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Understanding the proposed debt deduction creation rules

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Continuing concerns over the erosion of the Australian tax base by multinational companies have given rise to a new set of proposed integrity provisions called the “debt deduction creation rules” (DDC rules).

These rules can be found in the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share—Integrity and Transparency) Bill 2023 introduced on 22 June 2023.

Despite clear concerns raised by taxpayers and advisers, the latest and final report delivered by the Senate Economics Legislation Committee on 22 September 2023 has endorsed the proposed DDC rules as they are currently drafted, subject to certain amendments already foreshadowed by Treasury (likely to be just minor technical amendments). These rules will take effect retrospectively from 1 July 2023 onwards, with no grandfathering provisions for existing arrangements. 

The DDC rules will be hosted under the newly created Subdivision 820 EAA of ITAA 1997 and will enable the Commissioner to disallow deductions when they are related to a debt creation scheme. As detailed in the explanatory memorandum, these schemes lack genuine commercial justification, and operate to create artificial interest-bearing debt to shift profits out of Australia through tax-deductible interest payments.

The ATO has expressed concerns that the switch to an earnings-based approach under the revised thin capitalisation rules could make the Australian tax base more susceptible to debt creation schemes. One specific concern is that companies may exploit earnings fluctuation by strategically creating debt to maximize debt deductions in particular years.

Concerns regarding the exploitation of related party debt by multinational companies have previously come to light in a number of  high-profile cases such as Orica Ltd v FCT [2015] FCA 1399, Singapore Telecom Australia Investments Pty Ltd (SingTel) v FC of T and Chevron Australia Holdings Pty Ltd v Commissioner of Taxation (No 4). In Orica, the Federal Court held Pt IVA applied to a scheme whereby deductions of $112m were claimed for interest on cross-border intercompany loans made by an Australian subsidiary of a US corporate group. While in SingTel and Chevron, intercompany loans were used to finance the purchase of respective related party entities. In both cases, the Commissioner successfully argued that the interest rate applied in those intercompany loans were non-arm’s length and excessive.  The DDC rules have been broadly drafted to ensure they can apply to a wide array of debt creation schemes, regardless of complexity.

What are the proposed rules?

Generally, the DDC rules will only apply to entities already subject to the revamped thin capitalisation rules (and who have not been granted an exemption), which in short will be most multinational enterprises reporting total debt deductions exceeding $2 million in the given fiscal year.

Subdivision 820-EAA will be limited to two specific scenarios, being:

  1. Acquisitions: Entity A obtains a capital gains tax (CGT) asset, or a legal or equitable obligation (such as debt) either directly or indirectly from one or more entities (the disposers), and at least one disposer forms an associate pair with Entity A.

    The explanation memorandum explains the following transactions may be captured under this scenario:

    • Entity A creates debt to buy shares in a foreign subsidiary from a foreign associate.
    • Entity A uses debt to acquire business assets from domestic and foreign associates after a global merger

  2. PaymentsEntity A borrows from its associate to make payments (which can include dividends, repayment of loans or returns of capital) to that associate or another associated entity. This includes payments made to one or more interposed entities, regardless of whether the payment occurred before or after the debt interest was created. There is also no need for the Commissioner to prove that the debt funded the specific payments made through each of the interposed entities.

    This scenario has wide-reaching application and may apply to relatively straight-forward debt rationalisation projects. For example, if an Australian entity receives a loan from an offshore related party entity (like the group’s offshore treasury subsidiary) to repay an intercompany debt, even if the repayment is to another Australian related-party entity.

Lastly, Subdivision 820-EAA includes its own set of anti-avoidance provisions. Those provision apply if the Commissioner is satisfied that a principal purpose of a scheme was to avoid the application of the DDC rules. If so, then the Commissioner may determine that the DDC rules apply to that debt deduction.


Current concerns with the proposed rules

When enacted, the debt deduction creation rules will apply to assessments for income years on or after 1 July 2023, with no grandfathering provisions for existing arrangements. Meaning, it will likely apply to interest deductions from 1 July 2023 in relation to past transactions. Treasury’s reasoning being that grandfathering provisions will create unnecessary complexities, and they expect taxpayers with June balance dates to restructure their arrangements before their FY24 tax returns are due.

The explanatory memorandum and subsequent statements made by the ATO confirm that the aim of the debt deduction creation rules is to target schemes that lack genuine commercial justification. However, the Bill does not seem to give effect to this stated intention nor mention “genuine commercial justification” anywhere. Instead, the DDC rules are structured to operate very broadly, capturing all debt deductions that meet the outlined criteria.

The ATO has noted that the rules are needed due to the difficulties and costs of applying Part IVA, described as a “provision of last resort”, to such circumstances. The need for another set of specific integrity rules to be layered on top of, or around, the existing general anti-avoidance provision is concerning, and the new measures will simply increase complexity and compliance costs for taxpayers.


What you need to be aware of now

Taxpayers should begin determining how the potential application of DDC rules might apply to both forthcoming and existing related party debt agreements or transactions that are likely to result in a future debt deduction. Namely, it will be crucial for taxpayers to maintain detailed documentation as to the purpose of the borrowings and the actual use of the borrowings.

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