Tax Insight – Senate Report on Thin Capitalisation Provisions

On 22 September 2023, the Economics Legislation Committee handed down the final report of its inquiry into the provisions of the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share-Integrity and Transparency) Bill 2023. The Report is deeply disappointing and does not augur well for other important consultations. This Tax Insight focuses on the parts of the Bill and Report dealing with the thin capitalisation provisions.

1.  Background

The background to this Bill starts with the proposal announced by the ALP in April 2022 as part of its tax policies for the 2022 election to change the thin capitalisation test to one based on the ratio of interest expense to earnings, rather than the ratio of debt to asset values. (The ALP’s election policies with respect to tax are available here.)

After the election, in August 2022, Treasury released a Consultation Paper, Government election commitments: Multinational tax integrity and enhanced tax transparency which laid out some of the likely parameters of the new design. (Our Tax Insight on the Consultation Paper is available here.)

In March 2023, Treasury released an Exposure Draft of provisions to give effect to the policy. The Draft did give effect to the Government’s promise to reconceptualise the thin capitalisation regime, but it also included an unexpected proposal to repeal s. 25-90, denying a deduction for interest incurred to capitalise or buy foreign subsidiaries. While this surprise attracted the most attention, the Exposure Draft contained other problematic provisions. (Our Tax Insight on the Exposure Draft is available here.)

The furore created by the Exposure Draft caused Treasury to modify its position somewhat. When the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share – Integrity and Transparency) Bill 2023 was introduced into the House of Representatives in late June 2023, the contentious proposal to repeal s. 25-90 was removed for further consultation, but it was replaced by another surprise – a so-called “debt deduction creation” regime. Many of the problematic provisions of Exposure Draft had not been resolved. (Our Tax Insight on the Bill is available here and our podcast is available here.)

2.  Senate Committee process and recommendations

The Senate then referred the Bill to the Senate Economics Legislation Committee. The Committee received 53 submissions on the Bill by 21 July and held one day of public hearings on 15 August. Its report was released on 22 September 2023.

Most of the submissions from the tax profession and industry addressed technical shortcomings with the design and the drafting, focussing on issues such as:

  • issues in the current calculation of EBITDA,
  • difficulties in the accessing the external debt test,
  • difficulties meeting the conditions for the conduit financier regime,
  • problems applying the fixed ration and group ratio rules to groups of trusts,
  • transitional rules and commencement dates,
  • substantial issues in relation to the “debt deduction creation” regime and the seemingly broader than anticipated scope of operation,

and so on. Those submissions were consistent and thorough.

The Committee split along party lines with a majority position endorsed by the 4 members from the ALP and Greens, and a minority position from the 2 Liberal members. The majority recommendation was that, “the bill be passed subject to technical amendments foreshadowed by Treasury.” In other words, the Committee was completely unmoved by any of the submissions other than accepting an undertaking by Treasury to make “minor technical amendments” which Treasury acknowledged in the hearing. These included:

  • making clarifications to the Australian resident requirement so that the third party debt test applies to trusts that may have been ‘inadvertently excluded’ in the drafting of the bill”;
  • a possible “narrowing of the (debt deduction creation) rules” which could involve “excluding the securitisation vehicles and even perhaps the authorised deposit-taking institutions (ADIs) on a similar basis to how they’re excluded from the proposed amendments to the thin capitalisation rules…”; and
  • Including certain exclusions which would clarify the operation of the rules modelled on the former 16G ITAA 1997 (sic) exclusions”

The qualification that Treasury can make the “technical amendments [it] foreshadowed” implies that these changes have been evaluated and endorsed by the Committee, but apparently “this committee has not seen those amendments, despite the request by committee members for Treasury to provide them …” This is particularly disappointing given industry had less than 4 weeks to make submissions but Treasury, having had the benefit of 2 months to review the submissions and 5 weeks from the public hearings, was still not in a position to provide the proposed amendments to the committee for review. So, it seems the majority was content to leave everything to the wisdom of Treasury and inquire no further.

Equally as concerning was the majority’s acceptance of the justification for the debt creation rules. Treasury and the ATO only provided high level reasons, without specific examples of issues that were of concern: “When we drafted the current debt deduction creation law, we drafted it with a view to other guidance and perhaps changes in legislation that have occurred since the original rules were in place” … and  “… we are aware of views in the tax advisor community that the absence of the debt creation laws since 2001 actually allowed for debt creation schemes to take place in a way that we can’t otherwise address without these rules, so there’s evidence of it in the past.”

Similarly, requests by taxpayers and the profession for the debt deduction creation rules to be grandfathered were waved away as being too administratively difficult for taxpayers to track and too complex to draft, despite a grandfathering rule having been introduced when changes were made to the rules governing sovereign immunity. In addition, requests for the start date of the thin capitalisation rules to be deferred were met with a dead bat on the basis that “essentially, the changes commencing from 1 July 2023 would only need to be reported in tax filings for the 2023-24 financial year, which, for ordinary June balances, would not be until later in 2024. So there is also time for entities to make appropriate changes accordingly.”

3.  Next steps

Given tenor of the report, it seems likely that the Government will simply accept the report and adopt its recommendations. Whether or not Treasury will decide to fix any of the technical drafting defects before the Bill is enacted remains to be seen, but given the composition of the committee, it is almost certain that whatever Treasury decides to do will just be rubber-stamped by both Houses of Parliament.

