Thin Capitalisation and other Integrity Measures

What you need to know

On 22 June 2023, the Australian Government introduced the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share – Integrity and Transparency) Bill 2023 into the House of Representatives.

The Bill contains material amendments to Australia's thin capitalisation regime that are likely to have significant impacts on a wide range of taxpayers.  These changes take effect from 1 July 2023 and in many instances could have a more materially adverse impact on taxpayers than the draft rules contained in the Exposure Draft. 

If the legislation is enacted in its current form, examples of some of the key adverse (and unexpected) impacts include:

1. Where there is gearing at a holding entity level in a non-consolidated group, the tax EBITDA of that holding entity is likely to be minimal.  Accordingly, applying the fixed ratio test to holding entities is likely to lead to material debt deduction denials;
2. Trusts and partnerships are ineligible to apply the third party debt test, meaning they will have to rely on the fixed ratio test or the group ratio test;
3. The third party debt conditions require that the third party lender has recourse only to the assets of the borrower, and further that those assets do not consist of guarantees or other forms of credit support (even where the credit support is provided by an Australian entity holding Australian assets, and even where the credit support is provided by a third party (e.g., a bank guarantee)).  The most standard security arrangements would typically give the bank recourse against the holder of the equity of the borrower, and potentially also assets of downstream entities.  Accordingly, very few common third party lending arrangements will satisfy the third party debt test;
4. The conduit financer provisions – which were intended to permit deductions in respect of on-lending of third party debt on back to back terms – specifically prohibit the conduit financer (e.g., Finco vehicle) from actually on-lending on arm's length terms.  Accordingly, Finco vehicles will have all of their debt deductions denied under the third party debt test or, if they on-lend on non-arm's length terms, the entity to which they on-lend will likely have all of their debt deductions denied on the basis the on-lending is not on "the same terms" with respect to costs.

The Bill also implements new rules on the disclosure of information about subsidiaries. For financial years commencing on or after 1 July 2023, Australian public companies (listed and unlisted) must disclose information about subsidiaries in their annual financial reports.

What you need to do

We recommend that taxpayers urgently consider:

• Whether the thin capitalisation measures have altered the status of any entities for thin capitalisation purposes, noting that the measures change the definition of a "financial entity";
• How the thin capitalisation measures will impact current financial arrangements (including swaps), and whether the measures will result in an increased level of disallowed debt deductions;
• The impact the financial statements measures will have on financial report disclosures, noting it will require disclosure of the tax residence of offshore subsidiaries which may not currently be publicly available information. 

Thin capitalisation measures

The measures significantly amend Australia's thin capitalisation regime, impacting all taxpayers that are currently subject to the rules.  Sectors that are most likely to be adversely impacted are capital-intensive sectors, such as real estate and infrastructure, although a wide range of other sectors may be affected.  

In addition, a new measure – not contained in the Exposure Draft – applies to all taxpayers which are subject to the thin capitalisation rules, and targets so-called "debt creation".  This element of the thin capitalisation measures could apply in the context of a wide range of transactions, including internal restructures.

Classification changes

Entities that are currently classified as "general investors" (whether inward or outward) will now be classified as "general class investors".  In addition, certain entities that were previously classified as financial entities, such as entities registered under the Financial Sector (Collection of Data) Act 2001 (Cth) but which play a role in internal-group financing (for example) will now also be classified as general class investors.

General class investors will no longer have access to the current safe harbour debt amount, arm's length debt amount, or worldwide group debt amount – rather, they will apply (on a default basis) the "fixed ratio test", or (on an elective or deemed basis) the "third party debt test" or (on an elective basis) the "group ratio test".

In addition, financial entities, while they will retain access to the safe harbour debt amount and the worldwide gearing debt amount, will now apply (on an elective or deemed basis) the third party debt test rather than the arm's length debt amount.

Each of these tests are summarised below.

Fixed ratio test

As mentioned above, the fixed ratio test replaces the existing safe harbour debt amount.  It is the default test for "general class investors" which have not made an election or been deemed to have made an election to use an alternative test.  The fixed ratio test will deny debt deductions where a taxpayer's "net debt deductions" exceed the taxpayer's "fixed ratio earnings limit". 

