Tax Insight – Debt Creation Regime

It was not a complete surprise when the proposal to repeal s. 25-90 was omitted from the thin capitalisation Bill introduced into Parliament on 22 June – the lobbying against the measure had been extensive. But Treasury’s decision to include a new debt creation regime instead was unexpected. Having considered the new debt creation rules, this may be a case of, be careful what you wish for.

1.     Background

In the lead-up to the May 2022 election, the ALP announced that, if elected, it would replace Australia’s existing asset-based thin capitalisation regime with a model based on the recommendations of the OECD’s Final Report on BEPS Action 4: to cap debt deductions by multinationals at 30% of earnings. The ALP had taken a different policy to the 2019 election, proposing to repeal all but the ‘worldwide gearing ratio’ as the thin capitalisation test for Australian entities.

In August 2022, after the ALP election win, Treasury released a consultation paper, Government election commitments: Multinational tax integrity and enhanced tax transparency posing questions about the implementation of the policy, along with questions about a group-based fixed ratio test (in lieu of the existing worldwide gearing test) and an external debt test (in lieu of the existing arm’s length debt test).

In March 2023, Treasury released an Exposure Draft of the thin capitalisation provisions. The Draft also included a proposal to repeal s. 25-90 (and the parallel s. 230-15(3)(c) in the TOFA provisions). Not surprisingly, this provision in the Exposure Draft drew loud complaints as this proposal had not been mentioned in the campaign for the 2019 election or the 2022 election or in the August 2022 consultation paper.

It was not a big surprise when the proposal to repeal s. 25-90 was omitted from the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share – Integrity and Transparency) Bill 2023 when it was introduced into the House of Representatives on 23 June 2023. But the decision to substitute a debt creation regime was completely unexpected. This regime will be difficult to negotiate and will operate as a serious impediment on corporate restructuring and intra-group debt in many circumstances.

The Bill was referred to the Senate Standing Committee on Economics on 22 June, and submissions closed on 21 July. The Committee received over 40 submissions, with many focussed on the debt creation component. The Committee’s report is due by 31 August.

2.     Debt creation

The Bill attacks debt deductions arising from debt connected with two scenarios:

  • Debt (from related parties or third parties) which is used to fund the acquisition, refinancing or retention of assets (or liabilities) acquired from an associate pair [s. 820-423A(2)]; and
  • Debt (from related parties only) that is used (or helps) to finance a payment or distribution to an associate pair [s. 820-423A(5)].

At first glance, the scope of the regime seems tolerably clear, but many traps and snares lie hidden in the text. A few of the more obvious problems based on the current drafting of the Bill are:

  • even though the debt creation provisions will be located in Div 820, the drafting expressly undoes many of the exceptions from the thin capitalisation rules which currently exist. Consequently, taxpayers who currently enjoy an exception from the rest of the thin capitalisation regime (for example, insolvency remote SPVs or investors with 90% of their assets onshore) may find they are exposed to the debt creation rules;
  • in the same vein, the debt creation rules will operate alongside the thin capitalisation rules. So taxpayers who can pass the interest-to-earnings test or external debt test, are nevertheless still exposed to the debt creation regime;
  • there are no express cross-border elements to the operative rules. Consequently, entirely domestic transactions will be caught if done by an entity within the scope of Div 820 (usually, an associate of the entity with the cross-border operations). So, the rules can apply to resident-to-resident sales, or to borrowing from residents who will be assessable in Australia on the interest;
  • one of the more curious interpretation issues is the application of the rule to “acquiring … a legal obligation” from a “disposer”. Does this mean taking on an obligation (ie, borrowing from an associate “disposer”) or “acquiring” an existing obligation from the obligor (which would be acquiring a CGT asset, a transaction that is already covered)? If the phrase means taking on an obligation, then it would amount to a blanket ban on all related party debt, whether the debt is used to finance the acquisition of an asset, or making a payment, or anything else;
  • the second limb of the test denies a deduction for interest on debt which helps an entity make a “payment.” The term “payment” is not defined, so presumably it would include all payments such as paying the price for goods, land or services, repaying the principal of a loan, returns of capital or share buy-backs, and so on; and
  • the language of the Bill attempts to diminish the importance of a direct linkage between the borrowing and the use of the funds. For example, it will be sufficient if the money is used “predominantly” in one of the prohibited ways so presumably the borrowed funds can be supplemented or depleted for other uses, and the rule will still have partial effect. And, so far as the second rule is concerned, the money does not need to be strictly traceable into a payment or distribution to the associate; it will be sufficient if the borrowed money will “increase the ability of any entity … to make …” a prohibited payment or distribution.

