A 'thin new world' part 2 – proposed changes to Australia's thin capitalisation provisions

17 minute read 28.06.2023 Jeremy Geale, Tim Lynch, Elissa Romanin, Craig Silverwood, Shyam Srinivasan, Adrian Varrasso, Hamish Wallace, Robert Yunan

Under proposed new law, organisations may be limited in their ability to claim debt deductions from 1 July 2023.

Key takeouts

The proposed modifications to sections 25-90 and 230-15, which would have resulted in entities no longer being entitled to claim deductions for interest on borrowings to derive certain foreign dividends, has been deferred.

Significant changes have been made to the third party debt test for general class investors and financial entities that are not ADIs, including to broaden the availability of the third party debt test.

The new integrity measure referred to as the debt deduction creation rules seek to mitigate the base erosion arising from excessive debt deductions created in connection with acquisitions of assets from associates or payments to associates by denying debt deductions in certain circumstances.

On 22 June 2023, the Government introduced Treasury Laws Amendment (Making Multinationals Pay Their Fair Share – Integrity and Transparency) Bill 2023 (Bill) into Parliament. The main amendments introduced relate to the thin capitalisation rules in Division 820 of the Income Tax Assessment Act 1997 (Cth) (ITAA97).

The Bill includes a number of key differences to the Exposure Draft – Treasury Laws Amendment (Measures for Future Bills) Bill 2023: Thin capitalisation interest limitation (ED) issued on 16 March 2023.

Legislation to begin on or after 1 July 2023

The measures contained in the Bill will apply to income years commencing on or after 1 July 2023 and there are no transitional concessions which exclude arrangements entered into prior to this start date. The Bill was not issued for public consultation in the same way as the ED. However, the Bill has been referred to the Senate Economics Legislation Committee (SELC) which is due to report by 31 August 2023. Accordingly, the Bill will not be passed before 1 July 2023 and will therefore have retrospective application for entities that have income years commencing on 1 July 2023.

Although the Bill has been introduced into Parliament, as the Bill has been referred to the SELC, it is still possible to make submissions directly to this committee. The closing date for submissions is 21 July 2023, and it is possible that further amendments will be made to the Bill following any recommendations of the SELC.

New tests

At a high level, the proposed amendments to the thin capitalisation regime in the ED are retained in the Bill. In particular, the Bill preserves the current balance sheet-based thin capitalisation treatment for authorised deposit-taking institutions (or ADIs) and financial entities. The balance of taxpayers, which will be general class investors, will fall within the new rules which generally permit a taxpayer to rely on one of three alternative tests:

Default fixed ratio test (FRT)

The FRT is an earnings-based test that replaces the existing safe harbour debt test. The FRT allows an entity to claim net debt deductions of up to 30% of its tax EBITDA for the income year (i.e. fixed ratio earnings limit). Any net debt deductions that exceed this limit for the income year will be disallowed, subject to a carry forward regime.

Group ratio test (GRT)

The GRT is another earnings-based test that replaces the current worldwide gearing test. Under the GRT, an entity must determine the ratio of the worldwide group's net third party interest expense to the group's EBITDA for an income year (group ratio) and multiply this by its tax EBITDA for the income year (group ratio earnings limit). Any net debt deductions that exceed the entity's group ratio earnings limit for the income year will be disallowed.

Third party debt test (TPDT)

The TPDT replaces the current arm's length debt test (ALDT). The TPDT allows an entity to claim all debt deductions which are attributable to third party debt, subject to satisfying certain conditions. Any debt deductions (not net debt deductions) that exceed the third party earnings limit for the income year will be disallowed. Importantly, where this method is chosen, all debt deductions attributable to related party debt will be disallowed. Broadly, the entity's external third-party earnings limit is the total of the entity's debt deductions attributable to third party debt of the entity. The TPDT is also available to financial entities which are not ADIs, with ADIs continuing to have access to the arm's length capital test.

Transfer pricing

The Bill retains an important change announced in the ED, which requires both the quantum of debt and the terms (including the interest rate) of the debt to be arm's length under the transfer pricing rules. Practically, this means that prior to applying the two alternative earnings-based tests, a transfer pricing analysis will need to be prepared to confirm the quantum of debt and prevailing capital structure are struck on an arm's length basis.