Under the fixed ratio test, taxpayers' "fixed ratio earnings limit" will be 30% of its "tax EBITDA".  Broadly, tax EBITDA is the sum of a taxpayer's taxable income (or tax loss), net debt deductions, and Division 40 and 43 depreciation expenses (except where the deduction is for the entire amount of the expense incurred by the entity).  This exclusion primarily seems to apply to deductions available under Subdivision 40-H, applying to certain capital expenditure on exploration and prospecting, rehabilitation of mining sites, and environmental protection activities (among others). 

The definition of tax EBITDA has been changed from the Exposure Draft.  In particular, the Division 40 deductions which are added back in calculating tax EBITDA has been broadened (which is positive), but importantly the capacity to add back tax losses utilised in the income year has been removed.  The overall effect of this change is that prior year tax losses are used in priority to debt deductions (including current year debt deductions).  

One of the problems with the original tax EBITDA definition in the Exposure Draft that remains is that it adversely impacts upstream gearing.  It is common in various sectors (such as real estate) for taxpayers to obtain "portfolio debt" at a level above the asset-holding entities (e.g., at a holding entity level).  This is also a common structure in respect of acquisitions of entities.  The definition of tax EBITDA adversely impacts these structures, as the measures do not allow the upstream vehicle to include in its tax EBITDA underlying depreciation amounts, even where that tax EBITDA is not utilised in the downstream thin capitalisation position.

Remarkably, the introduced legislation goes further than the Exposure Draft in its impact on upstream gearing.  New sections now exclude franking credits, dividends, and assessable income amounts arising from holding interests in associate entity trusts and partnerships in determining tax EBITDA.  This will, in effect, deny upstream holding entities from having a positive tax EBITDA completely, rendering their debt deduction capacity under the fixed ratio test nil.  Given that the rules take effect from 1 July 2023, these taxpayers will find themselves with insufficient time to restructure debt arrangements to sit at the asset entity level prior to these rules taking effect (and, even if there were time to restructure to shift debt to the asset entity level, they could face potential issues under the debt creation provisions (discussed below), among other integrity provisions (such as Part IVA)).  

To take an example, consider a holding trust that invests in three asset trusts.  Because the holding trust holds (indirectly) a portfolio of assets, it will often be able to achieve better terms with respect to debt financing where it borrows at the holding trust level (secured by the downstream assets), as compared to borrowing at each asset trust.  In addition, it may be more likely to satisfy relevant financial covenants, such as loan-to-value ratios or interest coverage ratios.  

In this scenario, the holding trust's assessable income will include its share of the net income of the asset trusts, calculated by reference to the share of the income of those trusts to which it is presently entitled.  However, for the purposes of calculating its tax EBITDA, it is required to exclude from its assessable income those amounts.  Accordingly, it is highly likely that holding trusts (or companies) will now have negative tax EBITDA, giving rise to a denial of all debt deductions under the fixed ratio test.

Finally, the drafting appears not to have contemplated the AMIT regime – a regime that was introduced fewer than 8 years ago.  AMITs are trusts, but they do not calculate net income (they are specifically excluded from the operation of Division 6 of the Income Tax Assessment Act 1936 (Cth)).  Prima facie, therefore, AMITs will have no net income to be included to be included in determining their tax EBITDA.  AMITs applying the fixed ratio test under the rules as drafted would accordingly have no thin capitalisation capacity.

Net debt deductions

"Net debt deductions", which is relevant to calculating both tax EBITDA (as noted above) and the total disallowed amount, as well as in the context of the group ratio test (discussed below), includes a taxpayer's "debt deductions" less income that comprises amounts of interest, amounts in the nature of interest, or amounts that are economically equivalent to interest.  

The concept of "debt deductions" is being amended, so that it captures amounts that are not in relation to a debt interest.  The changes to the relevant components of the definition of debt deductions make it clear that it is now intended to capture deductions arising in respect of swap arrangements (such as interest rate swaps, but potentially not foreign exchange swaps), but it is not clear whether it is intended to capture other arrangements where payment flows are economically equivalent to interest.