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
Jinny Chaimungkalanont
Jinny Chaimungkalanont
Partner, Sydney
+61 418 479 417

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: Thin Capitalisation Bill – In More Detail

This Tax Insight gives a fuller analysis of the changes to the thin capitalisation measures contained in the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share – Integrity and Transparency) Bill 2023 introduced into Parliament last week. The Bill departs from the Exposure Draft, which was released for consultation in March 2023, in important respects. This Tax Insight focuses on five key rules and concepts that have changed since March.

Calculating the Fixed Ratio

The new thin capitalisation test will cap the “net debt deductions” of a general class taxpayer in any year at 30% of the taxpayer’s “tax EBITDA” (unless it qualifies for, and elects to use, one of the other tests).

The Exposure Draft defined these terms and the Bill has adjusted the definitions slightly:

  • the amount of “net debt deductions” put in jeopardy by the new rules has been reduced slightly: that is, more amounts will now potentially reduce the deductions at risk of being denied;
  • the amount of “tax EBITDA” has been amended so the 30% test is now measured against a different number. For example:
    • depreciation deductions allowed under any Subdivision of Div 40 will be added back (increasing the “D” component of EBITDA). The March Bill had limited the add-back just to amounts claimed under Subdivision 40-B, but the expansion in the Bill will mean deductions like project pool amounts and black hole expenses will now increase the size of tax EBITDA;
    • however, amounts which are immediately deductible under Division 40 will not be added back. This would mean some mining expenditure and amounts claimed under instant asset write off provisions will not be added back;
    • similarly, assessable dividends (including from portfolio investments) and franking credits (which would have increased the “E” component of EBITDA) are now excluded. And, for trusts, distributions from other trusts will usually not be included in the “E”, which means head trusts which borrow to capitalise sub trusts will often have difficulty in deriving any earnings under this formula as drafted; and
    • prior year losses are no longer reversed out (so losses will now decrease the “E” component of EBITDA).

In addition, new provisions have been added in the Bill to accommodate the calculation of “net income” which is the concept applicable to trusts and partnerships.

Carry forward of debt deductions denied under the FRT

The Exposure Draft contained provisions which allowed a taxpayer to carry forward deductions denied under the Fixed Ratio Test (but not the other tests) for up to 15 years. This was particularly important for entities with little cash flow in the early years of their operations or where earnings are highly volatile.

However, the Exposure Draft, proposed that the ability to carry forward deductions would be lost if either:

  • the taxpayer switched from using the Fixed Ratio Test to either the External third-party debt test or the Group ratio test at some point, or
  • there was a change to the majority ownership of a company (although no equivalent loss had been proposed for trusts).

As a result of the consultations, the Bill has adjusted these rules. Carry forward deductions will now be available if the business continuity test has been met for companies and the trust loss rules have been passed for trusts.

External Debt Test

The Exposure Draft revealed that the existing arm’s length debt test would be repealed for general class investors, which was something of a surprise given the ALP’s election commitment to, “maintaining the arm’s length test.” Instead, the new external debt test would permit the deduction of all interest expense provided it was being paid to third parties.

A taxpayer who makes this election can deduct their interest expense up to the amount of interest incurred on external debt. If the taxpayer has only external debt, this means the taxpayer can deduct all its interest expense. If the taxpayer has a modest amount of related party debt, it might still want to make this election, knowing that the election comes at the cost of abandoning the deduction for interest on the related party debt. But the Bill has improved that calculus somewhat by specifically adding amounts incurred on hedging with non-associates in the total that can be deducted.

The version in the Exposure Draft imposed a number of restrictive conditions, some of which have been tweaked in the Bill. Debt will not qualify as “third party” debt if:

  • borrower: the issuer is a non-resident;
  • lender: the debt interest was issued to an associate of the entity, or the debt interest is held by associate of the entity at any time during the income year;
  • recourse: the holder of the debt interest has recourse to assets beyond the Australian assets of the entity; or
  • use of funds: the debt is used to fund the entity’s Australian operations, and is not –
    • used to fund a foreign PE, or
    • lent to an associate, or injected as debt or equity into a controlled foreign entity.

The revisions made in the Bill have focussed mostly on cross-border aspects of the test:

  • the requirement that only residents can elect to use the external debt test is new;
  • the requirement that residents must be using the debt to fund “commercial activities [being conducted] in Australia” is new; the previous version allowed a taxpayer to fund any “assets [held] for the purposes of producing assessable income …” which would have extended to offshore operations if they did not amount to a branch;
  •  the holder must not be able to access the borrower’s rights under a guarantee or other form of credit support (most likely given by a related parent entity). Presumably this acts as an indirect constraint on the amount of debt unrelated lenders are willing to advance; and
  • the debt cannot generally be secured although there are exceptions. The interaction between various rules seems to produce these outcomes:
    •  the debt can be secured if the security is over the borrower’s own assets in Australia (whether land or not);
    • the debt can also be secured by a resident associate of the borrower, provided the security is only over land in Australia; but
    • a non-resident associate cannot give security even if it is only enforceable against the non-resident’s Australian land (and definitely not if it is enforceable against the non-resident’s foreign assets).

But even with these adjustments, the requirements may lead to odd outcomes. For example, the prohibitions on parental guarantees and credit support are doubtful. The Explanatory Memorandum says these requirements exist to –

ensure that multinational enterprises do not have an unfettered ability to fund their Australian operations with third party debt. Given Australia’s relatively high corporate tax rate, multinational enterprises may seek to fund their Australian operations with high levels of debt relative to their operations in other jurisdictions.

