A summary of the main changes to thin capitalisation from a transfer pricing perspective. Primarily, interest deductions may be denied either under the proposed thin capitalisation rules or under Australia's transfer pricing regime.
On 16 March 2023, Australia’s Treasury Department released Exposure Draft Legislation (the Draft Bill) in respect of new and previously announced changes to Australia’s interest limitation (thin capitalisation) rules. The proposed changes were foreshadowed in Treasury’s consultation paper entitled ‘Government election commitments: Multinational tax integrity and enhanced tax transparency’, which preceded the October 2022 Federal budget.
The proposed changes reflect the Government's commitment to amending Australia's thin capitalisation rules to align with the Organisation for Economic Cooperation and Development's (“OECD’s”) recommended approach under Action 4 - Limiting Base Erosion Involving Interest Deductions and Other Financial Payments of the BEPS Action Plan. Specifically, the proposed changes are targeted at Base Erosion or Profit Shifting (BEPS) arrangements by addressing the risk of erosion to Australia's tax base arising from excessive debt deductions.
When do the changes to interest limitation apply?
The proposed changes are intended to operate for income years commencing on or after 1 July 2023.
What has changed from a transfer pricing perspective?
The Draft Bill introduces new earnings-based tests to determine whether an amount of an entity’s debt deductions will be disallowed, replacing the current asset-based tests. Under the Draft Bill the transfer pricing rules will apply in parallel with the new earnings-based tests. In other words, interest deductions may be denied either under the proposed thin capitalisation rules or under Australia's transfer pricing regime.
Prior to the introduction of the new rules, the thin capitalisation legislation provided a ‘safe harbour’ with respect to the maximum allowable debt amount, and the transfer pricing rules only applied to limit a deduction based on a revised interest rate, where the arm's length interest rate was applied to the actual amount of debt. However, the proposed rules will now require all ‘general class investors’ (i.e., taxpayers who are not authorised deposit taking institutions but who are subject to the thin capitalisation rules) to separately consider, support and document the arm’s length nature of their debt amount in addition to calculating any deductibility limitations under the proposed thin capitalisation rules.
The thin capitalisation rule changes
The earnings-based tests under the Draft Bill allows general class investors to select one of the following methodologies:
- The fixed ratio test is the default test that applies for general class investors/taxpayers that do not make a choice to use either the group ratio test or the external third-party debt test. The fixed ratio test will allow an entity to claim net debt deductions up to 30% of ‘tax EBITDA’
- The group ratio test can be used as an alternative to the fixed ratio test, which may be useful for more highly leveraged groups (replacing the worldwide gearing test). The group ratio test allows an entity 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 external third-party debt test will allow deductions for third-party debt that satisfy certain conditions, but it will disallow all other debt deductions (i.e., all those that are not attributable to qualifying third party debt). In other words, if an entity has only eligible third-party debt, and no related party funding arrangements, the external third-party debt test may be used to obtain a full interest deduction provided the debt amount is used to wholly fund Australian operations.
It is noted that the proposed new tests do not apply to financial entities and ADIs. These entities and institutions will continue to have access to the existing thin capitalisation rules with some exceptions, however, it is proposed to limit the definition of ‘financial entities’. The legacy $2 million debt deduction de minimis threshold continues to apply under the proposed new rules.
For completeness, in the case where taxpayers choose to apply the fixed ratio test, the new rules allow a special 15 year carry forward of denied interest deductions subject to the taxpayer satisfying the continuity of ownership test.
What does this mean for taxpayers?
If implemented ‘as is’, taxpayers going forward must satisfy both sets of rules to claim an interest deduction, being:
- The transfer pricing rules (in respect of the arm’s length interest rates/amount)
- The amended thin capitalisation rules (for the deductible interest amount).
Therefore, in absence of a positive transfer pricing assessment, or by calculating a disallowance under one of the earnings-based tests, taxpayers are likely to find themselves in a position where they are unable to deduct all interest expenses.
The proposed changes to the interest limitation/thin capitalisation rules are not uncommon. Based on the latest commentary provided on the OECD’s website, we note that a number of OECD and Inclusive Framework members have adopted similar interest limitation rules or are in the process of aligning their domestic legislation with the recommendations of BEPS Action 4. Countries such as Argentina, India, Malaysia, Norway, South Korea, the US, the UK and all the European Member states already apply an interest cap restricting a taxpayer’s deductible borrowing cost.
In its current form, the proposed rules significantly impact certain categories of taxpayers, such as those operating with significant upfront investments (e.g. greenfield investments, asset/ capital intensive industries, etc) or entities that are in their initial phase of operations (e.g. start-ups, loss making entities, etc). Unfortunately, the Draft Bill at this stage does not provide any carveouts for asset-intensive and/or highly geared industries (for instance the UK rules carve-out funds invested in long-term infrastructure for the public benefit, whereas the Canadian rules carve out third-party financing on public-private partnerships involved in infrastructure projects). We expect further clarification and updates to be provided in the final draft in this regard.
Given that many taxpayers who previously fell within the thin capitalisation safe harbour rules or utilised the ‘de minimis’ exemption may not have considered documenting the arm’s length nature of their balance sheet, we strongly recommended that taxpayers assess the potential impact of the Draft Bill.
The amount of work required from a transfer pricing perspective will likely be equal to the size and scale of the business and the quantum of the proposed debt deduction. Some immediate practical next steps include:
- Assessing the impact of the proposed changes on taxpayers’ current arrangements to determine the amount of debt deductions that may be supportable
- Finding evidence of arm’s length behaviour with respect to levels of debt, e.g. a review of existing bank debt for covenants that may be applied as benchmarks
- In the absence of covenant data, undertaking standalone ‘balance sheet benchmarking’ using a TNMM style approach but applying the analysis to determine debt/asset or other debt serviceability ratios
- For more ‘risky’ situations, the transfer pricing work necessary to support a debt deduction may also extend to full blown serviceability analysis, similar in some ways to the prior Arm’s Length Debt Test (ALDT).
Most importantly, given the imminent application of the proposed changes, it is necessary for appropriate consideration to be given to this issue prior to the proposed application date to avoid the potential for material amounts of disallowed debt deductions, particularly where a taxpayer has not previously considered the arm’s length nature of its capital structure.
Questions? Contact us for more information
If you have any questions or would like more information on the changes to the Australian interest limitation rules, please contact your local BDO transfer pricing adviser to discuss how the proposed changes impact you.
For more information, BDO's tax team recently published a detailed technical update of the proposed changes to the thin capitalisation rules.