Important changes have been proposed to Australia's thin capitalisation tax regime. A further proposed change is the repeal of the part of provision allowing interest deductions relating to the derivation of non-assessable non-exempt distributions from foreign non-portfolio investments. These significant changes are set to apply from income years commencing on or after 1 July 2023.
As previously foreshadowed in the 2022-23 October Budget, on 16 March, the Government released exposure draft legislation (Exposure Draft) and explanatory materials for proposed changes to the thin capitalisation rules in Division 820 of the Income Tax Assessment Act 1997 (Cth) (ITAA). These amendments reflect the Government's commitment to amending Australia's thin capitalisation rules to align with the Organisation for Economic Cooperation and Development's (OECD) recommended approach under Action 4 of the BEPS Action Plan. Specifically, the amendments are targeted at base erosion or profit shifting (BEPS) arrangements by addressing the risk of erosion to Australia's tax base arising from excessive debt deductions.
The proposed amendments replace the existing thin capitalisation rules that indirectly addressed BEPS measures (which focused on an entity's ratio of debt to equity), with new direct earnings-based rules for non-financial entities ('general class investors'). The proposed amendments also establish a new arm's length debt test (ALDT) in the form of an external third-party debt test.
The changes also included a measure not previously announced (and not directly related to thin capitalisation), making interest non-deductible where it relates to the funding of non-portfolio foreign equity.
Summary of change
The Exposure Draft introduces new thin capitalisation earnings-based tests targeted at general class investors that may disallow all or part of the entity's debt deductions for an income year. The following new tests apply to general class investors:
- a fixed ratio test to replace the existing safe harbour test;
- a group ratio test to replace the existing worldwide gearing test; and
- an external third party debt test to replace the ALDT (this test also applies to financial entities that are not authorised deposit-taking institutions (ADIs)).
General class investors will capture those entities that previously were covered by the existing classes of entities in the current thin capitalisation rules – being 'outward investor (general)', 'inward investment vehicle (general)' and 'inward investor (general)' – but does not include financial entities or ADIs. This means that general class investors will include:
- Australian entities carrying on business in a foreign country at or through a permanent establishment or through a controlled entity;
- Australian entities that are controlled by foreign residents; and
- foreign entities with investments in Australia.
Financial entities and ADIs are not general class investors for the purposes of the new rules so are not caught and continue to be subject to the existing thin capitalisation tests (with the exception of the ALDT, which is replaced by the external third party debt test, but they will continue to have access to the arm's length capital test). The proposed amendments have also amended the definition of a financial entity for these purposes by removing from the definition an entity that is not an ADI but is a registered corporation under the Financial Sector (Collection of Data) Act 2001. This means that non-ADI corporations can no longer register under that Act and qualify as a financial entity for the purposes of the thin capitalisation rules.
Fixed ratio test
The fixed ratio test is the default test that applies to general class investors who do not choose to either use the group ratio test or the external third party debt test.
The fixed ratio test allows an entity to claim net debt deductions of up to 30% of its tax EBITDA. Any net debt deductions that exceed this limit for the income year will be disallowed.
An entity's net debt deductions for an income year is worked out broadly, by determining the entity's debt deductions for the year and subtracting from that amount all of the entity's assessable income derived from interest (or amounts in the nature of interest or that are calculated by reference to the time value of money). For a group finance company, which is not otherwise exempt as an insolvency remote vehicle, the approach of using net debt deductions may produce a better outcome than the existing rules which consider gross, rather than net, debt deductions. This approach may also assist a non-ADI corporation which no longer qualifies as a financial entity, as mentioned above.
Tax EBITDA is broadly the entity's taxable income or tax loss, adding back net debt deductions, deductions under subdivision 40-B (decline in value) and Division 43 (capital works) and prior year tax losses. This effectively means that a portion of the entity's profits will remain taxable each year and the entity cannot rely on its debt deductions to completely offset its net profits.
