Expected and Unexpected Thin Capitalisation Changes
On 16 March 2023, Treasury released Exposure Draft Legislation (Draft Bill) on new and previously announced changes to Australia’s interest limitation (thin capitalisation) rules. The draft Bill introduces new earnings-based tests, to determine whether to disallow an amount of an entity’s debt deductions (e.g. interest) based on the entity’s earnings/profits, replacing the current asset-based tests. The main test changes include:
- an earnings based ‘fixed ratio test’ will replace the existing ‘safe harbour test’
- a ‘group ratio test’ will replace the existing ‘worldwide gearing test’
the third-party debt test will be replaced to only allow debt deductions on genuine third-party debt.
The new tests will apply to a new ‘general’ class of entities, which combines the current:
- ‘outward investor (general)’
- ‘inward investment vehicle (general)’
- ‘inward investor (general)’.
These new tests will not apply to financial entities and authorised deposit-taking institutions (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 $2 million debt deduction de minimis threshold will also remain.
It is also proposed to amend Section 25-90 and Section 230-15 of the Income Tax Assessment Act (ITAA 1997), to deny debt deductions in relation to non-assessable dividends from non-portfolio foreign companies.
When enacted, the amendments are proposed to operate for income years commencing on or after 1 July 2023. The government has called for comments on the consultation by 13 April 2023 and we intend to provide a submission.
New thin capitalisation tests
Fixed ratio test
The fixed ratio test will be the default test that applies for general class investors 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’, which is broadly, the entity’s taxable income or tax loss, adding back:
- net debt deductions (net interest)
- decline in value of depreciating assets
- capital works deductions
- deductions for prior year tax losses.
Consequently, the current safe harbour 60% gearing test will be removed.
This fixed ratio test will be difficult to pass for entities with low revenue/profits such as start-ups and entities in resources industries that are in the exploration stage or early stages of production.
Carry forward of disallowed interest deductions
A special deduction will also be allowed in a future income year for debt deductions that were previously disallowed under the fixed ratio test if the entity's net debt deductions are less than 30% of its tax EBITDA for that future income year. Debt deductions disallowed over the previous 15 years can be carried forward and deducted in future years under this special deduction rule. However, fixed ratio test disallowed amounts must be applied in sequence, such that disallowed amount attributable to the earliest income year, subject to the 15- year limit, are applied first.
For companies, this special deduction is subject to satisfaction of a modified version of the continuity of ownership test (COT) in the company tax loss rules in Divisions 165, 166 and 167 ITAA 1997. However, you cannot use the continuity of business test.
The ability to carry forward disallowed interest deductions for 15 years will be useful for start-ups but the lack of a continuity of business test will limit this advantage if there is a change of ownership in the future, which is common with start-ups.
Group ratio test
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.
If the group ratio test is chosen, the amount of debt deductions of an entity for an income year that are disallowed is based on the ratio of 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. This test may allow entities to claim deductions in excess of the limit calculated under the fixed ratio test.
The group ratio test will replace the current 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.
External third-party debt test
The Draft Bill will also replace the current arm’s length debt test with an external third party debt test for general class investors and financial entities that are not ADIs. The external third-party debt test will not disallow any 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).
The current arm’s length debt test 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 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 debt must, amongst other things, be issued on the same terms as the real third-party debt and only be secured by the assets of the ultimate borrower.
Removal of deductions for NANE income
Currently, Section 768-5 of the ITAA 1997 deems certain foreign equity distributions as non-assessable non-exempt (NANE) income of an entity, including foreign equity distributions from non-portfolio equity interests (examples include dividends from foreign subsidiaries). At the same time, Section 25-90 and Section 230-15 of the ITAA 1997 provide that interest expenses incurred to derive this type of NANE income are specifically deductible.
This is contrary to the general rule in Australia’s tax system which provides that expenses incurred in deriving NANE income are non-deductible. However, this concession was introduced in conjunction with the introduction of the current thin capitalisation rules in 2001, which include mechanisms to limit interest deductions related to controlled foreign equity interests. The new earnings-based tests do not contain these mechanisms and therefore the current Government considers that this concession is not in accordance with the policy intent of the new earnings-based tests which is to limit the amount of deductible interest expense in Australia by reference to earnings in Australia.
