Major Changes to Australias Thin Capitalisation Regime

What you need to know

On 16 March 2023, Treasury released Exposure Draft legislation and explanatory materials regarding the proposed changes to the thin capitalisation rules. 

The proposed changes will significantly impact taxpayers that are subject to the thin capitalisation regime.  The intended effect of the new regime is to more closely align Australia's thin capitalisation rules with the OECD's best practice guidance by implementing a direct approach to limiting taxpayers' allowable interest expense and to prevent taxpayers from claiming excessive interest deductions. 

Consultation on the Exposure Draft is open until 13 April 2023 and the proposed regime will take effect from income years starting on or after 1 July 2023. 

What you need to do

We recommend that taxpayers urgently consider:

• Their classifications as either a "general class investor" or a "financing entity"
• How the proposed regime will impact current financing arrangements, including whether this may result in an increased level of disallowed debt deductions
• Re-financing options, including replacing related party debt with third party debt or equity
• The impact of proposed changes to deny debt deductions incurred for non-portfolio foreign investments, even if the new thin capitalisation rules do not deny the debt deduction.  For any Australian companies with foreign non-portfolio investments, this is likely to cause a significant adverse impact for the deductibility of debt deductions unless it can be established that the debt was not incurred for those purposes.  

Key Action Items for Taxpayers: 

Key action items include:  

• Taxpayers which are currently classified as "financial entities" under the current regime only by virtue of being a "registered corporation under the Financial Sector (Collection of Data) Act 2001 (Cth)" will not be classified as financial entities under the proposed regime.  Entities to which this applies may then only be classified as "general entities" under the proposed regime, thus preventing the ability to continue to rely on the potentially higher permissible gearing levels that are available under the thin capitalisation measures that apply to financial entities.  Accordingly, existing financial entities should urgently assess their classification under the proposed regime. 
• As the proposed regime does not incorporate or replace the existing associate entity rules by which excess thin capitalisation capacity may flow to upstream vehicles, all non-consolidated taxpayers which have upstream debt (whether third party or related party) are likely to be more negatively impacted under the "Fixed Ratio Test" compared to having asset-level debt.  
• All taxpayers who presently rely on the existing arm's length debt amount with respect to third-party debt arrangements should urgently assess the terms of these debt arrangements and their financing structure.  The proposed "External Third Party Debt Test" imposes conditions in order to satisfy the test that may be problematic for common commercial financing arrangements.  Moreover, taxpayers who have borrowed third-party debt indirectly, i.e., through a related financing company (FinCo), may be equally negatively impacted by the External Third Party Debt Test.  Although these issues were raised during consultation, the design of the proposed regime's "conduit financing" rules are unlikely to apply to the most common FinCo on-lending arrangements.  Critically, borrowing entities that on-lend  must do so on terms that "are the same" as the terms of the third-party debt (other than the amount of debt) in order for the ultimate borrower to access the External Third Party Debt Test.  
• Australian companies that have used debt to fund foreign non-portfolio investments should carefully review the availability of interest deductions.  The proposed changes to deny debt deductions incurred for non-portfolio foreign investments was not expected and was not referred to in previous Government or Treasury announcements regarding the multinational enterprises package of measures.  The amendment applies to both existing and future debt arrangements.  Affected taxpayers will need to consider if it is possible to identify and trace debt used for these purposes and if it is possible to refinance the debt such that it is incurred for Australian purposes going forward.

Overview of the Proposed Regime: 

The underlying policy objective of the proposed regime is to strengthen Australia's thin capitalisation rules to combat what the Government considers to be excessive debt deductions eroding the domestic tax base.  

The extent of the impact of the proposed regime on specific taxpayers will depend upon the relevant classification of entity that taxpayer falls within. Based on the revised rules, these are: 

• General class investors (but including entities that were previously financial entities where that status arose as a consequence of being registered under the Financial Sector (Collection of Data) Act);
• Financial Entities (subject to the proposed change to the definition noted immediately above); and
• ADIs. 

