- The final version of the legislation continues to unfairly impact on legitimate commercial transactions that do not have a tax avoidance purpose.
- Clients may need to appropriately structure (or restructure) their financing arrangements in light of the changes to the thin capitalisation rules
- 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.
On February 5 2024, the Senate Economics Legislation Committee recommended that Treasury Laws Amendment (Making Multinationals Pay Their Fair Share – Integrity and Transparency) Bill 2023 be passed by Parliament. The Bill had been referred to the Senate Committee for review in December 2023 following amendments which were made by the Government to ensure that the rules were appropriately targeted. This followed a brief consultation process (after an exposure draft of the amendments was released in October 2023). As the Senate Committee has recommended that the Bill be passed it is more than likely that this is the final iteration of the legislation.
Thin Capitalisation rules – the background
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 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”.
Summary of updates in Thin Capitalisation rules
As noted above the amendments make changes to the Bill to ensure the “new” rules operate appropriately. The notable changes include:
- delaying the start date of the debt creation rules until income years commencing on or after 1 July 2024,
- limiting the scope of arrangements that may fall within the ambit of the debt creation rules,
- allowing companies, partnerships and trusts (i.e. MITs and unit trusts) that apply the fixed ration test to transfer their excess Tax EBITDA provided certain requirements are satisfied,
- increasing the flexibility of the third party debt test,
- making changes to the calculation of an entity’s Tax EBITDA (e.g. providing that only dividends from associated entities are excluded from the Tax EBITDA of an entity).
Analysis and Impact
The delaying of the start date for the debt deduction creation rules will allow affected taxpayers the opportunity to fully consider the impact of these rules and more closely examine their funding arrangements. It should also provide the Commissioner the time to publish guidance on the application of the rules in the form of a Practical Compliance Guideline. However, notwithstanding the delayed start date of 1 July 2024, the debt creation rules can still apply retrospectively to prior year transactions as there is no grandfathering for existing arrangements. Accordingly, taxpayers will still incur significant compliance costs when analysing the impact of the rules on prior year arrangements.
The debt deduction creation rules can generally apply where related party debt is used to fund the acquisition of assets or make payments. The amendments have sought to exclude ordinary commercial transactions from the application of the rules. For example, the debt creation rules will not apply where debt funding is used to:
- subscribe for new shares issued by a company,
- acquire tangible depreciating assets provided certain requirements are satisfied,
- fund related party lending where one entity has borrowed funds under a commercial arrangement and on-lends to an associate.
Moreover, the changes to limit the application of the debt creation rules to debt funded payments relating to dividends, returns of capital or trust/partnership distributions ensures that ordinary commercial transactions will be excluded from the operation of the rules. Nevertheless, there will still be a requirement for detailed tracing to determine the use of any existing and new related party debt. Unfortunately, there is still no exemption for transactions involving trading stock such as where an entity acquires trading stock from a related entity under credit terms.
Another welcome amendment is the exclusion of entities that apply the third party debt test from having to also comply with the debt creation rules. This is a sensible change that recognises the debt deductions of an entity applying the third party debt test are limited to debt deductions incurred in respect of genuine third party debt. The amendments have also clarified that the debt deduction creation rules are to be applied before the fixed ratio or group ratio test. Accordingly, any deductions removed under the debt deduction creation rules would not be taken into account when applying the fixed ratio test or group ratio test.
The changes to the third party debt test will also generally allow for a wider range of legitimate third party debt arrangements to satisfy the debt test. However, the prohibition against foreign parents or holding companies providing guarantees or security to borrowings undertaken by subsidiaries will still restrict the ability of Australian entities securing debt funds from third parties under legitimate commercial arrangements.
The original exposure draft released for public consultation in October 2023 proposed a change to allow unit trusts to transfer their excess tax EBITDA to unit trusts further up the chain provided certain requirements were satisfied. Based on feedback and submissions received by Treasury, the Government has expanded the application of the concession to other entities such as companies and partnerships. The changes will allow a lower tier entity to transfer its excess tax EBITDA to another entity provided the following requirements are satisfied:
- the other entity is an Australian corporate taxpayer, resident unit trust, managed investment trust or partnership (where more than 50% of the partnership interests are held by Australian residents)
- the other entity is applying the fixed ratio test in the relevant income year,
- the other entity has a 50% or greater interest in the lower tier entity, and
- the lower tier entity is an Australian corporate taxpayer, resident unit trust, managed investment trust or partnership which applies the fixed ratio test in the relevant income year.
This change was necessary to ensure that non-consolidated grouped entities which had trading operations in a subsidiary and debt held in a holding company would not be disadvantaged when calculating their Tax EBITDA under the fixed ratio test. Unfortunately, entities that have interests between 10 and 50% in a lower tier entity will continue to be disadvantaged. This is because such entities would be required to exclude the distributions from the lower tier entity in their Tax EBITDA calculation but could not benefit from a transfer of the excess Tax EBITDA of that entity.
Andersen in Australia comment
The final amendments to the Bill have favorably expanded the changes that were outlined in the exposure draft. Unfortunately, the final version of the legislation continues to unfairly impact on legitimate commercial transactions that do not have a tax avoidance purpose. For example, while the changes to the third party debt test have expanded the transactions that satisfy the third party debt conditions, the continued exclusion of debt arrangements which are secured or guaranteed by a foreign parent is a significant barrier to Australian subsidiaries of multinational groups securing third party debt funding. Similarly, the exclusion of entities with interests of between 10 and 50% in a lower tier entity from being able to benefit from the excess Tax EBITDA of the lower tier entity creates an anomaly whereby distributions from the lower tier entity are excluded from the holding entity’s Tax EBITDA but transfers of excess Tax EBITDA are not permitted. Moreover, the deferral of the start date of the debt creation rules to 1 July 2024 will provide taxpayers with temporary relief but they will still incur significant compliance costs in unravelling their related party debt arrangements because of an absence of grandfathering for arrangements entered into prior to 1 July 2024.
As mentioned previously, 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 final legislation and explanatory memoranda is available here: ParlInfo – Treasury Laws Amendment (Making Multinationals Pay Their Fair Share—Integrity and Transparency) Bill 2023 (aph.gov.au)