The Explanatory Memorandum to the Bill (EM) specifically emphasises Australia's transfer pricing reconstruction provisions as the 'normal rules' for the purpose of determining the arm's length conditions that apply to a debt instrument. These changes in law and emphasis depart from the existing rules, and will require general class investors to analyse and document whether their amount of debt is consistent with how independent parties would enter the same or similar arrangements, regardless of whether interest would have otherwise been disallowed under the earnings-based tests.

Key differences between ED and Bill

Definition of debt deduction and net debt deductions

The ED amended the current law by removing the requirement in the debt deduction definition that a cost incurred by an entity must be in relation to a debt interest issued by the entity. The ED also included amounts calculated by reference to the time value of money in the assessable income component of net debt deductions. The Bill makes a number of further amendments to the definition of debt deduction and net debt deductions, including:

The Bill no longer excludes losses and outgoings directly associated with hedging or managing the financial risk in respect of a debt interest from being debt deductions, meaning that they could be subject to denial under the thin capitalisation rules; and
The Bill also includes amounts economically equivalent to interest (instead of amounts calculated by reference to the time value of money) in both the assessable income component of the definition of net debt deductions and the deductions component of the definition of net debt deductions due to the debt deduction definition modification. This would, for example, result in the capture interest rate swap payments and swap receipts within the concept of net debt deductions.

Election to utilise GRT or TPDT

Under the ED, the choice to utilise a method other than the default FRT was irrevocable. Under the Bill, this choice is revocable with the consent of the Commissioner of Taxation (Commissioner), who must be satisfied that at the time the choice was made, it was reasonable to believe that the chosen test allowed for a higher earnings limit than under the FRT.

Associate entity definition

The definition of associate entity for the purposes of the rules has generally been relaxed from a TC control interest threshold of 10% in the ED to a TC control interest threshold of 20% in the Bill. However, the Bill retains the 10% threshold for partners and beneficiaries when determining tax EBITDA under the FRT for partnerships and trusts (refer below).

Carry forward of unused deductions

The carry forward test for unused net debt deductions under the FRT has been modified. Under the ED, a modified continuity of ownership test (COT) was required to be satisfied to utilise carry forward debt deductions disallowed under the FRT for up to 15 years and no tests applied to carry forward debt deductions for trusts. Under the Bill, a modified continuity of business test is also made available (as an alternative if the modified COT is not passed) for companies but trusts must now pass a modified version of the trust loss rules in Schedule 2F of the Income Tax Assessment Act 1936 (Cth) (ITAA36) to utilise the carry forward amount.

Tax EBITDA

The definition of tax EBITDA, which is relevant to the application of the FRT and GRT, has been modified. The higher the tax EBITDA of an entity, the higher the earnings limit under the FRT and GRT. The key modifications include:

Depreciation – the add back to tax EBITDA for tax depreciation under the Bill includes all deductions under Division 40 of the ITAA97 (other than once off deductions). This was previously limited to depreciation available under Subdivision 40-B of the ITAA97 under the ED. This modification is likely to increase the tax EBITDA and therefore the earnings limits under the FRT and GRT;
Prior year tax losses – Under the ED, tax EBITDA included an add back for prior year tax losses utilised in the current income year. This has been removed in the Bill; and
Distributions – the ED did not specifically address franked dividends and trust / partnership distributions in determining tax EBITDA, which allowed for double counting. Under the Bill, dividends and the gross up for franking credits are specifically excluded from tax EBITDA. Trust and partnership distributions are also specifically excluded from tax EBITDA where the beneficiary / partner holds at least 10% in the trust or partnership (i.e. is an associate entity). This will limit double counting of income in calculating the tax EBITDA of groups.

