On 18 October 2023, the Government released an Exposure Draft outlining the changes recommended by the Senate to Treasury Laws Amendment (Making Multinationals Pay Their Fair Share— Integrity and Transparency) Bill 2023 (the Bill). The draft amendments are aimed at ensuring the “new” thin capitalisation rules are appropriately targeted.
The Bill was originally introduced into Parliament on 22 June 2023. It proposes to strengthen Australia’s thin capitalisation regime by adopting the best practice guidance of the Organisation for Economic Cooperation and Development (OECD). The legislation was subsequently referred to the Senate Committee for review. In line with the Senate Committee’s final report, the Government has now released an exposure draft which proposes to implement the changes recommended in the report.
The thin capitalisation regime was put in place to limit the debt deductions that an entity can claim for tax purposes. The original rules restricted the debt deductions of an entity based on the amount of debt used to finance its operations compared with its level of equity. The new proposed rules strengthen the thin capitalisation regime in Div 820 of ITAA97 by introducing the following changes:
- Replacing the concept of “inward” and “outward” investors with a “general class investor”.
- Implementing new earnings-based tests for ‘general class investors’ in the form of a fixed ratio test to replace the existing safe harbour test and a group ratio test to replace the existing worldwide gearing test.
- Replacing the arm’s length debt test with a third party debt test.
- Introducing new debt deduction creation rules which will disallow debt deductions to the extent that they are incurred in relation to debt creation schemes.
The default test that will apply to general class investors under the proposed new rules will be the fixed ratio test. Under this test the debt deductions of an entity will be effectively capped at 30% of its “Tax EBITDA”.
An entity’s Tax EBITDA for an income year is worked out according to the following steps:
|Step 1||Work out the entity’s taxable income or tax loss for the income year (disregarding the operation of the thin capitalisation rules and treating a tax loss as a negative amount).|
|Step 2||Add the entity’s ‘net debt deductions’ for the income year.|
|Step 3||Add the sum of the entity’s decline in value and capital works deductions (under Division 40 and 43 of ITAA97) for the income year.|
|Subject to Step 4, the result of Step 3 is the entity’s Tax EBITDA for the income year.|
|Step 4||If the result of Step 3 is less than zero, treat it as being zero.|
Certain amounts are disregarded when calculating an entity’s Tax EBITDA (e.g. amounts that are included in their assessable income under Div 207 of ITAA97 (i.e. franking credit gross-ups), dividends paid by associated companies and distributions from unit trusts or partnerships where the entity holds a 10% or greater interest).
However, a special deduction for debt deductions disallowed under the fixed ratio test over the previous 15 years is available to general class investors in certain circumstances. The special deduction allows entities to claim debt deductions that have been previously disallowed within the past 15 years under the fixed ratio test in a later income year when they are sufficiently profitable.
New Subdivision 820-EAA (the debt deduction creation rules) proposes to disallow debt deductions to the extent that they are incurred in relation to debt creation schemes that lack genuine commercial justification. Similar to the thin capitalisation rules the debt deduction creation rules only apply to entities that are part of a multinational enterprise and have total debt deductions of over $2 million for the income year.
As noted above the exposure draft proposes to make changes to the Bill to ensure the “new” rules operate appropriately. The proposed changes are as follows:
- Simplifying the conditions for making and revoking choices and clarifying the ordering between a third party debt test choice and a group ratio test choice.
- Clarifying the operation of the rules in relation to identifying entities with an “obligor group”.
- Making changes to the calculation of an entity’s Tax EBITDA. The proposed amendments are summarised below:
|Plantation and forestry entities (Amended s 820-52(1)(c))||The following deductions are added back to taxable income or tax loss when calculating an entity’s Tax EBITDA:|
-general deductions that relate to forestry establishment and preparation costs
-capital costs of acquiring trees (s 70-120 of ITAA97)
|Tax losses from earlier income years (New s 820-52(1A))||A corporate entity is assumed to deduct all of its tax losses from previous income years when calculating its taxable income or tax loss for Tax EBITDA purposes.|
|Dividends (Amended s 820-52(3))||Only dividends from an associate will be excluded from an entity’s Tax EBITDA.|
|Attribution managed investment trusts (New s 820-52(6A) and (6B))||Modifications are included to calculate the net income of an AMIT.|
|Notional deduction of R&D entities (New s 820-52(10))||An R&D entity that has a notional deduction for eligible expenditure must deduct the amount of the notional deduction when determining their taxable income/tax loss for tax EBITDA purposes.|
- Amending the third party debt test to:
- take into account an interest rate swap cost that relates to multiple debt interests,
- allow the holder of the debt interest under the third party debt test to have recourse to a wider range of assets(e.g. moveable property situated on land if the property is incidental to and relevant to the ownership and use of the land and situated on the land for the majority of its useful life).