The definition of "debt deductions" and the amounts that reduce debt deductions in calculating net debt deductions remain non-symmetrical.  That is, certain items of expenditure are included in debt deductions, but then income amounts of an equivalent nature are not necessarily applied as a reduction in calculating net debt deductions.  This is likely to increase taxpayers' net debt deductions in certain circumstances.

Carry forward of denied deductions

Consistent with the Exposure Draft, denied debt deductions under the fixed ratio test are able to be carried forward and utilised in future years (for a period of up to 15 years), where there is sufficient capacity under the fixed ratio test in those future years. 

However, if a taxpayer has elected (or been deemed to have elected) to apply either of the elective methods in the intervening period, such carry forward amounts are lost.  The carry forward of denied deductions by companies is subject to either a modified continuity of ownership test and, in contrast to the Exposure Draft, a modified business continuity test (which is positive).  

However, and in another change from the Exposure Draft that adversely impacts trusts, trusts will now have to satisfy the 50% stake test (or alternatives) in order to access carry forward amounts.  As most trusts are not able to apply the same or similar business test, most trusts will not have this as a fall back option where the 50% stake test is failed.  Those trusts that are eligible to apply the same or similar business test to tax losses will be entitled to apply those tests to carried forward denied deductions.

Third party debt test

The Government committed in the October Budget 2022-23 to "retain an arm's length debt test as a substitute test which will apply only to an entity's external (third party) debt".  With respect, many taxpayers will consider that the Government has significantly underdelivered on this commitment.

The third party debt test comprises two elements – a base test that is intended to apply when an entity borrows directly from a third party (Base Test), and a "conduit financer" regime that is intended to apply when an entity borrows indirectly through a conduit vehicle, such as common Finco structures (Conduit Financer Test).

Where a borrower elects to apply the third party debt test, certain other entities are deemed to have also made the third party debt test election.  In particular, any associate entity that is a member of the "obligor group" is deemed to have made an election, and any party which has entered into a cross-staple arrangement with an electing entity is also deemed to have made the election.  The concept of an "obligor group" extends beyond the traditional definition of an obligor group in standard debt documentation, and includes any entity against which the creditor has recourse for payment of the debt.

In addition, an entity that has made an election (but not an entity which has been deemed to have made an election) can apply to the Commissioner to have that election revoked.  In order to have that decision revoked, they need to demonstrate that at the time of the election, it was reasonable to believe that making the election would have increased their thin capitalisation limit.  As drafted, it is not possible to revoke an election because of an adverse impact on another entity which is deemed to have made the third party debt test.  Accordingly, a borrower that has incorrectly made an election which has had adverse impacts on the collective thin capitalisation capacity of the obligor group, but not for itself, is unable to seek to revoke that election.

An entity's third party earnings limit is the sum of each debt deduction that satisfied the third party debt conditions in relation to the income year.  The third party debt conditions, under the Base Test, are as follows:

1. The entity issued to the debt interest to an entity that is not an associate entity (with some modifications to the definition of associate entity);
2. The debt interest is not held at any time in the income year by an entity that is an associate entity;
3. The holder of the debt interest (i.e., the borrower) has recourse only to Australian assets that are held by the entity (i.e., the borrower), provided those assets and are not rights under or in relation to a guarantee, security, or other form of credit support (even if that guarantee or credit support is from an Australian entity holding Australian assets, or even if it is from a third party (e.g., a bank guarantee));
4. The entity uses all, or substantially all of the proceeds of issuing the debt interest to fund its commercial activities in Australia that do not include business carried on through an overseas permanent establishment, and do not include the holding of any associate entity debt, or controlled foreign entity debt or equity; and
5. The entity is an Australian resident.

