New Australian thin capitalisation rules now enacted

On 8 April 2024, following a lengthy consultation process since their announcement in the 2022-23 Federal Budget, the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share — Integrity and Transparency) Bill 2023 (the Bill) to amend the thin capitalisation rules and introduce the debt deduction creation rules in Division 820 of the Income Tax Assessment Act 1997 (ITAA 1997) was given Royal Assent and therefore enacted into law. Both rules operate to limit the amount of income tax deductions for interest and other ‘debt deductions’. The Bill also introduced new reporting requirements under the Corporation Act 2001 for Australian public companies including a requirement to make certain disclosures in respect of their subsidiaries in their annual reports.

Application date

The new thin capitalisation rules apply to income years beginning on or after 1 July 2023 and the debt deduction creation rules apply for income years commencing on or after 1 July 2024. However, there was a late amendment to the Bill that requires the Government to commence an independent review of the amendments to commence no later than 1 February 2026, with a written report due within 17 months of commencing the review.

The new Corporations Law reporting requirements apply to annual reports for financial years commencing on or after 1 July 2023.

New thin capitalisation rules

The new thin capitalisation rules introduce the concept of a ‘general class investor’, which in most instances combines the concepts of ‘outward investing entity (general)’, ‘inward investing entity (general)’, and ‘inward investor (general)’.

The new rules for general class investors will:

• Replace the ‘safe harbour test’ (60% of the average value of assets) with a new ‘fixed ratio test’, which is an earnings-based test where an entity’s debt-related deductions will be limited to 30% of tax EBITDA (the default method);
• Replace the ‘arm’s length debt test’ with the ‘third party debt test’ (on election by taxpayers), which allows debt deductions for qualifying external third party debt but disallows all other debt deductions; and
• Replace the ‘worldwide gearing test’ with the ‘group ratio test’, which allows an entity in a group to claim debt deductions up to the same proportion of Tax EBITDA as the proportion of the worldwide group’s net third party interest expense as a share of earnings (on election by taxpayers).

Exclusions

The existing exemptions from the thin capitalisation rules will broadly be retained including the de-minimis exemption for entities with associate inclusive debt deductions below AUD 2 million.

Authorised deposit-taking Institutions (ADIs) and financial entities (non-ADI) will not be subject to these new rules so they will continue to apply the existing special rules for ADIs in Division 820, except that financial entities (non-ADI) will be subject to the new ‘third party debt test’ instead of the arm’s length debt test. However, the definition of ‘financial entity’ has been changed to include requirements for the entity to be carrying on a business of providing finance (but not predominantly for the purposes of providing finance for the entity’s associates). The financial entity must also derive all, or substantially all, of its profits from that business. This change will restrict the number of entities that will be treated as ‘financial entities’.

The new rules will not apply to Australian plantation forestry entities, which are entities that solely or predominantly carry on a business of establishing and tending trees for felling in Australia. This means the thin capitalisation rules in Division 820 as in force immediately before the commencement of the amendments in the Bill continue to apply to these entities.

Net Debt Deductions

The definition of debt deductions for thin capitalisation purposes has been amended to be interest or amounts in the nature of interest or any other amount calculated by reference to the time value of money. Due to the expanded definition, interest equivalent amounts such as guarantee or facilitation fees may also be included in debt deductions.

However, the new fixed ratio test and the group ratio test only apply to limit the ‘net debt deductions’, which is the extent the amount of debt deductions exceed amounts included in the entity’s assessable income that are interest or interest equivalent amounts; whereas the existing rules apply to limit the gross debt deductions. This change could be beneficial to some entities that were previously subject to the thin capitalisation rules because they had a large gross debt deduction expense but also have offsetting interest income, resulting in a low ‘net debt deduction’ amount. As a result, these entities may have lower or no debt deductions disallowed because of the new rules. 

Where a general class investor has negative net debt deductions the thin capitalisation rule will have no application under the fixed ratio test or the group ratio test, however the debt deduction creation rules may still apply (refer below).

Transfer pricing interaction

Importantly before applying the new earnings-based thin capitalisation tests, and as a key differentiator from the existing thin capitalisation rules, the arm's-length conditions will need to be assessed from a transfer pricing perspective, including both the applicable interest rate and now the appropriate amount of debt.

Fixed Ratio Test (30% of tax EBITDA)

The fixed ratio test disallows debt deductions to the extent that net debt deductions exceed 30% of tax EBITDA.