Guarantees may indeed allow more debt to be borrowed, but they also mean any debt should be cheaper. Treasury no doubt believes that without this rule, the Australian operations will carry excessive debt; it may turn out that with this rule, the Australian operations will carry very expensive debt. One cannot predict ex ante which outcome will happen, or which will be better (or worse) for the Australian revenue.

Conduit financing structures and the Third Party Debt Test

The Exposure Draft contained a conduit financing regime to accommodate the common practice of using a “Fin Co” to raise external funds and on-lend to other members of the (non-consolidated) group. The rules allowed the on-lending of externally-raised debt to associates of the borrower by relaxing some of the conditions that would ordinarily prohibit this (the associate test and the recourse test). But even with these adjustments, the conditions which had to be met were very strict, in essence requiring a back-to-back loan arrangement of the borrowed funds (only) and on the same terms.

The Bill has relaxed some of the strictness of the former conditions relating to the “recourse” test and the “same terms” requirements, but a number of issues remain, including for stapled structures.

Associated entities

Multiple provisions (in the current law, the March Exposure Draft and in the Bill) turn on whether the parties involved in a structure or transaction are “associated entities.” For example,

  •  the thin capitalisation provisions in Div 820 are only enlivened if an entity, all its associates, are claiming debt deductions greater than $2 m for the income year;
  • the status of a financial entity or ADI attaches to every associate of the financial entity or ADI;
  •  the debt creation rules (discussed below) are based on a test which uses the concept of an associate;
  •  third party debt cannot be borrowed from, or held by, an associate;
  •  the conduit financing regime requires that every party in the chain is an associate;

and so on.

In the Exposure Draft, the level of ownership which would make an entity an “associated entity” was to be reduced from the standard 50% to 10%. The Bill has relaxed this restriction for some rules to an interest of 20% or more. But the change to a 20% test is not universal – the definition of “associated entity” will need to be carefully monitored in each scenario to see whether the 10%, 20% or 50% threshold applies.

Debt creation regime

The biggest surprise in the Bill was the decision to revive the debt creation rules, a version of which existed as Div 16G ITAA 1936 and operated between 1988 and 2001. The Explanatory Memorandum makes it clear that the “targeted debt creation rules were progressed in … place [of the proposed repeal of s. 25-90, which was deferred.]” The Explanatory Memorandum also relies on the OECD’s Report on BEPS Action 4, “which recognises the need for supplementary rules to prevent debt deduction creation.” These measures were not included in the March Exposure Draft and so were not the subject of consultation.

The new provisions will disallow debt deductions to the extent that they are incurred in relation to “debt deduction creation.”  At its simplest, the Bill contemplates two transactions:

  •  an entity acquires a CGT asset, or takes on a legal or equitable obligation from another entity which is an associate and the relevant entity incurs debt deductions in relation to the acquisition or holding of the CGT asset or obligation. The Explanatory Memorandum gives as examples,
    • issuing debt to acquire shares in a foreign subsidiary from a foreign associate or
    • issuing debt to acquire business assets from foreign and domestic associates in an internal reorganisation after a global merger;
  • an entity borrows from an associate to fund a payment to that entity, or another associate. The Explanatory Memorandum gives the example of debt issued to allow an entity to make payments to a foreign associate as part of an entirely internal restructure.

The debt creation rules will affect financial entities and to ADIs, both of which were immunised from most of the other changes being made in the Bill.

The substantive rules are also buttressed by a dedicated anti-avoidance rule which allows the Commissioner to issue a determination negating a scheme “for more than one principal purpose that included the purpose of …” ensuring that the debt creation rules were not triggered.

The provisions will operate independently of the rest of the thin capitalisation provisions. Hence, an entity which may have only external third party debt may nevertheless fall foul of these rules. If both rules can apply, there will be an ordering issue, similar to the problem which currently exists between thin capitalisation and transfer pricing or between thin capitalisation and the debt-equity rules.

Because these rules exist inside Div 820, they will be subject to the same $2m de minimis threshold that applies to the rest of Div 820. But, unlike the rest of Div 820, and unlike the former Div 16G, there are no cross-border elements to these rules – once the relevant entity has the cross-border attributes which attract Div 820 (eg, it is owned by a non-resident), the rules can be triggered by entirely domestic transactions and reorganisations.

Finally, while these provisions were added as the price for deferring the repeal of s. 25-90, our crystal ball strongly suggests these provisions are now permanent features of the law and will not be reversed even if s. 25-90 is removed.

What hasn’t changed

The Bill has not addressed two matters in the Exposure Draft which drew detailed submissions:

  • the transfer pricing rules will now require general class investors to demonstrate that the amount of debt they owe is not excessive (ie, even if the fixed ratio test is applied and debt deductions are less than 30% of tax EBITDA); and
  • the new rules will apply for income years commencing on or after 1 July 2023 with no grandfathering of existing debt or transition period to allow for the reorganisation of existing structures.

Key contacts

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

 

Tax Insight: Government Introduces Thin Capitalisation Changes

The Government has introduced into the House of Representatives the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share – Integrity and Transparency) Bill 2023 to enact its proposed changes to Australia’s thin capitalisation regime. This Tax Insight gives a brief summary of the key points; a fuller analysis will follow.

