Thin capitalisation changes require rethink of
The Government has released draft legislation which if passed will mark significant changes to Australia’s Thin Capitalisation legislation to apply from 1 July 2023.
New thin capitalisation rules draw interest from multinationals
On 16 March 2023, the Government released the much-anticipated changes to the thin capitalisation regime that were originally announced in the October 2022 budget. As most Australian taxpayers subject to thin capitalisation have been calculating their debt deductions with reference to 60% of its gross assets, the proposed legislation in subdivision 820-AA of the Income Tax Assessment Act 1997 (‘ITAA 97’) will instead allow debt deductions of up to 30% of EBITDA.
The change from the previous asset-based rules to the earning-based rules will mean Australia’s thin capitalisation regime will now be more closely aligned with much of Europe and the US. However Australian taxpayers and their advisors will not have long to analyse how to apply the three new methods, as the start date of the new rules is proposed to be for income years starting on or after 1 July 2023.
The main elements of the new thin capitalisation regime are:
1. Consolidation of categories of Australian taxpayers subject to new thin capitalisation rules
Under the proposed thin capitalisation rules, a new concept of “general class investors” has been introduced, representing a consolidation of the following categories:
- Outward investor (general)
- Inward investment vehicle (general)
- Inward investor (general)
The only Australian taxpayers that do not fall under general class investor class will be authorised deposit taking institutions (also referred to as ‘ADI’s). The ADI taxpayers will largely be subject to the existing thin capitalisation tests in division 820, with some exceptions listed below.
2. New methods to calculate the maximum allowable debt
If an Australian taxpayer is a general class investor, it must apply one of the new thin capitalisation tests, being “fixed ratio test”, “group ratio test” or “external third party debt test” to calculate its maximum allowable debt (‘MAD’) deductions. These old versus new methods are summarised in the table below:
Old method | New methods | Details on the new law |
Safe harbour debt test
An entity’s MAD is 60% of the value of its Australian assets. The proportion of debt exceeding MAD will be the proportion of debt deductions denied. | Fixed ratio test
Net debt deductions that exceed 30 % of tax EBITDA will be disallowed.
| The fixed ratio test will be the default method for general class investors to limit debt deductions in accordance with an entity’s earnings. This method will disallow net debt deductions to the extent it exceeds 30% of tax EBITDA.
The tax EBITDA for an income year is worked out as follows:
It is important to note that any interest and depreciation added back under step 3 does not include AASB 16 interest and depreciation. This test also allows for any disallowed deductions to be carried forward (see point 3 below).
|
Worldwide gearing debt test
An entity’s Australian operations is allowed to be geared up to 100% of the gearing of its worldwide group. The proportion of debt exceeding MAD will be the proportion of debt deductions denied. | Group ratio test
Debt deductions will be disallowed to the extent that the entity’s debt deductions exceed the group ratio earnings limit. | The group ratio test may allow an entity in a highly leveraged group to deduct debt deductions in excess of the amount permitted under the fixed ratio rule. Under this test, the entity can deduct up to the group’s EBITDA ratio multiplied by the entity’s EBITDA calculated under the fixed ratio. General class investors can access this test if its group parent prepares audited consolidated financial statements and these financials report a group EBITDA of more than nil. However, by electing into the group ratio test, the Australian taxpayer will forfeit any carry forward denials under the fixed ratio test.
An entity’s group EBITDA ratio for an income year is broadly worked out, with reference to the group financial statements, as follows:
|
Arm’s length debt test
Debt deductions are disallowed where the entity’s debt exceeds the amount of debt that could have been borrowed from an independent comparable party. | External third party debt test
Debt deductions which are attributable to third party debt and that satisfy certain other conditions will be allowed. If this test is chosen, all related party debt deductions will not be allowed. | General class investors can choose to apply the external third party debt test by making an irrevocable choice each year. However, 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; and - at least one of the associate entities does not make a choice to use the external third party debt test. The intention is to simplify the former arm’s length debt test. If an independent lender has assessed and accepts the level of debt finance, then it should be viewed as arm’s length and therefore deductible.
Any debt deductions that exceed the entity’s ‘external third party earnings limit’ for the income year will be disallowed.