Accordingly, Section 25-90 and Section 230-15 will be amended so that they will not allow a deduction for interest expenses incurred to derive the NANE income under Section 768-5 ITAA 1997.
Definition of debt deduction expanded
The definition of debt deduction in Section 820-40 of the ITAA 1997 will be amended to capture interest and amounts economically equivalent to interest, whether or not they are incurred in relation to the issue of a debt interest by the entity. This is in line with the OECD best practice guidance.
The current definition of debt deduction requires that the expense be incurred in relation to a debt interest issued by the entity incurring the expense. Costs incurred by an entity no longer need to be ‘incurred’ in relation to a debt interest issued by the entity for that cost to be a debt deduction.
The Explanatory Memorandum to the Draft Bill does not provide examples of additional expenses that will be covered by new definition, but it may be referring to expenses incurred in respect of a debt interest issued by another entity or it may be in respect of a an equity interest issued by the entity, provided the other requirements of the definition are met i.e. the expense is:
- Calculated by the reference to time value of money
- The difference between the financial benefits received and the financial benefits provided by the entity or
- An amount directly incurred in maintaining the financial benefits received by the entity under a scheme giving rise to a debt interest (whether or not issued by the entity).
Amended definition of financial entity
The current definition of financial entity includes various types of financial entities, including a registered corporation under the Financial Sector (Collection of Data) Act 2001. The Draft Bill proposes to amend this definition to exclude such registered corporations. Affected entities will no longer have access to the current safe harbour debt test for financial entities and will have to determine their allowable debt deductions under one of the new tests mentioned above. Other financial entities and ADIs will continue to have access to the existing thin capitalisation rules. The exception being, for financial entities, where the arm’s length debt test will be replaced by the new third-party debt test.
Modifications to transfer pricing rules
As the new thin capitalisation tests deny debt deductions on an earnings basis, changes have been made to ensure the arm’s length conditions for transfer pricing should not be disapplied for entities using the new earnings-based tests.
The proposed changes to the transfer pricing legislation will require all general class investors to consider the arm’s length nature of their balance sheet - previously this was not the case.
Prior to the introduction of the new rules, the thin capitalisation legislation focused on determining a maximum allowable debt amount, and the transfer pricing rules only applied to limit the deduction based on the interest rate, where the arm's length interest rate was applied on the actual amount of debt.
However, under the proposed rules, as the tests do not determine the maximum allowable debt, all general class investors will need to separately consider, support and document the arm’s length nature of their debt amount in addition to calculating any deductibility limitations under the fixed ratio test or group ratio test.
BDO considers the Government’s decision to retain the $2million debt deduction de minimis threshold welcomed, considering the previous Treasury discussion paper mooted removing this threshold. However, given the $2 million threshold was introduced more than 20 years ago without indexation, it would have been preferable if the threshold had been increased to account for inflation.
The default fixed ratio approach (30% of EBITDA) will make application of the thin capitalisation provisions far more volatile, especially when interest rates are high in the first stages of a recession.
Regarding the proposed special 15-year carry-forward interest deduction we note:
- while the 15-year limitation is consistent with the OECD proposal, it is not consistent with the general Australian policy approach of indefinite carry forward of deferred tax benefits
- the carried forward amounts are not indexed so will slowly lose their value due to inflation
- the limitation of the carried forward deductions by the continuity of ownership test is understandable, but it is unfortunate that there is no ability to rely on the continuity of business test.
We note that the proposal to remove the arm’s length debt test, which will be replaced by a much more objective third-party debt analysis will be useful for entities and groups that have a high proportion of external debt but is unlikely to be very useful for most entities. To be deductible, the debt must, amongst other things, be issued under the same terms as the original third-party debt and only be secured by the assets of the ultimate borrower. That will be rare. However, the group ratio test may be useful as an alternative where the on lent debt is not on the same terms and /or secured by the ultimate borrower.
We also note that the draft Bill Applies from first year commencing on or after 1 July 2023 – which gives minimal planning time for 30 June balancers.
Should have any questions regarding the content of this article, please contact your BDO tax adviser for further guidance.