While the requirements in (1) and (2) above are reasonable and expected, the requirement in (3) will be failed by many taxpayers, potentially other than those in a tax consolidated group.  In standard security arrangements, the external financer will take security not only over the assets of the borrower, but typically also (at least) over the assets consisting of the equity and debt interests in the borrower.  Those security interests are targeted at ease of enforcement of security, and not credit support.  Nonetheless, those standard security arrangements will mean that most taxpayers will not be able to access the third party debt test.

The requirements in (3) are also problematic for non-consolidated groups with gearing above the asset holding entity level.  Again, the standard security arrangements will see the external financier taking security over downstream assets (e.g., of downstream asset entities), including mortgages, charges, or liens.  Again, these very common security arrangements will result in the third party debt conditions not being satisfied.

The requirement in (4) is also problematic.  Although there are specific conduit financer provisions, the actual conduit financer itself (i.e., the Finco) is required to satisfy the Base Test, subject to a small modification under the Conduit Financer Test in respect of the recourse requirement.  However, under the Base Test, the conduit financer is prohibited from using all, or substantially all of the proceeds from the debt to hold "associate entity debt" – i.e., arm's length on-lending entered into with associate entities.  Prima facie, therefore, a conduit financer which elected to apply (or was deemed to have elected to apply) the third party debt test would have all of its debt deductions denied.  One hopes that this was a legislative oversight that will be corrected.  

As drafted, the only apparent way to meet this requirement, which prohibits using the funds to hold associate entity debt, would be for the on-lending to occur on a non-arm's length basis (meaning the on-lending would not be classified as associate entity debt).  While this may assist the conduit financer in satisfying the Base Test, it would likely mean that the entity to which the funds had been on-lent would fail the Conduit Financer Test (discussed below), as one of the requirements is that the conduit financer on-lends the amount on "the same terms" with respect to costs (subject to some qualifications).  Accordingly, taxpayers seeking to rely on the conduit financer-related provisions would appear to have to choose where they want the debt deduction denial:  at the conduit financer level, or at the on-lending level.  Taxpayers may be forgiven for wondering who would make a third party debt test election where there is a conduit financer in their structure.  

The final requirement in (5) limits the application of the third party debt test to Australian residents, the definition of which only applies to companies and individuals.  Accordingly, trusts and partnerships, which are subject to the thin capitalisation rules, are not able to apply the third party debt test.  Taxpayers who took the Government's commitment to provide a path to deductibility for interest on third party debt at face value should rightfully be upset that trusts and partnerships are not able to access the third party debt test.

On the Base Test, the requirements in (3) above is modified where the relevant debt financing is in respect of a development asset (or, more specifically, the creation or development of a CGT asset that is, or is reasonably expected to be, real property situated in Australia (including a lease)).  This modification disregards the prohibition on guarantees, securities, or other forms of credit support, unless that is credit support provided by a foreign associate entity.  Accordingly, Australian-headquartered multinational groups will be able to provide credit support to subsidiaries to develop certain land assets, while foreigners will not.  Construction finance for material construction typically requires some form of parental support (whether by way of guarantees, equity commitment letters, or equivalent), and so inbound investors may struggle to obtain deductibility for third party construction finance facilities under the third party debt test.

Finally, one of the problems with the Exposure Draft legislation was that the third party debt test did not provide a path to claiming debt deductions for swaps, notwithstanding the definition of debt deductions was amended with the intended effect of capturing these payments.  Under the introduced legislation, a debt deduction is treated as being attributable to a debt interest if the debt deduction is directly associated with hedging or managing interest rate risk in respect of the debt interest, and the amount is not paid to an associate entity.  Accordingly, where taxpayers hedge in respect of a number of debt interests, the third party debt test is likely to remain problematic.  In addition, the provision does not apply if the debt deduction is referrable to an amount paid directly or indirectly to an associate – accordingly, back to back swaps through a conduit financer will now generate debt deduction denials.