Carry forward denied deductions – 15 year rule
A special deduction will be allowed for a particular income year if the entity has net deductions for that year of less than 30% of its tax EBITDA and the entity has debt deductions that were disallowed under the fixed ratio test in a prior year (Disallowed Deductions). This carry-forward rule was not mentioned in the original Budget announcement, and appears to have been introduced following feedback in relation to the Budget announcement. Having said that, there are a number of conditions that must be met before an entity can utilise a Disallowed Deduction:
- the Disallowed Deductions must have arisen in the previous 15 years – i.e. any Disallowed Deductions that relate to an income year more than 15 years before cannot be claimed and will be lost;
- the entity must have used the fixed ratio test in every income year since the Disallowed Deduction arose in order to be able to deduct it in a later year – i.e. if an entity used the fixed ratio test in an income year but does not use it in a subsequent year, it will lose any previously Disallowed Deductions for income years going forward; and
- if the entity is a company, it must satisfy a modified continuity of ownership test in relation to that Disallowed Deduction – which broadly requires the company to have maintained a majority ownership and control over voting power of the company since the amounts were disallowed. There is no alternative same or similar business test.
The Disallowed Deductions can be transferred into a consolidated group, if the modified continuity of ownership test is satisfied, subject to the following:
The 15 year period is not reset when the Disallowed Deductions are transferred into the group;
The Disallowed Deductions remain in the group if the entity later leaves; and
The Disallowed Deductions are taken into account in calculating group's ACA, whether or not they are used.
Group ratio test
The group ratio test can be used as an alternative to the fixed ratio test for entities that are members of highly leveraged worldwide groups and allows these entities to deduct debt deductions based on their worldwide group ratio. In order to be eligible to use the group ratio test:
- the entity must be a member of a GR group, which is a group that is comprised of the worldwide parent entity (that has audited consolidated financial statements for the period) and generally, all other fully consolidated group members; and
- the GR group EBITDA for the period must not be less than zero.
Broadly, under this test, the entity must determine the ratio of the worldwide group's net third party interest expense to the group's EBITDA for an income year (this is called the group ratio earnings limit). Any net debt deductions that exceed the entity's group ratio earnings limit for the income year will be disallowed.
Under this test, entities must prepare and keep records of how they calculated their group ratio by the time the entity is due to lodge its tax return for that income year.
Entities which get a better outcome under the group ratio test than the fixed ratio test but are still not able to claim all their net debt deductions in a particular year, will need to consider whether they should instead apply the fixed ratio test, and carry forward all the difference to a later year. This will involve forecasting the entity's likely outcome under the fixed ratio test in subsequent years, as well as taking into account the entity's cost of capital in the intervening period.
External third party debt test
The external third-party debt test replaces the ALDT test and allows an entity to deduct 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 external 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 earning limit is the total of the entity's debt deductions attributable to third-party debt of the entity.
However, if the general class investor has associates that are also general class investors in relation to the same income year and are subject to the thin capitalisation rules, that entity cannot choose to use the external third-party debt test for that income year if at least one of those associates does not also choose to use the external third-party debt test. That is, an investor and all its associate entities must all decide to use the external third-party debt test if one of those entities wishes to apply that test. This is an integrity measure aimed at ensuring that investors and their associates do not structure their affairs in way to allow them to artificially maximise their tax benefits by applying a combination of different thin capitalisation tests.
Again, the entity will need to consider whether it would be better off applying the fixed ratio test and retaining the ability to carry forward any unused debt deductions, even if the external third-party debt test would produce a better result in a particular year.
How to make a choice
If an entity wishes to use either the group ratio test or the external third-party debt test for an income year, it must make a choice in the 'approved form' on or before the earlier of the day it lodges its tax return for that period or the due date for lodgement of that return. The Government has not specified what will be an 'approved form'. The Commissioner can defer the time to lodge the approved form.
Once an entity has made a choice for an income year, it cannot revoke that choice.
Other matters
The definition of debt deduction has been broadened to capture amounts which are economically equivalent to interest, even if they are not incurred in relation to a debt interest issued by the entity.
Entities will no longer be entitled to claim deductions for interest on borrowings to derive foreign dividends, where those foreign dividends are non-assessable non-exempt (NANE) income.
The de minimis exemption is retained for entities which (with their associates) have less than $2 million in debt deductions. Similarly, the exemption has been retained for entities whose average Australian assets are more than 90% of their total average assets.
There is no grandfathering for existing debts.
Next steps
The Government has sought comments on the Exposure Draft by 13 April 2023. Once those comments have been considered, the Exposure Draft will be converted into a Bill for introduction into the House of Representatives.
Whether there will be enough time for the Bill to be introduced and passed by its intended start date of 1 July 2023, or whether it will take effect retrospectively, or be deferred, remains to be seen.
Please get in touch with one of the members of our team if you need assistance in navigating the proposed new measures.