Application of TPDT

The TPDT has been significantly modified. Most of the modifications broaden eligibility, however, there are a number of changes which could operate to narrow the ability to rely on the TPDT. The key differences between the ED and Bill in respect of the TPDT include:

Eligibility and elections – Under the ED, if a general class investor made a choice to apply the TPDT, then all associate entities had to do the same. That is, an investor and all of its associate entities must have decided to use the TPDT if one of those entities wished to apply that test. This has been relaxed under the Bill, which provides that where a general class investor makes a choice to apply the TPDT, all of the members of the entity's obligor group (which consists of the borrower and any entity to which the creditor has recourse for the payment of the debt) and all other parties to a cross-staple arrangement are deemed to have made the choice to apply the TPDT;
Use of funds – The ED required that the proceeds of issuing the debt were used wholly to fund an entity's investments attributable to an Australian permanent establishment (PE), or to assets held for the purposes of deriving assessable income. This has been broadened to permit the use of all or substantially all of the borrowed funds to fund commercial activities in Australia other than the holding of any associate entity debt, controlled foreign entity debt or controlled foreign entity equity. These exclusions mean that if the proceeds of the debt are on-lent to an associate or used to fund any foreign equity, the TPDT will not be available;
Credit support and greenfields development concession – Under the ED, in order for the debt to be third party debt, the lender could only have recourse to the assets of each borrower and conduit financier. Under the Bill, the TPDT permits recourse for certain credit support arrangements to the Australian assets of the support provider, but only where debt financing wholly relates to the creation or development of Australian real property assets (e.g. greenfields property development);
Conduit financing (recourse under a conduit financing arrangement) – Under the Bill, the security available under the ultimate loan can extend to members of the obligor group that are Australian residents, but only to the extent of their Australian assets; and
Conduit financing (conditions of conduit loans) – the conduit financing rules require the borrower of the ultimate loan to on-lend amounts to conduit financiers. Under the ED, the terms of these loans (conduit loans) were required to be on the same terms as the ultimate debt issued by the borrower to the third party. The Bill relaxes this requirement to refer to terms which relate to cost, allowing for the recovery of administrative and similar costs.
Non-application to Australian PEs – the TPDT was available to Australian PEs of foreign entities under the ED. This has been removed under the Bill.

Section 25-90

The ED proposed to modify sections 25-90(b) and 230-15(3)(c) of the ITAA97 so that entities will no longer be entitled to claim deductions for interest on borrowings to derive certain foreign dividends, where those foreign dividends are non-assessable non-exempt income. The proposed modifications have been deferred and will be considered via a separate process.

New integrity rules

As a trade-off for the retention of sections 25-90(b) and 230-15(3)(c) of the ITAA97, new 'targeted' rules have been introduced to address debt creation schemes or debt deduction creation where an entity acquires an asset from an associate or borrows from an associate in order to fund a payment or distribution to an associate. The Bill also includes a specific anti-avoidance rule in relation to the new debt deduction creation rules (DDCR). This anti-avoidance rule applies if the Commissioner is satisfied that the principal purpose of a scheme was to avoid the application of the DDCR. In these circumstances, the Commissioner may determine that the rules apply to the relevant debt deduction. The DDCR and the associated anti-avoidance rule did not have an equivalent in the ED. We consider some of the practical issues associated with these measures in further detail below.

Debt deduction creation rules

Subdivision 820-EAA in the Bill has unexpectedly introduced new DDCR, which are a flashback to the former debt creation provisions in Division 16G of the ITAA36. The EM states that these DDCR were progressed in place of the modifications to paragraphs 25-90(b) and 230-15(3)(c) of the ITAA97.

The proposed DDCR seek to mitigate the base erosion arising from excessive debt deductions created in connection with acquisitions of assets from associates or payments to associates by denying debt deductions in certain circumstances, independently and in addition to the operation of the FRT, GRT and TPDT.

The stated aim of the DDCR is to disallow debt deductions to the extent that they are incurred in relation to debt creation schemes that lack genuine commercial justification. However, the Bill does not seem to give effect to this stated intention. Instead, new Subdivision 820-EAA operates very broadly where the transaction comes within a set of prohibitions, whether or not the transaction is domestic or cross border.

The DDCR also contains an anti-avoidance rule which applies where it is reasonable to conclude that one or more entities entered into a scheme with a principal purpose of achieving an outcome of obtaining a debt deduction that would otherwise be denied. However, there is no principal purpose or similar integrity gateway under the primary provisions, and therefore in their present drafting, the DDCR operate as a very blunt instrument which is likely to deny debt deductions in a wide variety of ordinary circumstances which would not normally be considered a debt creation scheme.