Thin capitalisation changes

So far as thin capitalisation is concerned, the Bill will enact the key components of the policy which the ALP took to last year’s election and released for consultation earlier this year. See our Tax Insight at https://hsfnotes.com/taxaustralia/2023/03/27/tax-insight-changes-to-thin-capitalisation-rules/

For general investors:

  • The current safe harbour for general investors (the level of debt must not exceed 60% of the value of assets) will be replaced by test which limits debt deductions to no more than 30% of tax EBITDA.
  • Where interest is denied under this test, the deficiency may be carried forward for up to 15 years.
  • The current option which allows gearing of the Australian entity up to the gearing level of the worldwide group will be replaced by a test based on the adjusted earnings ratio of the worldwide group.
  • The arm’s length debt test has been replaced by an external third party debt test.
  • The new tests start from 1 July 2023.

There have been modifications to some of the detail in the Exposure Draft, but the key design elements remain.

Section 25-90 deferred, but …

An Exposure Draft of the Bill released for comment earlier this year had included a proposal to repeal s. 25-90. See our Tax Insight at https://hsfnotes.com/taxaustralia/2023/03/17/tax-insight-new-limits-on-deducting-interest/

This measure has been omitted from the Bill, but it is not dead. The Explanatory Memorandum to the Bill says, “stakeholder concerns regarding section 25-90 were considered by Government, with the proposed amendment deferred, reflected in its removal from the final legislation, to be considered via a separate process to this interest limitation measure.”

And the deferral of s. 25-90 came at a price. The Bill includes new “debt creation” rules (based on the former Div 16G ITAA 1936) which were not released for consultation. The Explanatory Memorandum to the Bill says, the “targeted debt creation rules were progressed in its place.” The measure will disallow debt deductions, “to the extent that they are incurred in relation to debt creation schemes”. The Bill outlines 2 cases:

  • an entity borrows to acquire an asset from an associate, and
  • an entity borrows from an associate to fund a payment it will make to that entity or another associate.

These rules will operate independently of the thin capitalisation regime, as a discrete measure to deny interest deductions. They will require careful and detailed analysis.

Other measures in the Bill

The Bill also contains amendments to the Corporations Act 2001 to require Australian public companies (listed and unlisted) to disclose itemised information about subsidiaries in their annual financial reports. This requirement will apply to financial reports for financial years starting on and after 1 July 2023.

Status update

The Government also took the opportunity to give an update on the work toward meeting some of its election commitments, re-announced in the October 2022 Budget, and previously released for consultation. Consequently, a large part of the Explanatory Memorandum to the Bill has nothing to do with measures in the Bill; it is devoted to explaining what is happening elsewhere. These measures include:

Measure Update
MNEs will be required to publish tax information drawn from country-by-country (CbC) reports which will be made public

[See our Tax Insight at https://hsfnotes.com/taxaustralia/2023/04/18/tax-insight-another-public-tax-reporting-obligation/]

“… four additional data disclosures – related party expenses, the effective tax rate disclosure and the two intangible assets disclosures – [have been] removed from the proposed option

The proposed [measure is] deferred … by 12 months, to apply from 1 July 2024 …

While the disaggregated CbC reporting is intended to support meaningful improvements to tax transparency disclosures, there is a recognition that it does depart from the EU and OECD approaches, and that further consultation with industry may be beneficial on this element of the measure (and the measure more broadly).”

Tenderers for Australian government contracts worth more than $200,000 must disclose their country of tax domicile. “This element does not require legislative amendments and will instead be implemented via administrative changes to the Commonwealth Procurement material”
Denying a deduction for payments made by a SGE to a related party for the exploitation of an intangible asset, where the arrangement leads to income derived in a low or no-tax jurisdiction.

[See our Tax Insight at https://hsfnotes.com/taxaustralia/2023/04/18/tax-insight-new-limits-on-deducting-payments-involving-intangibles/]

“The option is the preferred option … The option applies to payments made from 1 July 2023.”

 

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

Tax Insight: Changes to Thin Capitalisation Rules

Treasury has released an Exposure Draft of provisions to enact the new thin capitalisation limits, to give effect to the policy which the ALP took to the last election. The Draft contains a few surprises, not least, the novel way the Exposure Draft says it meets the ALP’s promise that the new test would be based on profits “…while maintaining the arm’s length test”. This Tax Insight focuses principally on the changes affecting commercial and industrial MNEs.

1.   Key Points

  • The Exposure Draft creates a new class of taxpayers for the purposes of the thin capitalisation rules: the ‘general class investor’ which combines both foreign owned Australian entities and Australian entities with foreign operations.
  • General class investors will be subject to a new thin capitalisation test based on their adjusted earnings (30% of ‘tax EBITDA’) rather than the average value of their assets and debt. This is referred to as the ‘fixed ratio test’ and does not operate as a safe harbour.
  • Deductions denied under this test (but not the other tests mentioned below) can be carried forward for up to 15 years. Denied deductions will be lost if there is a change of ownership of a company with carry-forward denied deductions.
  • The Exposure Draft permits some taxpayers to adopt a test based on the adjusted earnings ratio of the worldwide group (in lieu of the existing worldwide gearing test).
  • The Exposure Draft repeals the arm’s length debt test for general class investors and financial entities and enacts instead an external third party debt test.
  • The treatment of the category of “financial” investors is left largely unaffected except for replacing the arm’s length debt test with the external third party debt test.
  • The treatment of Authorised Deposit-taking Institutions is left largely untouched.
  • The Exposure Draft also makes significant changes to the deductibility of interest on money borrowed to acquire shares in offshore subsidiaries (see our Tax Insight available here).
  • The Exposure Draft also adjusts the transfer pricing rules to require general class investors to demonstrate that the amount of debt they owe is not excessive (ie, even if the fixed ratio test is applied and debt deductions are less than 30% of tax EBITDA).
  • The new rules will apply for income years commencing on or after 1 July 2023 with no grandfathering of existing debt or transition period to allow for the reorganisation of existing structures.
  • Treasury has set a deadline of 13 April 2023 for submissions on the Exposure Draft.