Broadly, tax EBITDA is calculated starting with the entity's taxable income or loss for the year and disregarding the application of the thin capitalisation rules other than the debt deduction creation rules (i.e. the debt deduction creation rules apply first, refer below). The following specific adjustments are then required:

Add:

• Net debt deductions for the year
• Division 40 depreciation deductions (excluding immediately deductible expenses)
• Division 43 claims for capital works deductions.
• The excess tax EBITDA amount transferred from 50% controlled entities (refer below)
• General deductions under section 8-1 that relate to forestry establishment and preparation costs and deductions under section 70-120 (capital costs of acquiring trees).

Deduct:

• If the entity is a corporate tax entity that has made a choice under section 36-17 ITAA 1997 not to claim all prior year tax losses, the amount of the unclaimed prior year tax losses i.e. assume that it made a choice to utilise all prior year tax losses.
• Notional R&D deductions that have been added back in the calculation of taxable income
• Franking credits included in assessable income under Division 207 ITAA 1997
• Dividends, trust distributions or partnership distributions received from an ‘associate entity’ (where the entity has a thin capitalisation control interest of 10% or more in the ‘associate entity).

The result of this calculation is the ‘tax EBTIDA’. If it is negative, the tax EBITDA is regarded as being zero.

Where the entities net debt deductions are more than 30% of the tax EBITDA, the excess amount is a disallowed tax deduction under the fixed ratio test.

Carry forward FRT denied debt deductions

To the extent deductions are denied under the fixed ratio test, they may be carried forward and claimed in a subsequent income year (up to 15 years) subject to satisfaction of the Continuity of Ownership Test (‘COT’) or in the alternative, the Business Continuity Test (‘BCT’).

Excess Tax EBITDA

Where an entity is an Australian company, resident unit trust, resident MIT or Australian Partnership and has applied the fixed ratio test, if it has net debt deductions of less than 30% of its tax EBITDA (excess tax EBITDA), the excess tax EBITDA can be transferred up the chain to its controlling entity. The controlling entity must also be an Australian company, resident unit trust, resident MIT or Australian Partnership and have a direct controlling interest of 50% or more in the entity and must also apply the fixed ratio test. The controlling entity adds the transferred excess tax EBITDA amount to its tax EBITDA, refer to the tax EBITDA calculation above.

Where the controlling entity also has excess EBITDA, it can transfer its excess Tax EBITDA to its controlling entity (if it has one).

Group Ratio Test

The group ratio test can be used as an alternative to the fixed ratio test. This test may be useful for more highly leveraged groups. 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 the relevant financial ratio of the worldwide group.

If the group ratio test is chosen, the disallowed debt deductions of an entity for an income year is based on the ratio of the group’s third-party interest expense to its financial EBITDA (base on audited consolidated financial statements). This ratio is applied to the tested group entity’s tax EBITDA to determine the maximum amount of debt deductions allowable. If the tested entity’s net tax deductions are more than the maximum amount of debt deductions under the group ratio test, the difference is a disallowed tax deduction. This test may allow entities to claim deductions in excess of the amount calculated under the fixed ratio test.

For general class investors, the group ratio test replaces the worldwide gearing debt test, which currently allows an entity's Australian operations to be geared up to 100% of the gearing of the worldwide group to which the Australian entity belongs.

There is no ability to carry forward debt deductions denied under the group ratio test.

The group ratio test applies by election only.

External Third-Party Debt Test

The new rules replace the arm’s length debt test with the third-party debt test for general class investors and financial entities (non-ADI). The third-party debt test will not disallow any third-party debt interest provided the debt satisfies certain conditions, but it will disallow all other debt deductions (i.e. all those that are not attributable to qualifying third-party debt).

This compares with the arm’s-length debt test, which disallows debt deductions where the amount of the entity's debt exceeds the amount of debt that could have been borrowed by an independent party carrying on comparable operations as the Australian entity. The third-party debt test will generally be less complex to calculate than the arm’s-length debt test, but it will also be more restrictive than the arm’s-length debt test.

Conduit financing arrangements

The third-party debt test allows for conduit financier arrangements, where a group member borrows from an external third party and on lends to another group member. In these cases, the recipient group member can treat the intra-group loan as third-party debt, provided certain conditions are met. However, the intra-group debt must, amongst other things, be issued on the same terms as the real third-party debt. 

