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
External third-party debt test
|For inward and outward ADIs|
|Safe harbour capital amount|
Arm’s length capital amount
Worldwide capital amount (outward investor ADI only)
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:
|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|
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.
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.
For further information, please contact:
Toby Eggleston, Partner, Herbert Smith Freehills