- Amending the debt deduction creation rules to:
- clarify the order of application of Subdivision 820-EAA and all other provisions in Div 820. If debt deductions are disallowed under Subdivision 820-EAA, the disallowed debt deductions are disregarded for the purposes of applying all other provisions in Division 820,
- exempt ADIs and securitisation vehicles from the operation of the debt deduction creation rules,
- ensure the rules do not apply where the following assets are acquired from an associated entity:
- a new membership interest in an Australian entity or a foreign entity that is a company, and
- certain new tangible depreciating assets.
- exclude certain related party lending arrangements,
- exclude payments that are entirely referable to mere on-lending to an Australian associate, where the on-lending is on the same terms,
- delay the start date of the rules to 1 July 2024 for arrangements entered into before 22 June 2023.
- Inserting new s 820-52(1)(ca) which allows eligible unit trusts to transfer their excess Tax EBITDA amounts to other unit trusts. An eligible unit trust must be a resident unit trust, a general class investor and using the fixed ratio test. In addition, the trust receiving the excess Tax EBITDA must have a 50% or greater interest in the eligible trust.
The proposed changes are in the most part acceptable especially those which widen the scope of the third party debt test and restrict the application of the debt deduction creation rules. Unfortunately, the absence of a tax purpose test in the debt deduction creation rules means that the rules can still potentially apply to legitimate commercial transactions such as, for example, where an entity borrows from a related party to purchase trading stock from a related entity. Moreover, the proposed rules can also continue to apply to domestic arrangements that do not involve amounts being paid/transferred offshore despite the overall purpose of the legislation being to prevent base erosion and international profit shifting.
In addition, aside from a brief 12 month amnesty for arrangements entered into before 22 June 2023, the rules could apply retrospectively to post-1 July 2023 debt deductions that relate to pre-30 June 2023 arrangements. The changes will also substantially increase the compliance costs for taxpayers as they will be required to trace their use of funds and acquisitions of assets.
While the minor changes that have been made to the third party debt test are welcome, the exposure draft does not address a major issue with the third party debt requirements in proposed s 820-427A(3). The Government have persisted with the requirement that a third party lender cannot have recourse to a guarantee, security or other form of credit support with the exception of credit supports on the creation or development of Australian real property assets including moveable property. This requirement will result in the majority of Australian subsidiaries of multinational groups being unable to satisfy the third party debt test as most third party lenders would often require that a foreign parent company provide some of security or guarantee for the borrowing.
Similarly, while the introduction of proposed s 820-52(1)(ca) which allows eligible trusts to transfer their excess Tax EBITDA is a sensible concession. The proposed changes do not go far enough as similar concessions are not available for partnerships and non-consolidated companies. Moreover, entities that hold between ten and fifty percent of a trust cannot access the concession despite the entity having to exclude any distributions from the trust from its Tax EBITDA.
Clients may need to appropriately structure (or restructure) their financing arrangements in light of the changes to the thin capitalisation rules. In addition, clients with start-up enterprises or activities where they have significant up-front deductible expenditure (e.g. infrastructure projects) will also need to reconsider their arrangements as it is likely that a significant portion of their interest deductions will be denied under the “new” rules. Multinational groups will have increased compliance costs from having to navigate an earnings-based ratio test with the added complication of having to consider the transfer pricing impacts of both the quantum of debt and the rate on interest.
The Senate Economics Committee Report on the Bill is available here:
The Exposure draft is available here:
Contact Information:Mr Meng Lee
Director – National Tax