The bad news continues for taxpayers who were hoping to rely on the Conduit Financer Test.  We outlined above why the third party debt test is unlikely to permit deductibility for the conduit financer itself, but the Conduit Financer Test are also overly restrictive with respect to the on-lent debt.  Some of the problems can be summarised as follow:

1. Any swaps between the conduit financer and the ultimate borrower will result in debt deductions associated with the swap being denied;
2. External financier recourse is permitted over the assets of the members of an obligor group, but only where those members are Australian residents.  Again, if trusts and partnerships are within the obligor group, this will result in a complete failure of the third party debt conditions.  Furthermore, there is significant uncertainty about how the modifications to the recourse provisions apply in the case of on-lending within an obligor group.  Whether the provision as drafted works appropriately will depend on the manner in which the Australian Taxation Office and, ultimately, the courts, take to interpreting the provision;
3. The requirement that the funds are not used to hold associate entity debt remains with respect to the activities of the entity to which the conduit financer on-lends, meaning that if that entity makes internal group loans, the requirements will be failed;
4. The terms of the on-lending which relate to costs are required to be the same as the terms of the ultimate debt interest which relate to costs.  Certain terms of a debt interest are then disregarded – for example, terms that relate to the recovery of reasonable administrative costs that relate to the ultimate debt interest or the relevant debt interest, or terms that allow recoverability of swap-related costs.  While we understand these adjustments are intended to facilitate access to the Conduit Financer Test, they appear to actually limit access to the Conduit Financer Test in certain circumstances.  In addition, because the administrative costs must relate to the ultimate or relevant debt interests, the right to recover for entity administrative costs (e.g., tax return preparation costs, audit costs), or more general costs (e.g., legal expenses in drafting on-lending arrangements), the right to recover these would appear to result in a failure of the Conduit Financer Test.  

Group ratio test

The group ratio test is intended to operate as an alternative to the rigid operation of the fixed ratio test for globally highly leveraged groups.  

The group ratio test allows an entity in certain groups (GR group) to claim debt-related deductions up to the ratio of the worldwide group’s net interest expense as a share of earnings as determined for accounting purposes (subject to certain adjustments), which is then applied to the tax EBITDA of the entity.  As noted above, this test may be particularly relevant to globally highly leveraged groups, although given the material problems with the definition of tax EBITDA, it will not provide relief for many taxpayers.

A taxpayer's "group ratio" is the GR group's net third party interest expense divided by its GR group's EBITDA, with some adjustments from the accounting position.  Adjustments include reducing the net third party interest expense for payments made to associate entities (using a threshold of 20% to determine if an entity is an associate entity), and also treating amounts in the nature of interest or economically equivalent to interest as being included in net third party interest expense.

One material change that has been made to the test is to ensure it is available to Australian headquartered groups (noting it was already available for foreign headquartered groups, where the relevant parent entity of that group was not controlled by another entity for accounting purposes).  The original drafting in the Exposure Draft appeared to inadvertently disqualify Australian parents from applying the group ratio test.  This appears to have been remedied, which is positive.

Deficiencies remain, however.  For example, certain inbound investors are classified as investment entities, and so are not required to prepare consolidated financial statements.  These entities may be controlled by upstream vehicles (e.g., foreign superannuation funds).  In this circumstance, the OECD recommends that the controlled entity that is not a parent entity should be able to form a group for group ratio purposes, where the ultimate controller does not prepare consolidated financial statements on a line-by-line basis.  Notwithstanding the OECD's recommendations, the Government has opted not to include such a provision, limiting access to the group ratio test.

Debt creation

In a surprise move (as this was not included in the Exposure Draft), a new Subdivision targets arrangements that are referred to as "debt creation" (which is a concept that used to be subject to an anti-avoidance rule some decades ago before that rule was removed).  This regime applies to all entities that are subject to the thin capitalisation regime – e.g., including authorised deposit-taking institutions and financial entities. 