The proposed regime introduces three new methods for determining a taxpayer's disallowed debt deductions.  General class investors, unlike Financial Entities and ADIs, cannot continue to rely upon the existing safe harbour debt amount or worldwide gearing debt amount.  No entity, other than ADIs, will be entitled to rely on the existing arm's length debt amount. 

As noted above, and notwithstanding that the Government indicated that financial entities would not be affected by the proposed reforms other than with respect to the change to the arm's length debt amount, the draft legislation changes the definition of a financial entity.  In particular, where an entity is currently a financial entity only because it is registered under the Financial Sector (Collection of Data) Act, that entity will no longer be a financial entity under the proposed reforms.  Accordingly, those entities may have significantly lower levels of thin capitalisation capacity.  

The new tests and their operation are detailed below. 

Fixed Ratio Rule 

The Fixed Ratio Rule will replace the existing safe harbour debt amount.  It is the default test for "general class investors" which have not made an election to use an alternative test. 

Under the Fixed Ratio Rule, taxpayers' "fixed ratio earnings limit" will be 30% of its "tax EBITDA".  Broadly, tax EBITDA is the sum of a taxpayer's taxable income, net debt deductions, Division 40-B and 43 depreciation expenses and Division 36 tax losses that were utilised in the income year.  

"Net debt deductions", which is relevant to calculating both tax EBITDA (as noted above) and the total disallowed amount, includes a taxpayer's "debt deductions" less income that comprises  amounts of interest, amounts in the nature of interest, or amounts determined by reference to the time value of money.  The concept of "debt deductions" is also being amended, so that it captures amounts that are not in relation to a debt interest.  It is not entirely clear what payments this is intended to capture – for example, whether it is considered to capture payments under interest rate swaps (which are not currently included in debt deductions).  

In the consultation process, it was anticipated that FinCo vehicles (which borrow externally and on-lend) would have no "net debt deductions", and therefore not (in effect) be impacted by the thin capitalisation changes.  However, due to the proposed definition of net debt deductions, it is likely that many FinCo vehicles may have debt deduction denials.  To take an example, borrowing costs such as legal expenses incurred by the FinCo vehicle on the external debt are to be included as "debt deductions" (see TD 2019/12), and typically the FinCo vehicle would be entitled to on-charge those amounts to the entity to which it has on-lent under the terms of the on-lending arrangement.  Prima facie, the on-charging of these amounts would not give rise to interest, an amount in the nature of interest, or an amount calculated by reference to the time value of money.  Accordingly, and because of a lack of symmetry between the definition of "debt deductions" and the adjustments that are made to determine "net debt deductions", it may be expected that FinCo vehicles may have net debt deductions in a range of circumstances, and those net debt deductions would then be subject to limitation unless there is other income which can effectively shelter them from denials.

The calculation of "tax EBITDA" is also potentially problematic in non-consolidated structures where debt is borrowed upstream from the asset-holding level (i.e., where there is debt at the holding level of a structure).  These holding entities are likely to have lower tax EBITDA, because they will not be claiming (for example) depreciation deductions at that level.  The proposed regime does not contain any associate entity rules which allow excess thin capitalisation capacity to flow to upstream associate entities.  Accordingly, holding vehicles determining their tax EBITDA will effectively be determining this after downstream depreciation and interest costs.  Those with debt at the upstream holding level should consider whether refinancing at a lower level of their structure would improve their thin capitalisation position, although noting that there may be a range of other tax issues associated with refinancing at the lower level (such as the deductibility of interest where the amount borrowed is distributed to equity holders to retire debt, as well as whether any anti-avoidance provisions may apply to any such refinancing). 

Under the Fixed Ratio Rule, the "total disallowed amount" is the amount by which a taxpayer's net debt deductions exceed its fixed ratio earnings limit. 

