New thin capitalisation rules receive Royal Assent

Further to our article “New thin capitalisation rules draw interest from multinationals”, the new thin capitalisation rules as part of the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share – Integrity and Transparency) Bill 2023 received Royal Assent on 8 April 2024, with effect for income years starting on or after 1 July 2023.

Under Australia’s existing thin capitalisation regime in division 820, an Australian multinational taxpayer with debt deductions of more than $AUD 2 million may have had a portion of its debt deductions denied under the ‘safe harbour test’ where its debt to equity ratio exceeded 60%.  However the new legislation in subdivision 820-AA of the Income Tax Assessment Act 1997 (‘ITAA 97’) has replaced the safe harbour test with the ‘fixed ratio test’ that will instead allow debt deductions of up to 30% of tax EBITDA for Australian ‘general class investors’. The new concept of ‘general class investor’ combines the previous thin capitalisation concepts of ‘outward investing entity (general)’, ‘inward investing entity (general)’ and ‘inward investor (general) and importantly, excludes Authorised Deposit-taking Institutions (‘ADI’s) and financial entities (non ADI) who will generally be subject to thin capitalisation rules division in 820.

As an alternative to the fixed ratio test, Australian general class investor taxpayers captured under subdivision 820-AA can instead elect to apply the following new tests:

• the ‘third party debt test’, replacing the ‘arm’s length debt test’, will allow debt deductions for qualifying external debt, but disallow all other debt deductions;
• the ‘group ratio test’, replacing the ‘worldwide gearing test’, will allow debt deductions up to the same proportion of tax EBITDA as the proportion of the multinational group’s net third party interest expense as a share of earnings.

These additional tests provide flexibility to taxpayers, but the rules are complex and advice should be sought to determine whether they can apply. Two notable issues include the debt deduction creation rules and tax EBITDA.

Debt deduction creation rules

The new debt deduction creation rules will apply for income years starting on or after 1 July 2024 to potentially disallow debt deductions on the following new and existing arrangement:

• where related party debt is used to fund the acquisition of a Capital Gains Tax (‘CGT’) asset or a legal or equitable obligation from its associate (Type 1); or
• where related party debt is used to fund distributions, a capital return or royalty payments to an associate (Type 2).

The debt deduction creation rules will apply to all Australian taxpayers, except for:

• taxpayers that qualify for the ‘de minimis’ exemption (where debt deductions of the Australian taxpayer and its Australian associates are less than $AUD 2 million);
• taxpayers who use the external third-party debt test;
• taxpayers that use insolvency remote special purpose entities;
• securitisation vehicles; or
• ADIs.

As the debt deduction creation rules can be far-reaching, debt deductions will not be disallowed under these rules for the following Type 1 asset purchases from an associate:

• the acquisition of a new membership interest in an Australian or foreign entity that is a company;
• the acquisition of certain new tangible depreciating assets;
• the acquisition of certain debt interests to ensure that genuine related party lending is not caught by the rules; and
• the acquisition of Australian currency.

However, it is important to note that there is no exemption for purchases of trading stock under Type 1, and as a result debt deductions may be denied where an Australian taxpayer uses related party debt to fund the acquisition of trading stock from an associate. This will likely capture arrangements where intercompany payables from the purchase of trading stock is left outstanding and will begin to accrue interest.  

The following debt deductions will not be denied where the debt is used to fund the following Type 2 payments to an associate:

• A payment that is entirely referable to mere on-lending to an Australian associate, where the on-lending is on the same terms (to the extent those terms relate to costs).
• A payment that is entirely referable to the repayment of principal under a debt interest.

Tax EBITDA

The determination of tax EBITDA is relevant to the fixed ratio test and group ratio test and has been amended to be calculated as follows:

1.     calculate the Australian taxpayer’s taxable income or loss (disregarding the operation of the thin capitalisation rules, other than the debt creation rules);

2.     add the taxpayer’s net debt deductions (eg interest, guarantee and utilisation fees);

3.     add the sum of the taxpayer’s deductions for depreciating assets and capital works, as well as certain deductions relating to the forestry industry;

4.     add any previous unrecouped tax losses where an Australian corporate taxpayer has made a choice under section 36-17; and

5.     if permitted, add the excess tax EBITDA from eligible entities that it has a 50% controlling interest in.

Specific amendments to the calculation of tax EBITDA also include:

• new provisions for the calculation of tax EBITDA, specifically catering for Attribution Managed Investment Trusts (‘AMITs’);
• allowing eligible unit trusts to transfer excess tax EBITDA to other eligible unit trusts;
• requirement to deduct franking credits that have been included in assessable income under division 207 ITAA 97; and
• requirement to deduct notional research and development deductions that had been added back in the calculation of taxable income.

Other amendments and next steps

Other amendments and important issues to consider as part of the new thin capitalisation rules include:

• The fixed ratio and group ratio tests rely on a new concept of ‘net debt deductions’ to net off interest (and similar) income and expenses, and not just solely focus on interest (and similar) expenses like the previous thin capitalisation rules;
• the Fixed Ratio Test disallowed amounts are also dealt with in the calculation of the Allocable Cost Amount (‘ACA’) for income tax consolidated groups, specifically to reduce the entry ACA for both ‘owned’ and ‘acquired’ carry forward amounts;
• Australian trusts and partnerships, as well as all financial entities and ADI’s are allowed access to the third party debt test;
• elections to apply the group ratio test or the third party debt test cannot be revoked unless approved by the Commissioner; and
• the transfer pricing rules now require an Australian taxpayer to review the quantum of international related party borrowings is arm’s length in addition to the interest rate being charged.

As next steps, we would recommend the following:

• assess whether you and your Australian associates have debt deductions in excess of $ AUD 2 million;
• if debt deductions exceed $AUD 2 million, consider whether you are eligible to apply the group ratio test or third party debt test, and understand the different outcomes under each test;
• analyse how a change in interest rates may impact the deductibility of your existing financing arrangements under the new thin capitalisation rules;
• review if and how the debt deduction creation rules will apply to your existing and proposed financing arrangements from 1 July 2024;
• analyse how the new thin capitalisation rules will impact cash flow for your business– our dedicated Infrastructure Finance team can assist with feasibility models forecasting the impact of these changes; and
• prepare transfer pricing documentation that concludes that the interest rate and quantum of international related party debt is arm’s length. 

For more information and to discuss how the new thin capitalisation rules may impact you, please contact your usual Mazars adviser or alternatively one of our specialists via the form below:

Author: Lauren Hill and Deepra Sen

Published: 29/04/2024

Disclaimer: Please note that this publication is intended to provide a general summary and should not be relied upon as a substitute for personal advice. We recommend that professional up to date advice specific to one’s circumstances be sought before making any decisions in this regard.

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