The examples in the Explanatory Memorandum (EM) do not acknowledge any of these problems and the potential unintended breadth of its operation. Instead, the EM justifies these rules using examples where there might be some mischief:

  • “debt deductions arising from debt [which] funded the acquisition of shares in a foreign subsidiary from a foreign associate; or business assets from foreign and domestic associates in an internal reorganisation after a global merger”
  • “debt deductions arising from related party debt created by an entity to fund or increase the ability of the entity to make payments to a foreign associate as part of an entirely internal restructure …”.

The Bill does not acknowledge that the rules can be enlivened in innocuous situations: where no additional debt is being introduced into the group, or where interest which used to flow offshore will now be paid to a resident instead. Rather the EM expressly acknowledges the potentially wide application of the provisions:

The provisions are drafted broadly to help ensure they are capable of applying to debt creation schemes of varying complexity. This approach is necessary given the ability of multinational groups to enter into complex debt creation arrangements.

These rules will need to be very carefully considered for any debt connected with a group restructuring (whether of entities or assets), and for any related party debt.

3.     Anti-avoidance rule

Recommendation 6.2(b) of the final report of the 1999 Ralph Review of Business Tax recommended that Part IVA be used “as the preferred response to … tax avoidance”, and that specific rules should be enacted only if, “they offer a more structured, targeted and cost-effective response”. For some reason, the drafters have ignored this recommendation and decided it will be useful to have a dedicated anti-avoidance rule just to protect the debt creation regime. The anti-avoidance rule will reinstate the operation of the debt creation rules where “the Commissioner is satisfied” a scheme has been put in place for a principal purpose that includes achieving the result that neither sub-section applies.

As with any anti-avoidance rules, there is obviously a great deal of wariness about just how ambitious the ATO will be in exercising its discretion to trigger the rule. For example, would the ATO assert these decisions are amenable to challenge:

  • the decision to raise external debt (rather than internal debt) to fund a payment to an associate, or
  • the decision to buy trading stock direct from a third party manufacturer (instead of via an associate wholesaler), or
  • the policy of acquiring assets from related parties with retained earnings or new equity, and using debt only to acquire assets from unrelated parties, or
  • the policy of using retained earnings to fund dividends, while at the same time borrowing from an associate to meet working capital expenses such as funding payments to staff and suppliers?

4.     Commencement and transition

The commencement rule in the Bill says the debt creation rules will apply to debt deductions incurred after 1 July 2023 regardless of (say) when the financed assets were acquired.

No express grandfathering or transition rule is provided, a situation which perhaps makes some sense for the general thin capitalisation provisions (debt on foot as at 1 July 2023 was already being measured against an assets-to-debt test, and will now be measured against an interest-to-earnings test instead). But the decision to apply the new regime to debt associated with corporate restructures which may have happened decades ago is more than a little surprising, especially given that the decision to defer the repeal of s. 25-90 was influenced in no small part by the retrospective impact of the change. Repealing s. 25-90 required unscrambling 20 years’ worth of eggs; applying the debt creation rules to debt associated with historic restructures will be just as hard.

Hopefully a suitable transitional rule will be added as a result of the Senate committee’s work. When a similar regime was introduced in 1987, the regime applied to interest incurred after 1 July 1987 but not if the acquisition of the financed asset had happened prior to that date, so there is a precedent for applying this kind of rule only to interest associated with a post-commencement restructuring.