The external third party earnings limit is the sum of debt deductions that is attributable to a debt interest issued by the entity that satisfies the following external third party debt conditions:
- investments that relate only to assets that are attributable to the entity’s Australian permanent establishments or that the entity holds for the purposes of producing assessable income. and - its Australian operations.
|
3. Any unused maximum allowable debt can be carried forward
Under the new fixed ratio test, the rules allow the taxpayers to claim a special deduction for debt deductions previously disallowed over the past 15 years to the extent that the entity’s tax EBITDA exceeds the entity’s net debt deductions for the income year. The amount of the deduction for an income year is worked out as follows:
- Calculate the amount of the entity’s fixed ratio earnings limit that exceeds its net debt deductions.
- Apply the amount in step 1 against the entity’s previously disallowed amounts under fixed ratio test from the previous 15 years.
- The amount of the deduction is the total amount applied under step 2.
For the special deduction to apply, the entity must be using the fixed ratio test every income year to maintain access to the carried forward fixed ratio test disallowed amounts. If the entity elects other tests in an income year, it will lose the ability to carry forward any existing FRT disallowed amounts for income years going forward.
In addition, Australian taxpayers must pass a modified version of the continuity of ownership test in relation to each of the fixed ratio test disallowed amounts. These disallowed amounts must be applied in sequence eg the earliest income year disallowed amounts are applied first.
4. Exemptions from thin capitalisation will continue to apply
The amendments maintain the existing “de minimis” threshold if the total debt deductions of that entity and all its associate entities for an income are less than $2 million.
While the general class investors category will replace the existing categories, only outward investing entities will be able to access the exemption to thin capitalisation where the sum of the average Australian assets of the entity and its associates is equal to or more than 90% of the average total assets of the entity and its associates.
The exemption for certain special purpose entities will still apply, provided:
(a) the entity has been established for the purpose of managing some or all of the economic risk associated with assets, liabilities or investments; and
(b) the total value of debt interests in the entity is at least 50% of the total value of the entity's assets; and
(c) the entity is an insolvency-remote special purpose entity according to criteria of an internationally recognised rating agency that are applicable to the entity's circumstances.
5. Choice of tests cannot be revoked
As discussed above, the general class investors can choose to apply the group ratio test or the external third party debt test in relation to an income year.
Once the entity satisfies the conditions (see the table), either the group ratio test or the external third party debt test could be elected by submitting the approved form. The election must be made on or before the earlier of the day the entity lodges its income tax return for the income year and the day the entity is required to lodge its income tax return for the income year.
The choice for an income year cannot be revoked and the Commissioner may defer the time within which an approved form is required to be submitted. For the general class investors that do not make a choice, the default test would be the fixed ratio test.
6. Restrictions on interest deductions for foreign dividends
Under subdivision 768-A ITAA 97, a distribution is treated as non-assessable non-exempt (‘NANE’) income if it is made by a non-resident company to an Australian resident corporate tax entity (directly or indirectly), and the Australian resident entity has at least a 10% interest in the non-resident. The current tax rules allow interest expenses incurred to derive this NANE income to be deductible, which provides a double benefit. The new rules will address this double benefit by disallowing the deduction for interest expenses incurred to derive this NANE income of the entity. Taxpayer’s will need to trace the use of borrowings in order to assess whether any deductions will be denied.
While these points provide an insight of the proposed regime, the new rules will be complex to apply, especially for start ups, those engaged in long term projects and losses making entities.
Multinationals will need to consider the impact of the new thin capitalisation rules during year end planning, to analyse and structure their debt to ensure the new regime does not create any unexpected denial of debt deductions. Entities undertaking feasibility and project planning will also need to adjust their financial models to reflect changes to expected after-tax cash flows.
Mazars specialises in providing tax advice regarding international business and tax issues, advising many Australians taxpayers on such issues. Our dedicated Infrastructure Finance team can also assist with feasibility models forecasting the impact of the proposed changes. For further information or assistance please contact your usual Mazars advisor or our tax specialists via the form or contact details below:
Brisbane – Jamie Towers | Melbourne – Robert James | Sydney – Lauren Hill |
+61 7 3218 3900 | +61 3 9252 0800 | +61 2 9922 1166 |
Author: Lauren Hill and Eileen Li
Published: 14/4/2023
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