2.   Who is affected

The principal changes affect the classes of taxpayers who used to be known as –

  • an inward investor (general) – a foreign entity with a PE or other investments in Australia,
  • an inward investment vehicle (general) – an Australian company, trust or partnership that is controlled by foreign residents, and
  • an outward investor (general) – an Australian entity that –
    • controls a foreign company, trust or corporate limited partnership,
    • carries on business abroad through a foreign PE, or
    • is an ‘associate entity’ of an outward investor.

These three groups are now combined into a single class of taxpayer – general class investors – which is made subject to the new thin capitalisation tests.

The other classes of taxpayer established in the existing rules – inward and outward financial entities and inward and outward ADIs – are also affected by the changes:

  • the Draft tightens the definition of ‘financial entity’ to limit access to the rules for financial entities on the basis that the rules for financial entities, “are generally more favourable to taxpayers than the new tests which only apply to general class investors”; and
  • the tests available to financial entities are also modified.

But provisions in the existing law which exclude certain securitisation vehicles and taxpayers with debt deductions below $2m remain unaffected (but also not indexed) by the Draft. The existing exemption for outward investing entities where Australian assets represent at least 90% of the value of total assets (on an associate-inclusive basis) is also unaffected.

Determining status. The rules now create 5 classes of entity and each class must apply the rules from the suite of rules relevant to that class. Prima facie, every entity is classified as a general entity and can be classified as financial investor or ADI only if it has that status for the whole of the income year.  (Under the prior law, status could change during a year and the relevant treatment applied to an entity for each period “that is all or a part of an income year …”)

The former distinction between inbound and outbound investors has been eliminated for general class investors but this distinction still survives for financial investors and ADIs. This creates a difficulty when an entity is both (eg, a foreign-owned Australian company with offshore operations).

3.   What is the impact of the changes

The main impact of the measures in the Draft is:

The existing test … Will be replaced by …
For general investors
Safe harbour debt amount
Arm’s length debt amount
Worldwide gearing debt amount
Fixed ratio test
External third-party debt test
Group ratio test
For inward and outward financial investors
Safe harbour debt amount
Arm’s length debt amount
Worldwide gearing debt amount
No change
External third-party debt test
No change
For inward and outward ADIs
Safe harbour capital amount
Arm’s length capital amount
Worldwide capital amount (outward investor ADI only)
No change
No change
No change

This change means Australia will employ multiple concepts for determining whether an Australian entity is thinly capitalised:

  • general investors can apply a test which looks at cash flows: interest as a percentage of earnings,
  • financial investors can continue to apply a test which looks at capital structure: the value of debt as a percentage of the value of assets, and
  • ADIs can continue to apply a test which looks at the entity’s regulatory capital: the value of its risk-weighted assets.
3.1   How the options will work for each class of taxpayer

Making an election: As the table above shows, each class of taxpayer has, and will continue to have, access to multiple tests to determine whether some or all of its debt deductions are disallowed.

Current law does not involve an explicit election: the taxpayer automatically gets the best outcome under any of the three tests. This means, the taxpayer can be wrong and not suffer – if needed, it can defend an audit relying on a method it did not actually apply. Further, the taxpayer does not need to make a formal election that it is choosing to apply one method rather than another.

The new law will work rather differently for general investors:

  • the taxpayer must apply the fixed ratio method for the income year unless it is eligible and elects to use either the group ratio test or the external third-party debt test for the year,
  • if it makes an election to use the group ratio test or the external third-party debt test,
    • the debt deduction is dictated by that election even if another method would produce a more favourable result,
    • the entity must notify the ATO in the approved form that it is making this election,
    • that election applies for the relevant year and is irrevocable for that year,
    • while a different election (or no election) can be made for subsequent years, changing methods across years can produce an unfavourable outcome if the taxpayer wants to carry forward denied deductions under the fixed ratio test to use in later years.

The existing automatic system will continue to apply to financial investors and ADIs.

One-in-all-in effect. As will be seen, for general class investors, the fixed ratio limit applies unless the taxpayer qualifies and decides to elect into either the group ratio limit or the external third party debt limit. The election is made by the taxpayer and its effect applies to all of the taxpayer’s debt. To put this the other way, a taxpayer cannot, for example, apply the external third party debt test to its external debt and apply the fixed ratio test to the remainder.

3.2   Fixed ratio test limit

The new fixed ratio test limit (based on interest as a percentage of adjusted cash flows) will replace the existing safe harbour test (based on the level of debt as a percentage of asset values) for general class investors.

The fixed ratio test disallows “net debt deductions” in excess of 30% of “tax EBITDA.”

Net debt deductions. The term “debt deductions” is used in the current law. It extends beyond interest to include some fees, rent, brokerage, stamp duty, net losses on some security arrangements and other amounts which are not technically “interest.”

The Exposure Draft also expands the existing definition of “debt deduction” to break the current link to the “debt test” in the debt-equity provisions – the existing definition requires that the expense is “incurred in relation to a debt interest issued by the entity.” That requirement will be removed and the Draft Explanatory Memorandum says this is being done “to capture interest and amounts economically equivalent to interest, in line with the OECD best practice.” In other words, Treasury prefers not to limit the new thin capitalisation measures by tying them to the debt-equity tests.