5.     Debt creation, alongside the repeal of s. 25-90

Even though the Explanatory Memorandum says the debt creation regime is being advanced while the proposed repeal of s. 25-90 is subject to further consultation, it seems highly likely that the debt creation regime will survive the repeal of s. 25-90.

The table below shows there would still be scope for:

  • the debt creation rules to operate after the repeal of s. 25-90 (eg, the repeal of s. 25-90 has an impact if the borrowed money is connected to a dividend receipt while the debt creation rules apply if the borrowed money funds a dividend payment), and
  • for the consequences of the repeal of s. 25-90 to have an impact even in the presence of the debt creation regime (eg, the repeal of s. 25-90 has an impact if the borrowed money is used to acquire a 10% shareholding from an unrelated entity while the debt creation rules would not apply unless both the borrowed money is used to acquire a larger stake and from a related party).
Section 25-90 Section 820-423A(2) Section 820-423A(5)
Lender is … Debt deductions on money borrowed from anyone Debt deductions on money borrowed from anyone Debt deductions on money borrowed from an associate pair
Funds used for … Borrowed funds are used to acquire shares (which pay NANE dividends) – ie, typically a 10% stake Borrowed funds are used to acquire (refinance or retain) any CGT asset or a liability Borrowed funds are used to fund a payment or distribution to an associate pair
Asset acquired from … Assets (shares) are acquired from anyone or issued by subsidiary Asset or liability is acquired from (or created by) an associate pair N/A

 

6.     What next?

As mentioned above, the Bill is currently being considered by the Senate Standing Committee on Economics, which is due to table its report by 31 August 2023. Assuming it recommends some changes to the Bill, it will then be up to the Government to decide whether or not to accept those recommendations. The Government has sufficient members on the Committee to suspect the report will not simply be ignored, but the taxation of multinational businesses is an area where the Government seems reluctant to modify announced views.

Toby Eggleston
Toby Eggleston
Partner, Melbourne
+61 413 151 183
Nick Heggart
Nick Heggart
Partner, Perth
+61 437 001 229
Ryan Leslie
Ryan Leslie
Partner, Melbourne
+61 418 186 499
James Pettigrew
James Pettigrew
Partner, Sydney
+61 2 9322 4783
Graeme Cooper
Graeme Cooper
Consultant, Sydney
+61 2 9322 4081
Jinny Chaimungkalanont
Jinny Chaimungkalanont
Partner, Sydney
+61 418 479 417

Tax Insight: New limits on deducting interest

Treasury decided to spring a very big surprise on multinationals in an Exposure Draft released on 16 March 2023. The Draft was expected to address the Government’s promise to reconceptualise the thin capitalisation safe harbour from a debt: asset ratio to a percentage of EBITDA, which it does (a detailed analysis will follow). The Draft was not expected to re-write rules about deducting interest incurred to capitalise or buy foreign subsidiaries.

Background

The ability of Australian companies to deduct interest on money borrowed onshore to capitalise their foreign subsidiaries with equity (or buy the shares in a target company) has always been an uneasy combination of 2 issues:

  • whether Australian tax law treated dividends received from the foreign subsidiaries as
    • assessable income, but with a credit for foreign tax (the rule just prior to 1990), or
    • non-assessable and non-exempt income (the rule from 1990), and
  • whether the treatment of the interest expense
    • followed the treatment of the dividend income (deductible if the dividend was assessable, and not deductible if the dividend was NANE) (the rule prior to 2001), or
    • was subject to a special rule to allow the interest deduction even if the dividends were NANE (the rule from 2001).