The first case broadly involves an entity acquiring an asset (or an obligation) from its associate. The entity, or one of its associates, will then incur debt deductions in relation to the acquisition of that asset. The debt deductions are disallowed to the extent that they are incurred in relation to the acquisition, or subsequent holding, of the asset. For example, debt deductions arising from debt created by an entity would generally be disallowed if the debt created funded the acquisition of:

equity in a subsidiary from a foreign associate or equity in a domestic entity from a domestic associate, where the domestic associate is not part of the same income tax consolidated group; or
business assets from foreign and domestic associates in an internal reorganisation after a global merger.

The second case broadly involves an entity borrowing from an associate to fund a payment (which can include the repayment of loans or returns of capital) or distribution to that or another associate. This limb is clearly designed to apply to returns of capital and dividends funded by related party debt, but it appears to go meaningfully further.

This prohibition is very broad and applies to any situation where the borrower uses the proceeds of the debt predominantly to increase the ability of any entity (including itself) to make a payment or a distribution to an associate. The ordinary meaning of the phrase increase the ability can be quite expansive and imprecise. The breadth of this rule is further illustrated by the fact that this limb can apply to payments made directly or indirectly through a series of entities.

It appears that any plain vanilla refinancing involving related party debt could be caught, subject to the taxpayer showing that the proceeds were not predominantly used to increase the ability of any entity to make a payment or distribution. This can also include refinancing existing arrangements because the new rules have resulted in existing debt becoming non-deductible. It is concerning that even simple transactions such as this, even if wholly domestic, are not clearly excluded from the scope of the DDCR.

Accordingly, for any future related party borrowings, it will be necessary to carefully consider the DDCR provisions and to maintain detailed documentation as to the purpose of the borrowings and the actual use of the borrowings.

Unless the DDCR are modified, there is also a significant risk that they apply to interest deductions from 1 July 2023 in relation to past transactions, as the DDCR appear to focus on the timing of the relevant deductions rather than the timing of entering into the relevant arrangement giving rise to those deductions.

Next steps

Given the impending proposed commencement date for the new thin capitalisation provisions (possibly as early as 1 July 2023), it is critical for taxpayers, and in particular in-house tax teams, to undertake a key impacts analysis, including:

Socialising with their key senior executive stakeholders (including the CFO), Audit Committee, other relevant delegated Board sub-committees and the Board, the inherently increased volatility risk associated with changing from an assets based approach to an earnings based approach under the FRT and GRT, as well as the potential impact on net profits after tax and cash flow if interest deductions are disallowed under the new thin capitalisation provisions;
Analysing whether the quantum of debt is arm's length for transfer pricing purposes, which will require an analysis that is not dissimilar to the former ALDT;
Working closely with in-house Budgeting, Forecasting and / or Treasury teams to obtain detailed forecasts of group EBITDA, so that tax EBITDA for the purposes of the FRT and GRT can be modelled accurately for future years;
Where the GRT is being considered, connecting with the majority shareholder's Budgeting, Forecasting and / or Treasury teams to obtain detailed forecasts of global net third party interest expense and global group EBITDA, for the purposes of accurately modelling the GRT for future years;
If there is a relatively low quantum of interest on related party debt, considering whether the TPDT would result in less interest deduction denial than under the FRT or GRT;
If reliance has previously been placed on the ALDT, evaluating the impact of this being replaced by the TPDT, especially where there are significant related party debt deductions;
Considering the impact of the DDCR on past or proposed transactions with related parties, e.g. post-deal Australian restructuring following any global or domestic M&A deal, refinancing of shareholder capital structures, returns of capital and dividends to shareholders, and the possible need for restructuring, subject to the DDCR anti-avoidance provisions;
Monitoring any further changes to the proposed legislation following the SELC report; and
Working closely with key stakeholders including relevant delegated Board sub-committees, the Board, the CFO, other senior executive stakeholders, the in-house Treasury team, external financiers and credit ratings agencies to determine what, if any, modifications to the group's capital structure or security arrangements may be appropriate as a result of the new thin capitalisation regime, subject to the application of any anti-avoidance provisions.