Taxpayers with disallowed debt deductions by operation of the Fixed Ratio Rule may carry forward those amounts where there is sufficient capacity under the Fixed Ratio Rule and claim those deductions for a 15 year period.  In order for companies to claim those amounts, a modified continuity of ownership test must be satisfied; for trusts, the 50% stake test does not apply.  If a company with disallowed deductions joins a tax consolidated group, the unutilised carry forward amounts can be transferred to the head company, subject to satisfying a modified continuity of ownership test.  Importantly, there is no alternative business continuity test, meaning that the disallowed deductions will be lost if there is a relevant change in ownership.

In addition, if the taxpayers elects to use an alternative method in a future year (discussed below), all carried forward deductions will be lost.  

Group Ratio Test

The Group Ratio test is intended to operate as an alternative to the rigid operation of the Fixed Ratio Rule for globally highly leveraged groups.   

The worldwide gearing debt amount will be replaced with a new earnings based Group Ratio Test that allows an entity in certain groups 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 those groups may not all be able to access the Group Ratio Test.

In particular, this test will only be available if the entity is a member of a "GR group", and the "GR group EBITDA" for the period is not less than zero.  In order to apply the rule, an irrevocable choice is required, with the choice applying in respect of a particular income year.

A "GR group" is the group comprised of the relevant worldwide parent entity (being an entity that is not controlled by another person) and all other entities that are fully consolidated on a line-by-line basis in the audited financial statements.  In other words, investment entities or other entities that do not line-by-line consolidate (such as those that equity account for subsidiaries) will not be able to access the test.  Positively, the current element of the worldwide gearing debt amount test which limits access for inward investors to those groups whose assets are predominantly non-Australian has not been replicated, meaning that the new test can apply to groups which have predominantly Australian assets.   

Under this test, an entity's net debt deductions will be limited to its group ratio multiplied by tax EBITDA.  

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 10% to determine if an entity is an associate entity), and also treating amounts in the nature of interest or calculated by reference to the time value of money as being included in net third party interest expense.

Because the test utilises different bases – i.e., the group ratio is calculated by reference to accounting numbers, but this ratio is then applied to the entity's tax EBITDA – it will be possible for denials to arise even when (from an accounting position) the Australian group may be geared at a lower level than the global group.  To take an example, if mark to market gains on assets are recognised for accounting purposes, the group ratio will be lower (where there are such gains) than would be the case if the tax position were considered.  This lower ratio is then applied to tax EBITDA (which will not include those gains), giving a lower level of allowable deductions.  

Finally, disallowed debt deductions under the Group Ratio Test cannot be claimed as a deduction in subsequent income years.  In addition, if there are previously denied deductions under the Fixed Ratio Test, and a taxpayer elects in a particular year to utilise the Group Ratio Test, those denied deductions under the Fixed Ratio Test will be lost. 

External Third Party Debt Test 

The External Third Party Debt Test will replace the existing arm's length debt amount for general class investors and non-ADI financial entities.  The test operates by a one-in all-in rule, in that it is not possible to apply the test in respect of some, but not all, associate entities that are subject to the thin capitalisation rules. 

In addition, the External Third Party Debt Test (as drafted) appears to only be available where a group of associate entities does not include any entity that is exempt from thin capitalisation, either because the relevant de minimis rules are satisfied, or because an entity qualifies as an insolvency remote special purpose entity.  The draft Explanatory Memorandum suggests this is not intended – i.e., it explains that the purpose of the provision is to allow an entity to make an election where all entities that are subject to the regime (and not exempted) make the election.  If that is the intention, the current drafting of the legislation would appear to be deficient in this regard.  

The restrictions on choosing the External Third Party Debt Test are stated to be intended to ensure that entities are not able to structure their affairs in a way that "artificially maximises their tax benefits by applying a combination of different rules".  

Under the External Third Party Debt Test, taxpayers' "external third party earnings limit" is the total debt deductions attributable to debt interests issued to third-parties that satisfy the "external third-party debt conditions".  A debt interest satisfies these conditions if: the debt interest is not issued to or held by (at any point in the income year) an associate entity, the holder of the debt interest has recourse as against the issuer's assets only, and the financing is used by the issuer of the debt interest to fund Australian investments and its Australian operations. 