An entity’s “net debt deductions” is the entity’s “debt deductions” reduced by any amounts of assessable income which are “interest”, “an amount in the nature of interest” and “any other amount that is calculated by reference to the time value of money.”

Tax EBITDA. “Tax EBITDA” is defined in the Exposure Draft quite briefly. In summary, the calculation is:

taxable income for the current year (disregarding the operation of the thin capitalisation rules
plus ‘net debt deductions’ for the income year (ie, interest and similar amounts minus debt deductions)
plus decline in value of depreciating assets calculated under Div 40-B (only)
plus capital works deductions calculated under Div 43
plus tax losses of earlier income years being deducted in calculating this year’s taxable income


Some implications.
This definition has some important implications:

  • the term is “tax EBITDA” – that is, it is defined using tax law concepts rather than the accounting concepts which the label might suggest,
  • only amounts of assessable income count for this purpose; amounts which are NANE (such as dividends from foreign subsidiaries or gains on the sale of shares in active foreign subsidiaries) or exempt income do not count as “Earnings” and so reduce the available envelope,
  • using the item “net debt deductions” is similarly unfriendly to taxpayers. As noted above, the term “debt deductions” is already drawn very broadly and will be expanded further, but the amounts which can offset debt deductions is narrower, and is limited just to “interest,” “an amount in the nature of interest” and “any other amount that is calculated by reference to the time value of money”,
  • to the same effect, adding back as the “Depreciation” component only deductions claimed under Subdiv 40-B and Div 43 means tax EBITDA will still be depleted by the impact of:
    • deductions calculated under Div 328 (which would seem a drafting oversight), or
    • amounts which are deducted under Div 40, but not Subdiv 40-B, such as balancing adjustments, in-house software development pool amounts, project pool amounts, certain primary production amounts, exploration and prospecting, mining site rehabilitation, black holes and so on.

Segregated functions in groups.  It is quite likely that some (non-consolidated) groups will have a group structure where assets are owned by operating entities and debt is raised (and on-lent) by finance entities. Once the group is owned from offshore or has foreign operations, this kind of structure will be problematic under an earnings-based rule unless the finance entity on-lends to the operating entities at interest to ensure that it has only modest “net debt deductions” which might exceed the limit. If the finance entity injects the funds interest-free or as equity into the operating entity, it may face obstacles in being able to satisfy an earnings-based test. The same issues would arise if the finance entity is a trust.

The driver of this problem is that (outside consolidation) the rules do not allow for the aggregation of structures where income is earned by the operating entity but interest is incurred by the finance entity. Thus, a project which might meet the 30% of EBITDA test considered as a whole, may fail because of separation of functions.

15 year carry forward.  If debt deductions are disallowed under the fixed ratio rule, the amount of the denied deductions in a year can be carried forward for up to 15 years (assuming there is ‘headroom’ in the subsequent year to absorb some or all the denied amount). This option is only available for amounts denied under the fixed ratio rule which means it is available only –

  • to general investors (other investors cannot use this rule),
  • who are using the fixed ratio test in the year in which the deduction is denied (rather than the group ratio rule or external third party debt rule), and
  • the taxpayer must be using the fixed ratio rule in the subsequent year and every intervening year as well (effectively removing the ability to make an election if the taxpayer ever hopes to use its denied deductions).

The Draft proposes to deny companies the ability to carry forward denied deductions if there is a change to the majority underlying ownership of the company (determined using the rules which apply for the purposes of loss carry forward). There is no similar business test alternative available to preserve the denied deductions after a change of ownership. The denial is not triggered if there is a change to the ownership of a trust.

There are also complex amendments dealing with the treatment of deferred deductions if a taxpayer with deferred deductions enters a consolidated group. The rules for transferring deferred deductions mirror existing rules dealing with the transfer of tax losses on entry into a consolidated group, but with some variations. For example, denied deductions that are transferred to a consolidated group when an entity joins will reduce the cost which can be pushed down onto the group’s assets but importantly there is no option to cancel the transfer of deferred deductions and leave cost unaffected. It also seems that deferred deductions cannot be transferred to MEC groups.

3.3   Group Ratio Test

The new group ratio test (the group’s third-party interest expense as a percentage of the group’s tax EBITDA) will replace the existing worldwide gearing test (the group’s level of worldwide debt as a percentage of the group’s worldwide equity). The Draft Explanatory Memorandum says, “the group ratio test allows an entity in a highly leveraged group to deduct net debt deductions in excess of the amount permitted under the fixed ratio rule, based on a relevant financial ratio of the worldwide group.”

The group ratio test disallows a portion of the debt deductions of a local entity if the net debt deductions exceed the group ratio earnings limit for the income year. So this test operates using a mixture of financial accounting concepts and Australian tax law concepts:

  • the group is defined to consist of all entities which are consolidated on a line-by-line basis in accounts of a “worldwide parent entity;”
  • the group ratio (the ratio of interest to EBITDA of the group) is calculated using the data from the audited consolidated financial accounts; and
  • that ratio is then applied to the “tax EBITDA” of the Australian entity for the income year; that is, to amounts defined under the Australian tax law.

