Following its announcement in the October 2022-23 Federal Budget, Treasury has recently released the Exposure Draft and Explanatory Materials for the proposed changes to the thin capitalisation regime contained in Division 820 of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997). The proposed new interest limitation rules will replace the existing thin capitalisation safe harbour, worldwide gearing and arm’s length debt tests.
These amendments reflect the Government's commitment to strengthen and align Australia’s thin capitalisation regime to the OECD’s recommended approach under Action 4 of the BEPS Action Plan.
The proposed rules are intended to apply to income years commencing on or after 1 July 2023.
Summary of changes
The Exposure Draft introduces new earnings-based thresholds, and a new arm’s length debt test, targeted at ‘general class investors’ - a new singular concept referring to each of the following entities under the existing regime: an ‘outward investor (general)’, ‘inward investment vehicle (general)’ and ‘inward investor (general)’. These new rules will disallow an entity’s debt deductions based on the entity’s earnings or profits for the income year.
Specifically, we note the following with respect to the new tests:
Overview of new test
Fixed ratio test (FRT)
- The FRT will disallow deductions to the extent that the general class investor’s ‘net debt’ deductions exceed 30% of its ‘tax EBITDA’. An entity’s ‘tax EBITDA’ is broadly the entity's taxable income or tax loss for the income year, adding back net debt deductions, decline in value and capital works deductions (if any) and prior year tax losses.
- An entity’s ‘net debt’ deductions will be worked out by taking its debt deductions for the income year, and then subtracting all amounts included in the entity’s assessable income which are interest, in the nature of interest or any other amount calculated by reference to the time value of money.
- To the extent debt deductions are disallowed under the FRT (referred to as ‘FRT disallowed amounts’), those amounts may be carried forward for a period of up to 15 years, subject to the company passing a modified version of the continuity of ownership test set out in section 165-12 of the ITAA 1997. Based on the current drafting of the draft legislation, trusts do not require satisfaction of the current trust loss tests to carry forward denied debt deductions.
- In order to access the special deduction referred to above, entities must elect to use the FRT in every income year.
- Special rules will also apply to relevant tax consolidated groups. For example, where an entity joins a tax consolidated group, the FRT disallowed amount of the joining entity will be transferred to the head company of that group at the joining time.
- The FRT is the default test where a general class investor has not made a choice to use either the group ratio test or the external third party debt test (see below) – which are themselves irrevocable choices.
The existing safe harbour test for all general class investors which broadly allows an entity to gear up to 60% of the book value of a company's Australian assets (or a debt-to-equity ratio of 1.5:1).
Group ratio test (GRT)
- The GRT will disallow 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 the ‘group ratio’ for the year multiplied by its tax EBITDA for the income year. The ‘group ratio’ is determined by reference to the group’s audited consolidated financial statements, including its third party interest expense, with certain adjustments.
- A general class investor can only choose to use the GRT if it is a member of a ‘GR group’ and the ‘GR group EBTIDA’ for the period is not less than zero.
- No carry forward is available for denied deductions.
The existing worldwide gearing test for all general class investors.
External third party debt test
- This test will disallow all debt deductions (not just net debt deductions) which exceed the ‘external third-party earnings limit’ for the income year. The ‘external third party earnings limit’ is the sum of each debt deduction of the entity for the income year that is attributable to a debt interest issued by the entity that satisfies the following external third party debt conditions:
- the entity issued the debt interest to an entity that is not an ‘associate entity’ of the entity;
- the debt interest is not held by an ‘associate entity’ at any time during the income year;
- the holder of the debt interest has recourse for payment of the debt only to the assets of the entity; and
- the entity uses the proceeds of issuing the debt interest wholly to fund its investments that relate only to assets that are attributable to the entity’s Australian permanent establishments or that the entity holds for the purposes of producing assessable income and its Australian operations.
- This test is not available for general class investors if one of its associates does not choose to use the external third party debt test. A modified definition of ‘associate entity’ in section 820-905(1)(a) of the ITAA 1997 will apply in this context.
- No carry forward is available for denied deductions.
- Additional rules will allow conduit financer arrangements to satisfy this test. Conduit financier arrangements exist in this context where an entity (a ‘conduit financer’) issues a debt interest to another entity (an ‘ultimate lender’) and that debt interest satisfies the external third party debt conditions. The conduit financier then on-lends the proceeds of that debt interest to one or more associate entities on the same terms as the debt interest issued to the ultimate lender.
- Interestingly, the debt interest that the associate entities (the ‘ultimate borrowers’) issue to conduit financier (the relevant debt interest) will satisfy the external third party debt conditions if, amongst other things, the terms of the relevant debt interest are the same as the terms of the ultimate debt interest. This may prove to be unworkable for many taxpayers where debt is raised externally offshore and on-lent within the group on terms that are closely aligned but not the same as the terms of the upstream external debt.
The arm’s length debt test for all general class investors and financial entities.
Authorised deposit-taking institutions will still be able to access the arm’s length debt test.
These amendments have the potential to substantially impact the ability of taxpayers to claim debt deductions in Australia – particularly, those taxpayers in the real estate and infrastructure, and private equity industries where assets are typically held in complex trust structures and with associated financing arrangements in a different trust to the trust generating the earnings; and start-up businesses with low or no earnings.
The concept of ‘debt deductions’ in section 820-40 itself will expand to cover amounts which are economically equivalent to interest, but which may not necessarily be incurred in relation to a debt interest issued by the entity.
Sections 25-90 and 230-15 will be amended so that they do not allow a deduction for interest expenses incurred to derive foreign dividends from non-portfolio subsidiaries, where those foreign dividends are non-assessable non-exempt (NANE) income.
We note, however, that the following existing concessions remain unchanged under Division 820:
- The de minimis exemption for entities which (with their associates) have less than $2 million in debt deductions.
- The exemption for entities whose average Australian assets are more than 90% of their total average assets (broadly, relevant for an outward investing entity that is not also an inward investing entity under the existing rules).
- The section 820-39 exemption for highly geared, insolvency-remote special purpose vehicles.
What should you do?
Taxpayers should review their existing arrangements given the aforementioned changes will be enacted in the coming months. Careful consideration will be required on the impact on agreed positions on tax elections, any underlying agreements, such as shareholder or unitholder agreements, and the restructure of any existing debt arrangements, and the tax implications that may follow (including the application of Part IVA).