Under the External Third Party Debt Test the total disallowed amount is the amount by which a taxpayer's debt deductions (not net debt deductions) exceeds its external third-party earnings limit.  Therefore, all debt deductions would be allowable in instances where the only debt deductions claimed equal the taxpayer's external third-party earnings limit. 

The External Third Party Debt Test will be problematic where a debt arrangement has multiple obligors, where security is provided by parties who are not the borrower, or where there is a guarantor.  In contrast to the current arm's length debt amount, which requires certain assumptions be made around the absence of credit support provided by associates in determining the quantum of allowable debt, the External Third Party Debt Test makes meeting these a gateway test to access the provision.  Accordingly, where the holder of a debt interest has recourse for payment of the debt to assets of entities that are not the borrower, the debt will not satisfy the external third party debt conditions.  It is common for banks to seek security from other members in a group in certain circumstances, such as where the debt is at the holding level (and downstream entities may be obligors), as well as to seek security over the equity issued in the borrower.  Where assets are under development, it would also be common to seek a parental guarantee or other form of credit support.  As drafted, all of these arrangements would prevent the External Third Party Debt Test applying to the third party sourced debt – even if the security is over Australian assets (i.e., so there is no concern with other entities providing credit support by way of their foreign assets to achieve a higher level of gearing in Australia).  

The External Third Party Debt Test contains further complexities with respect to "conduit financers", i.e., FinCos and intragroup on-lending.  In particular, in order to access the conduit financer provisions, there are a range of requirements that would not be satisfied with respect to the most common FinCo arrangements, including:

• The terms of the on-lending being "the same as the terms" of the external debt – the on-lending arrangement will typically not be secured (as the external financier would have sought security over the assets of the ultimate borrower), among a range of other terms and conditions which would typically be different;
• The ultimate lender has recourse only to the assets of each ultimate borrower, and each asset of the conduit financer that is the debt interests issued by the ultimate borrowers – typically, the external lender would take all asset security from the FinCo, and not security limited to the on-lending arrangements.

As drafted, the conduit financer provisions are not likely to apply to many FinCo arrangements.  We expect a key item of the consultation from a taxpayer perspective to be ensuring that the External Third Party Debt Test is broadened to cover genuine third party arrangements that are currently excluded.

Finally, disallowed debt deductions under the External Third Party Debt Test cannot be claimed as a deduction in subsequent income years.  In addition, if there are previously denied deductions under the Fixed Ratio Test, and a taxpayer elects in a particular year to utilise the External Third Party Debt Test, those denied deductions under the Fixed Ratio Test will be lost. 

Other measures

There are a range of other measures contained in the exposure draft legislation which were not flagged by the Government as part of consultation.  These include:

• A denial of deductions for debt deductions arising in respect of amounts incurred in deriving foreign equity distributions that are non-assessable non-exempt income under Subdivision 768-A.  That Subdivision contains the participation exemption in respect of foreign sourced distributions on non-portfolio interests.  As a consequence, it will now be necessary for Australian taxpayers to trace the use of funds borrowed in determining whether funds may be used to fund investments in foreign vehicles.  In addition, it will be necessary for taxpayers to trace previously borrowed amounts as well, as the amendment applies to both existing and future debt arrangements.
• Changes to the interaction between the thin capitalisation regime and the transfer pricing regime.  In particular, under the current law, where an entity is subject to the thin capitalisation regime, the transfer pricing regime operates by applying any arm's length conditions to the debt interest actually issued.  In other words, where the thin capitalisation regime applies to an entity, it is not necessary to separately consider whether the quantum of debt borrowed is in accordance with the arm's length requirements under the transfer pricing provisions.   As a consequence of this change, general class investors, along with any entity relying on the External Third Party Debt Test, will need to separately consider whether the quantum of cross-border debt arrangements fall within the arm's length requirements in the transfer pricing provisions, even if the thin capitalisation regime applies to that entity (and even if the thin capitalisation regime does or does not result in a debt deduction denial). 

Authors: Vivian Chang, Parnter; Sanjay Wavde, Partner; Steve Whittington, Partner; Ian Kellock, Partner.