Group ratio earnings limit.  As mentioned above, the group ratio earnings limit is calculated using information from the consolidated financial accounts of the group. It is the ratio of the “group net third party interest expense” for a period to the “group EBITDA” for the period:

  • the group net third party interest expense is the total amount appearing in financial statements which reflects:
interest expense
plus “amounts in the nature of interest
plus “any other amount that is calculated by reference to the time value of money”
minus payments made by the entity to an (ungrouped) associate of the entity (ie, this amount is not third party interest expense)
minus payments made by an (ungrouped) associate of the entity to the entity (ie, this is not third party interest income and so does not diminish the net interest expense).
  • the group EBITDA for a period is –
the group’s net profit
plus the group’s adjusted net third party interest expense
plus the group’s depreciation and amortisation expenses
minus tax expense


Records.
Because this test relies on the group’s consolidated financial statements which might be held offshore or incorporate data from subsidiaries in other countries which is similarly inaccessible to the ATO, special record keeping rules require the entity to keep dedicated records showing how the group earnings ratio limit was calculated.

Implications: Again, these requirements have some important implications:

  • this option is only available to a group with a single worldwide parent entity,
  • the parent entity must prepare consolidated financial statements and have them audited,
  • another requirement insists that the group EBITDA must not be less than zero, so this test cannot be used if the group is in losses worldwide (even if the Australian entity has taxable income).
3.4  External third-party debt test

The existing arm’s length debt test has been repealed for general class investors (and financial investors). Instead, they can choose to use the new, much narrower, external third-party debt test and all the group’s interest expense on qualifying debt will be unaffected by thin capitalisation considerations.

The decision to replace the arm’s length debt test contradicts the ALP’s policy position for the 2022 election that it would limit debt-related deductions using a test based on profits “… while maintaining the arm’s length test…” However, the kind of debt which will satisfy this new test is subject to pre-conditions which indicate the parties were dealing at arm’s length. But this decision, and Treasury’s decided lack of enthusiasm for using arm’s length tests, was strongly hinted at in Treasury’s Consultation Paper (August 2022) – Treasury was very concerned that the impact of the fixed ratio rule might induce taxpayers to start employing the arm’s length debt test instead. Consequently, “arm’s length debt” has been taken off the table and replaced with “third party debt.”

That is, under the new rules deductions may be denied for debt issued on arm’s length terms if it is issued to an associate.

The external third party debt test disallows the entity’s debt deductions for the income year if they exceed the entity’s external third party earnings limit. To put this the other way, an entity can deduct all the interest on debt it borrows from third parties (provided it only uses the funds in Australia to produce assessable income and is only secured over assets held by the entity, subject to the conduit financing rule).

External third party earnings limit. The external third party earnings limit starts from the debt deductions attributable to a “debt interest issued by the entity” (which effectively reintroduces the debt test). The test then removes –

  • any debt interest that was issued to an associate entity of the entity,
  • any debt interest held by an associate entity of the entity at any time during the income year,
  • any debt interest where the holder has recourse to the assets of some other entity, and
  • any debt which is used, even in part, to fund operations outside Australia if they produce NANE or exempt income (such as funding the assets or operations of a foreign PE).

In these rules, the level of ownership which will make an entity an “associate entity” will be reduced from the standard 50% to 10%.

Conduit financing structures.  The regime does contain one concession to the common practice of using a “Fin Co” to raise funds and have it on-lend to other members of the (non-consolidated) group.

The rules allow the on-lending of externally-raised debt to associates of the borrower by relaxing some of the conditions that would ordinarily prohibit this (the associate tests and the recourse test), but the conditions which must be met are very tight, in essence requiring a back-to-back loan arrangement of the borrowed funds (only) and on the same terms. The requirement that the loan arrangements be between “associate entities” may also cause problems for stapled structures.

The initial borrower and the entities to which it lends must all make an irrevocable to apply the regime and security can only be over the assets of the Fin Co and the ultimate borrower(s).

Election requirements: General class investors cannot make this choice if:

  • the entity has one or more associate entities who are general class investors for the income year; and
  • those associate entities are not exempt from the thin capitalisation rules (although the drafting in the proposed legislation implies the opposite); and
  • at least one of the associate entities does not make a choice to use the external third party debt test.

The EM states that “(t)he restriction on this choice ensures that general class investors and their associates are not able to structure their affairs in a way that allows them to artificially maximise their tax benefits by applying a combination of different thin capitalisation tests.” However, with such a low associate entity threshold, there may be instances where entities with a 10% common shareholder are not aware they are associate entities of each other, let alone what choices they may make.

Implications: Again, these requirements have some important implications:

  • the requirement that the holder may only have recourse to the assets of the entity which borrowed the money is unfortunate (and odd). This means debt with a parental guarantee cannot be external third party debt even though it has been borrowed from an unrelated lender (and the main effect of the parental guarantee will be to drive down the borrower’s interest cost – which should be a good thing!),
  • the back-to-back loan regime is potentially helpful (if some of the strict requirements such as identical terms are removed) but it only assists taxpayers where the initial borrower and the entities to which it is lending are all using the external third party debt test,
  • the requirement that all associate entities make the same choice will be problematic for portfolio companies of private capital funds, including both private equity and venture capital, and
  • even though the test is unnecessarily constrained, a taxpayer with only modest amounts of related party debt or non-qualifying debt might decide to apply this test even though it comes at the cost of not deducting the interest on some of its debt.
3.5  Operative rules

Amount denied. The operative rules all deny deductions to a taxpayer once the level of debt is excessive, but they work slightly differently depending on which regime is being applied:

  • if the taxpayer is applying the fixed ratio rule or the group ratio rule, the amount disallowed is the amount by which the entity’s net debt deductions for the income year exceed the entity’s fixed ratio earnings limit. That is, any interest income earned by the taxpayer reduces the amount of deductions potentially being denied, and
  • if the taxpayer is applying the external third party debt test, the amount disallowed is the amount by which the entity’s gross debt deductions for the income year exceed the entity’s external third party earnings limit.