Examples of so-called "debt creation" are where:

1. An entity acquires an asset from an associate entity (or acquires a legal or equitable obligation), and uses debt to fund the acquisition (in whole or in part).  In this case, debt deductions on the debt will be denied in their entirety.  This will be the case even where the debt satisfies the third party debt test, and even where the asset held by the original associate was itself geared (with debt giving rise to deductible debt deductions).  Accordingly, transferring assets between entities will need to be considered in detail.  This could act as a significant impediment to rationalisations of structures, internal restructures, as well as (potentially) on securitisation vehicles, among others;
2. An entity borrows from an associate in order to make a distribution (the definition of which is drafted broadly).  In this case, debt deductions on the debt will be denied in their entirety, even where the debt deductions are within the fixed ratio test or group ratio test.  Given the fixed ratio test, some taxpayers may seek to restructure borrowings so that they occur at the downstream entity level (and not the holding level).  However, where the structure borrows through a conduit financer, this debt creation prohibition would appear to prohibit restructuring the arrangements in  this manner.  

In the light of the breadth of the debt creation rules, they will require consideration in a range of common circumstances, including internal restructures, as well as group financing.

Other comments

There are two elements of the introduced measures that may be regarded as a (small) victory for those who participated in the consultation, as follows:

1. The proposed repeal of section 25-90 (and the equivalent provision in the TOFA provisions) is not occurring as part of this Bill.  The Explanatory Memorandum notes that:  "Stakeholder concerns regarding section 25-90 were considered by Government, with the proposed amendment deferred, reflected in its removal from the final legislation, to be considered via a separate process to this interest limitation measure."  Accordingly, watch this space.  In addition, taxpayers who intend to rely on the third party debt test will find themselves subject to a similar rule; and
2. The proposed changes to the definition of "financial entity" have been pared back.  The Exposure Draft proposed to remove from the definition of financial entity an entity that was registered under the Financial Sector (Collection of Data) Act 2001 (Cth).  That has been modified, and provided the relevant registered entity carries on a business of providing finance (but not predominantly for the purposes of providing finance directly or indirectly to associates), and derives all or substantially all of its profits from that business, then that entity will remain a financial entity.

Given the significant impact that the thin capitalisation measures will have on a large number of taxpayers, we expect that efforts to correct some of the more egregious elements of the legislation will continue.  

Public reporting measures

From 1 July 2023, Australian public companies must, as part of their annual financial reporting obligations, provide a “consolidated entity statement.”  If accounting standards require the public company to prepare financial statements in relation to a consolidated entity, the consolidated entity statement must include disclosures about entities within the consolidated group at the end of the financial year.  If, however, the accounting standards do not require the public company to prepare financial statements in relation to a consolidated group, the public company must provide a statement to that effect.

Under the new measures, the following information must be provided: 

• Name of each entity at the end of the financial year;
• Whether the entity was a body corporate, partnership or trust at the end of the financial year;
• Whether at the end of the financial year, the entity was any of the following:
  Trustee of a trust within the consolidated group;
  Partner in a partnership within the consolidated group;
  Participant in a joint venture within the consolidated group;
• If the entity was a body corporate, where the entity was incorporated or formed;
• If the entity is a body corporate, the public company’s percentage ownership of each of such entity at the end of the financial year; and
• Tax residence of each entity during the financial year. 

The directors' declaration about the financial statements, and the CEO's and CFO's declarations for a listed company, will need to include an opinion that the consolidated entity statement is true and correct.

Disclosures must be made available within the company’s annual financial report published on their website.  This measure will place an onus on public companies to be more transparent about their corporate structures.

Other proposed measures 

Two proposals which were announced as part of the Government's Multinational Tax Transparency measures were not implemented as part of this Bill, as follows:

• Public Country by Country Reporting (CBCR) – The Government has flagged in the Explanatory Memorandum to the Bill, that there will be additional consultation on public CBCR and indicated that the measure will be postponed by one year starting from 1 July 2024. 
  
  The good news is that based on the comments in Explanatory Memorandum, the Government has flagged a potential shift in its approach indicating that the policy, when implemented, will more closely mirror the regimes in other countries.

• Denying deductions for payments relating to intangible assets connected with low corporate tax jurisdictions – The Explanatory Memorandum appears to clearly recommend to push ahead with the proposal but curiously there is no legislation contained in the Bill itself.  It seems reasonable to assume it will be introduced into Parliament, but the start date and whether there will be changes from the Exposure Draft, remains to be seen.