On 29 November 2023, the Senate moved further changes to the much-criticised Treasury Laws Amendment (Making Multinationals Pay Their Fair Share – Integrity and Transparency) Bill 2023.
The Bill itself is designed to strengthen Australia’s thin capitalisation rules in Division 820 of the Income Tax Assessment Act 1997 and address ‘risks to the domestic tax base arising from the excessive use of debt deductions, which amount to base erosion or profit shifting arrangements’. The latest amendments to the Bill relate to the following:
Choice of thin capitalisation test
The new Subdivision 820-AA will deal with thin capitalisation rules for general investors, including how all or part of the debt deductions may be disallowed under one of 3 tests:
- the fixed ratio test;
- the group ratio test; or
- the third party debt test.
The amendments to the Bill clarify that, where an entity makes a choice to apply the third party debt test, it cannot subsequently make a choice to apply the group ratio test, and any choice previously made to apply the group ratio test is revoked and taken never to have been made.
The conditions for revoking a choice to apply a certain test have been refined and thus simplified. The Commissioner must still be satisfied that it is fair and reasonable to allow the entity to revoke the choice. The entity must now apply to revoke a choice in relation to an income year within 4 years after they lodge their return for the income year.
The time limit is designed to provide administrative certainty and ensure that entities have a reasonable amount of time to revoke a choice.
The meaning of ‘obligor group’
An amendment to the definition of ‘obligor group’ clarifies that a creditor does not need to have recourse to all the assets of an entity in order for that entity to be an ‘obligor entity’. It is sufficient for recourse to be had to one or more assets of that entity. Where a lender only has recourse to assets of an entity that are membership interests in the borrowing entity, that entity will not be an obligor entity. This ensures that entities which merely hold membership interests in the borrower (i.e., shareholders or unitholders) do not themselves become obligor entities.
A modified definition of ‘associate entity’ is used throughout the new thin capitalisation rules. Minor amendments were made to this definition to ensure the related definition of ‘associate’ in section 318 of the Income Tax Assessment Act 1936 does not conflict with the modifications to the definition of ‘associate entity’.
Meaning of ‘tax EBITDA’
Tax EBITDA is a concept under the new rules that is relevant to calculating the limit to an entity’s debt deductions under the fixed ratio and group ratio tests – e.g., under the fixed ratio test, the deduction limit is 30% of the entity’s tax EBITDA for the income year. Broadly, to calculate the tax EBITDA, an entity must work out their taxable income or loss for the income year and then add back net debt deduction and certain other deductions. The amendments moved by the Senate add two new deductions which are included in the calculation – being:
- general deductions that relate to forestry establishment and preparation costs; and
- specific deductions related to the capital costs of acquiring trees.
Other amendments include:
- Clarifying how a corporate entity calculates its tax EBITDA, taking into account its ability to choose the amount of its tax loss that it deducts in an income year. It will now be generally assumed that the entity chooses to deduct all its losses and that the provision relating to how corporate entities deduct tax losses will not apply.
- A point of much contention in the industry submissions in the lead up to the release of the Senate Amendments was trust distributions to beneficiaries being disregarded for the purposes of calculating a unitholder’s tax EBITDA. The effect of disregarding trust distributions is that unitholders will have a reduced tax EBITDA, and therefore a reduced interest deduction threshold. The Senate Amendments have retained this drafting. In line with this treatment of trust and partnership distributions, dividends are now only disregarded for tax EBITDA purposes where the entity receiving the dividend is an associate entity of the company paying the dividend.
- New provisions now specifically cater for AMITs and make modifications to the calculation of their and their members’ tax EBITDA. Additionally, distributions from an AMIT or trust to a beneficiary member will be disregarded to ensure that, because of the specific statutory assessment regimes being disregarded for the purposes of Subdivision 820-AA, such distributions are not considered ordinary income. The revised explanatory memorandum notes the paragraphs are not intended to have a broader operation.
- As a potential means to addressing some of the concerns about disregarding trust distributions and certain dividends in the calculation of an entity’s tax EBITDA, amendments have been included allowing eligible entities to transfer excess tax EBITDA to other eligible entities. The transferee must have a direct control interest of 50% or more in the transferor.
The third party debt test
There have been a number of amendments to the third-party debt test. The broad effect of the amendments is:
- The holder of the debt interest being tested can now have recourse to the following kind of assets:
- Australian assets held by the entity that issues the debt interest.
- Australian assets that are membership interests in the entity that issued the debt interest, unless the entity has a legal or equitable interest, directly or indirectly in an asset that is not an Australian asset.
- Australian assets held by an Australian entity that is a member of the obligor group in relation to the tested debt interest.
- In the context of the meaning of ‘third party debt conditions’, recourse to minor and insignificant ineligible assets is disregarded. This is intended to prevent the ‘third party debt conditions’ being contravened for inadvertent and superficial reasons. Determining whether recourse to ineligible assets is minor and insignificant will generally require a consideration of the ineligible assets to which recourse for payment of the debt can be had and their nature.
Several changes have been made to the conduit financing conditions to make interest rate swaps generally deductible and amend the focus on ‘relevant debt interest’ and ‘ultimate debt interests’. The changes ensure a reasonable degree of flexibility in how the sections operate.
The term ‘Australian entity’ is now used to ensure trusts and partnerships can access the third-party debt test.
The debt deduction creation rules
The start date for the application of these rules has been deferred to income years commencing on or after 1 July 2024. There is also an inclusion of a list of the type of payments to which these rules apply, rather than applying to payments or distributions generally. This ensures the rules are targeted towards kinds of payments and distributions that are common in debt deduction creation scheme and mitigates tracing requirements can be of particular relevance to high-volume transaction accounts such as cash pooling facilities.
A new section has been introduced clarifying the ordering between the debt deduction creation rules and all other thin capitalisation provisions. An entity first works out if their debt deductions are disallowed under the debt deduction creation rules. To the extent their debt deductions are disallowed, the disallowed debt deductions are disregarded for the purposes of applying all other provisions in Division 820. ADI and securitisation vehicles are now also excluded from the debt deduction creation rules.
Broadly, an entity that chooses the third party debt test for the income year will effectively be exempt from the debt deduction creation rules for that income year. This exemption recognises that such entities are subject to the third party debt conditions. These conditions are intended to ensure that an entity’s debt deductions are only allowed where they are attributable to genuine third party debt that is borrowed against Australian assets and is used to fund Australian operations.
You can read our summary of these rules as initially drafted here.
Schemes that seek to exploit the related party debt deduction conditions to artificially locate or ‘debt-dump’ third-party debt in Australia will be subject to the anti-avoidance rules in Division 820 and Part IVA. For example, such schemes may involve third party debt (and the associated debt deductions) located in Australia, whilst the proceeds of the debt are ultimately used for business activities outside Australia. Such schemes may have a sophisticated commercial guise or may be embedded into genuine commercial activity.
The anti-avoidance rules may also apply to any avoidance schemes relating to the debt deduction creation rules. However, these rules are not intended to apply to schemes where a taxpayer is merely restructuring, without any associated artificiality or contrivance, out of an arrangement that would otherwise be caught by the debt deduction creation rules. The application of these rules will ultimately depend on the facts and circumstances of each case. Questions remain as to what will be considered acceptable approaches to restructures of existing debt.
The proposed amendments have once again been referred to the Senate Economics Legislation Committee for a report due on 5 February 2024.