The explanation in the Draft Explanatory Memorandum says this difference is drawn, “to ensure that [the external third party debt test] achieves its policy of effectively denying all debt deductions which are attributable to related party debt.” This statement is curious; the taxpayer could be earning interest from the same external entity that was its financier.

Impact on deductions. Once the amount denied has been calculated, the impact is then spread across all debt deductions incurred by the taxpayer, reducing each debt deduction by the same percentage. The current rules work in a similar way.

4.   Thin capitalisation and transfer pricing

There has always been a complex interplay in Australian tax law between the thin capitalisation and transfer pricing rules.

One issue that has arisen is whether transfer pricing rules could potentially affect the amount of debt taken on by a taxpayer, as well as the price of the debt. Could a taxpayer find itself under challenge from transfer pricing rules for an amount of debt which was within thin capitalisation thresholds?

The argument was apparently put to the ATO that the enactment of thin capitalisation rules, which explicitly referred to the debt:assets test as a “safe harbour,” impliedly limited transfer pricing disputes just to disagreements about the price and not the size of any debt. In 2010 the ATO rejected that argument noting,

… at least since the 1990s consideration of the debt and capital structure has consistently been a consideration in achieving an arm’s length outcome in relation to risk reviews, audits and advance pricing arrangements. In some cases this has been as direct as asking the taxpayer to address the high level of debt by injecting equity …

During the re-writing of Australia’s transfer pricing rules in 2012 and 2013, one of the more incomprehensible provisions in the transfer pricing rules was included to try to sort out the interaction between transfer pricing and thin capitalisation. The drafter of the Explanatory Memorandum to the 2013 Bill said the provision was meant to protect the thin capitalisation rules from interference from the transfer pricing rules: “The rule preserves the role of Division 820 in respect of its application to an entity’s amount of debt [and] ensures that Subdivision 815-B does not prevent the operation of the thin capitalisation rules.” The author of the Explanatory Memorandum to the 2023 Draft takes a similar view: the provision “effectively disapplied [transfer pricing] in relation to the quantum of the debt interest.”

The 2023 Draft deliberately revisits this balance: an amendment to the transfer pricing rules will now re-instate transfer pricing considerations in determining the amount of debt permitted for general class investors if they are using the fixed ratio limit or group ratio limit.

5.   Other matters

The Draft makes some other changes to current law which are worth noting.

Section 25-90.  The decision to repeal s. 25-90 is a major change. It is discussed in detail in our Tax Insight available here.

Financial entity.  The range of entities which can qualify as a ‘financial entity’ for the thin capitalisation rules is being narrowed by removing “an entity other than an ADI that is … a registered corporation under the Financial Sector (Collection of Data) Act 2001 …”  According to the Explanatory Memorandum, many companies “can register under that Act for reasons unrelated to income tax” but “an increasing number of entities are now purporting (for tax purposes) to be financial entities.”  This category is being removed for integrity reasons.

Associates entities. It was noted above that an entity can be affected by the thin capitalisation rules if it is an “associate entity” of an “outward investor.” The Draft notes that this can cause problems for the superannuation sector.

A large retail or industry fund may have sizeable investments in many entities and thus a large number of “associate entities”. The “association” tests work in both directions:

  • if an investee is an outward investor and the fund is an associate entity, the fund becomes an outward investor as well even though all the fund members are residents and the fund has no offshore investments or operations of its own; and
  • if the fund is an outward investor and the investee is an associate entity, the investee becomes an outward investor as well even though the investee is not owned from offshore and may have no offshore operations of its own.

The associate entity tests for these purposes apply a 50% ownership test, rather than the 10% test applied in other parts of the thin capitalisation rules.

While the fund itself is generally prohibited from borrowing (and so has little to fear from the thin capitalisation rules), the associated entities may be adversely affected by the thin capitalisation rules: in other words, a resident company with no foreign operations may find its debt deductions are now in jeopardy because it is highly leveraged.

The Draft proposes to resolve this problem by amending the definition of “associate entity” so that it does not apply to a trustee of a complying superannuation entity (other than an SMSF). The apparent intention is to solve both problems:

  • to immunise a fund with some borrowings from being exposed to the thin capitalisation regime just because it has invested in an outward investor, and
  • to immunise an investee with borrowings from being exposed to the thin capitalisation regime because a retail or industry fund, which is an outward investor, has invested in it.

6.   Dates

The new rules will apply for income years commencing on or after 1 July 2023 with no grandfathering of existing debt or grace period to allow for the reorganisation of existing structures.

Treasury has set a deadline of 13 April 2023 for submissions on the Exposure Draft.

Toby Eggleston
Toby Eggleston
Partner
+61 3 9288 1454
Ryan Leslie
Ryan Leslie
Partner
+61 3 9288 1411
Nick Heggart
Nick Heggart
Partner
+61 8 9211 7593
Graeme Cooper
Graeme Cooper
Consultant
+61 2 9322 4081

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
Toby Eggleston
Partner
+61 3 9288 1454
Ryan Leslie
Ryan Leslie
Partner
+61 3 9288 1411
Nick Heggart
Nick Heggart
Partner
+61 8 9211 7593
Graeme Cooper
Graeme Cooper
Consultant
+61 2 9322 4081