditions, even if the ultimate lender is an associate of the conduit financer. This ensures that the test focuses on the underlying borrowing by the ultimate borrower from the external lender.
Consolidated and Multiple Entry Consolidated (MEC) Groups
- Application of Tests to Group Entities
The new thin capitalisation tests (FRT, GRT, and External Third-Party Debt Test) apply at the head company level for consolidated groups and MEC groups. The head company will be responsible for applying the chosen test to the group, taking into account the group’s debt deductions, tax EBITDA, and other relevant factors.
- Carry Forward of Debt Deductions
If a debt deduction is disallowed under the FRT for a group, the head company may carry forward the disallowed debt deduction for up to 15 years. The carry forward is subject to the modified Continuity of Ownership Test and tax consolidation rules. The carry forward provisions are not available for groups that choose to apply the GRT or External Third-Party Debt Test.
Anti-Avoidance Measures
The ED contains specific anti-avoidance measures aimed at arrangements designed to circumvent or exploit the new thin capitalisation rules. These measures include amendments to the general anti-avoidance rules and targeted integrity provisions, such as the denial of debt deductions for certain instruments classified as equity for accounting purposes and restrictions on the use of related-party financing arrangements.
De Minimis Threshold and Exemptions for Financial Entities and ADIs
- De Minimis Threshold
The ED maintains the existing de minimis threshold, which provides an exemption for taxpayers with associate inclusive debt deductions of $2 million or less. Under this provision, taxpayers whose debt deductions fall below this threshold are not subject to the new thin capitalisation rules. This exemption aims to reduce the compliance burden on smaller taxpayers who pose a lower risk of base erosion and profit shifting.
Practical guidance: Companies should assess their associate inclusive debt deductions to determine whether they fall below the de minimis threshold. If they do, the new thin capitalisation rules will not apply, and no further action is required. However, taxpayers should monitor their debt deductions regularly, as they may become subject to the new rules if their debt deductions exceed the threshold in the future.
- Exemption for Financial Entities and ADIs
Financial entities and Authorised Deposit-taking Institutions (ADIs) are exempt from the Fixed Ratio Test (FRT) and Group Ratio Test (GRT). Instead, these entities will continue to apply the existing Division 820 Thin Capitalisation rules. The rationale behind this exemption is to accommodate the unique nature of financial institutions, which typically have higher leverage compared to other entities.
Practical guidance: Financial entities and ADIs should continue to comply with the existing Division 820 Thin Capitalisation rules and monitor any future updates to these rules. They should also ensure that they maintain appropriate documentation and records to demonstrate compliance with these rules.
Removal of Debt Deductions for Non-assessable Non-exempt (NANE) Income
The ED proposes to legislate the removal of debt deductions related to non-assessable non-exempt (NANE) income. NANE income refers to income that is not subject to tax and does not reduce tax losses. By removing debt deductions associated with NANE income, the legislation aims to prevent entities from claiming excessive deductions in relation to income that is not subject to tax.
Practical guidance: Companies should review their debt deductions to identify any amounts related to NANE income. If any such deductions are identified, they should be prepared to adjust their tax calculations accordingly once the new legislation comes into effect. Entities should also establish appropriate processes to track and report NANE income and related debt deductions to ensure compliance with the new rules.
Consultation Process
The proposed measures in the ED are subject to a consultation process, allowing stakeholders to provide feedback on the thin capitalisation rules changes. Despite the consultation period being open until 13 April 2023, significant amendments to the ED prior to enactment are unlikely due to extensive consultations already conducted.
Practical guidance: Affected companies should monitor the consultation process and prepare to adapt their strategies and compliance measures accordingly. Participating in the consultation process can help companies better understand the potential implications of the new rules and contribute to a more balanced legislative framework. However, companies should be prepared for the possibility that the final legislation may not significantly differ from the current ED.
How companies can plan for the impact of the new rules?
Affected companies might consider taking the following steps to prepare for the new thin capitalisation legislation:
- Determine whether they fall under the new definition of ‘general class investor’ or are exempt from the new rules due to the de minimis threshold, or their status as a financial entity or ADI.
- Assess the potential impact of the new thin capitalisation tests (FRT, GRT, and External Third-Party Debt Test) on their operations and tax strategies through appropriate modelling and scenarios.
- Review their debt deductions to identify any amounts related to NANE income and adjust their tax calculations as necessary.
- Establish appropriate processes and documentation to ensure compliance with the new rules and monitor any future updates to the thin capitalisation regime.
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