The third-party debt must only be secured by:

• Australian assets of the borrower, other than certain assets of the entity that are rights under or in relation to a guarantee, security or other form of credit support (in conduit financing cases, this is extended to Australian assets of the conduit financiers and borrowers);
• membership interests in the entity that issued the debt interest, unless the entity has an interest in an asset that is not an Australian asset (in conduit financing cases, this is extended to membership interests in the conduit financiers and borrowers); or
• assets that are held by an Australian entity that is a member of the ‘obligor group’ in relation to the debt interest.

An entity is a member of an ‘obligor group’ in relation to a debt interest if the third-party creditor has recourse to assets of that entity. This extends the Australian assets that a third-party lender can have recourse to.

There is no ability to carry forward debt deductions denied under the third-party debt test.

The third-party debt test applies by election only.

Elections to apply the Group Ratio Test or the Third-Party Debt Test

If an election is made to apply the group ratio test or the third party debt test, this election cannot be revoked unless the Commissioner decides in writing that the election can be revoked, which must be done within 4 years after the earlier of the day that the entity lodged its income tax return for the year or the date the entity was required to lodge its income tax return for the year.

If a borrowing entity in relation to a debt interest has made an election to apply the third-party debt test, all the members of the obligor group (refer above) in relation to the debt interest are deemed to have also made a third-party debt test election.

Alignment with OECD thin capitalisation approach

These rules 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.

Debt deduction creation rules

The new debt deduction creation rules will apply to income years commencing on or after 1 July 2024. These rules apply both to pre-existing arrangements as well as new arrangements entered into after the start date.

The debt deduction creation rules apply to deny debt deductions before applying the thin capitalisation rules. They apply to all taxpayers subject to the thin capitalisation rules with the exception of:

• taxpayers who qualify for the ‘de minimus’ exemption (less than A$2 million debt deductions on an associate inclusive basis);
• taxpayers who use the external third-party debt test;
• taxpayers that use insolvency remote special purpose entities;
• securitisation vehicles; or
• ADIs.

Broadly, the debt deduction creation rules may apply to deny deductions on related party debt in two cases:

Asset acquired from an associate.

The first case is where related party debt has been used (in the current or prior years) to fund the acquisition of a Capital Gains Tax (‘CGT’) asset or a legal or equitable obligation directly or indirectly from an associate.

Prohibited payment rule

The second case is where related party debt has been used (in the current or prior years) to pay to an associate:

• a dividend or other profit like distribution;
• a capital return; or
• a royalty or similar payment for the use of or right to use an asset.

This ‘prohibited payments’ rule also extends to indirect payments used for non-prohibited purposes where the payment is used to indirectly facilitate a ‘prohibited’ payment.

Exemptions

Three exemptions apply to assets acquired from associates:

• The acquisition of a newly issued membership interest in an Australian entity, or a foreign entity that is a company;
• The acquisition of certain new tangible depreciating assets that are expected to be used for a taxable purpose within Australia within 12 months. This exception is broadly intended to allow an entity to bulk-acquire tangible depreciating assets on behalf of its associates;
• The acquisition of certain debt interests is disregarded. This ensures mere related party lending is not caught by the first case of the debt deduction creation rules; and
• the acquisition of Australian currency (which is not a CGT asset when used as legal tender).

Notably there is no exemption for the acquisition of trading stock in the rules.

Finally, the debt deduction creation rules also contain a specific anti-avoidance rule to address schemes which seek to avoid the rules and in doing so applies a principal purpose test.

BDO Comment

The new thin capitalisation rules have been subject to several iterations since they were announced in the 2022-23 Federal Budget with various consultation processes where BDO and other interested parties have submitted suggestions for improving these rules. While not all our suggestions have been incorporated into the new law, many of the initial issues in the various versions of the draft law have been resolved. However, the new rules are complex, much narrower by design and will require careful application. This is exacerbated by the new thin cap rules applying to income years commencing on or after 1 July 2023. As such, there is not a great deal of time to consider the implications of these new rules before the end of the 2024 financial year. 

While the new debt deduction creation rules will not apply until after 30 June 2024, they will require careful consideration of intra-group debt financing arrangements to determine whether the debt deductions associated with these arrangements will be deductible. This applies to both existing and future arrangements.

If you have any questions on the new thin capitalisation or debt deduction creation rules, please contact one of our partners. Our team of experts can assist you with a full suite of corporate and international tax services.