Those 2 rules have rarely been stable but the most recent changes to them were driven by Treasury pursuing sensible policy considerations:

  • the shift in the treatment of dividends from assessable to NANE in 1990 was made because, “the effect of the [foreign tax credit system] for companies … broadly equivalent to providing an exemption for the dividends, but it imposes greater compliance costs than would an exemption,” and
  • the decision to allow a deduction for interest incurred to earn NANE dividends in 2001 was made because, “debt deductions … will come within the scope of the thin capitalisation regime when determining the amount to be allowed” – in other words, the extension of the thin capitalisation regime to outbound investments was the appropriate method of preventing the Australian operations from carrying excessive levels of debt.

Treasury was happy with that theory in 2001, but apparently there was a contrary view inside the organisation because in May 2013 in the 2013-14 Budget, the Government announced that it would be, “removing the provision allowing a tax deduction for interest expenses incurred in deriving certain exempt foreign income” as part of a suite of measures to “address profit shifting by multinationals through the disproportionate allocation of debt to Australia.” No legislation was enacted before the election, and it seemed the proposal had died:

  • in November 2013, the incoming Government announced that it would not proceed with the May 2013 announcement but would instead “introduce a targeted anti‑avoidance provision after detailed consultation with stakeholders.” This measure too was never enacted,
  • in October 2015, the OECD issued its Final Report on BEPS Action 4 which criticised repeatedly “groups using third party or intra-group financing to fund the generation of exempt income.” Treasurer Scott Morrison did not address this part of the Report in his media release about Australia’s responses to the BEPS project, noting only that “Australia has already tightened its Thin Capitalisation rules,”
  • the Senate Economics Committee inquiry into Corporate Tax Avoidance examined the problem it termed “debt loading” but the Final Report in 2018 did not pursue the idea of repealing s. 25-90, recommending instead repealing the safe harbour and arm’s length debt tests, and using worldwide gearing as the only rule for thin capitalisation purposes, and
  • in the run-up to the 2022 election, the ALP’s tax policies focussed on changing the mechanics of the thin capitalisation safe harbour and a suite of other measures directed to multinationals; there was no mention of any change to s. 25-90.

So, the inclusion of 2 brief paragraphs in the Draft released yesterday, effectively repealing the ability of companies to deduct interest incurred to earn NANE dividends, was truly remarkable. The Explanatory Memorandum said that decision was made because:

 The rules … go against the policy underlying the new rules as it gives rise to a double benefit; the benefit of the income being NANE income and the benefit of a  deduction for the interest expenses incurred to derive such NANE income.

This bland statement doesn’t explain why that very position was acceptable tax policy for the last 20 years, why a thin capitalisation rule based on cash flows requires a different rule to one based on asset values, nor why the newly-tightened thin capitalisation rules will apparently be inadequate to protect the Australian tax system – especially when NANE income is excluded when calculating tax EBITDA for the purposes of the new 30% of EBITDA fixed ratio thin capitalisation test.

The measure

The Draft contains a simple 2-line proposal to remove references to s. 768-5 from s. 25-90 and the equivalent provision in the TOFA regime (s. 230-15). (Interest would still be deductible if incurred in connection with NANE dividends paid out of income already attributed from a CFC or FIF, but these dividends are made NANE because the profits out of which they are paid have already been attributed and taxed).

Assuming it is passed as drafted, the new measure will start for interest incurred in income years starting on and after 1 July 2023. There is currently no provision which would “grandfather” existing debt structures or allow a grace period for taxpayers to unwind them before the change applies.

The future

Assuming it is passed as drafted, we will return to 2000: a world of tracing of loan funds and apportionment for interest expense. One reason for the 2001 amendments was to get rid of the compliance nuisance that “the debts of an outbound investor are traced to an end use to determine the treatment of the interest expense.”

We will also likely return to a world of cash damming, quarantining funds and similar self-help practices to mitigate against the impact of the rule. It would a brave decision to put in place the kind of 2-tier structure struck down by the High Court in the Consolidated Press case in 2001, but no doubt variations will emerge over time.

The Draft is open for submissions until 13 April 2023.

Key contacts

Toby Eggleston
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Ryan Leslie
Ryan Leslie
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Graeme Cooper
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