Tax Insight: New limits on deducting interest

Treasury decided to spring a very big surprise on multinationals in an Exposure Draft released on 16 March 2023. The Draft was expected to address the Government’s promise to reconceptualise the thin capitalisation safe harbour from a debt: asset ratio to a percentage of EBITDA, which it does (a detailed analysis will follow). The Draft was not expected to re-write rules about deducting interest incurred to capitalise or buy foreign subsidiaries.

Background

The ability of Australian companies to deduct interest on money borrowed onshore to capitalise their foreign subsidiaries with equity (or buy the shares in a target company) has always been an uneasy combination of 2 issues:

• whether Australian tax law treated dividends received from the foreign subsidiaries as
  • assessable income, but with a credit for foreign tax (the rule just prior to 1990), or
  • non-assessable and non-exempt income (the rule from 1990), and
• whether the treatment of the interest expense
  • followed the treatment of the dividend income (deductible if the dividend was assessable, and not deductible if the dividend was NANE) (the rule prior to 2001), or
  • was subject to a special rule to allow the interest deduction even if the dividends were NANE (the rule from 2001).

Those 2 rules have rarely been stable but the most recent changes to them were driven by Treasury pursuing sensible policy considerations:

• the shift in the treatment of dividends from assessable to NANE in 1990 was made because, “the effect of the [foreign tax credit system] for companies … broadly equivalent to providing an exemption for the dividends, but it imposes greater compliance costs than would an exemption,” and
• the decision to allow a deduction for interest incurred to earn NANE dividends in 2001 was made because, “debt deductions … will come within the scope of the thin capitalisation regime when determining the amount to be allowed” – in other words, the extension of the thin capitalisation regime to outbound investments was the appropriate method of preventing the Australian operations from carrying excessive levels of debt.

Treasury was happy with that theory in 2001, but apparently there was a contrary view inside the organisation because in May 2013 in the 2013-14 Budget, the Government announced that it would be, “removing the provision allowing a tax deduction for interest expenses incurred in deriving certain exempt foreign income” as part of a suite of measures to “address profit shifting by multinationals through the disproportionate allocation of debt to Australia.” No legislation was enacted before the election, and it seemed the proposal had died:

• in November 2013, the incoming Government announced that it would not proceed with the May 2013 announcement but would instead “introduce a targeted anti‑avoidance provision after detailed consultation with stakeholders.” This measure too was never enacted,
• in October 2015, the OECD issued its Final Report on BEPS Action 4 which criticised repeatedly “groups using third party or intra-group financing to fund the generation of exempt income.” Treasurer Scott Morrison did not address this part of the Report in his media release about Australia’s responses to the BEPS project, noting only that “Australia has already tightened its Thin Capitalisation rules,”
• the Senate Economics Committee inquiry into Corporate Tax Avoidance examined the problem it termed “debt loading” but the Final Report in 2018 did not pursue the idea of repealing s. 25-90, recommending instead repealing the safe harbour and arm’s length debt tests, and using worldwide gearing as the only rule for thin capitalisation purposes, and
• in the run-up to the 2022 election, the ALP’s tax policies focussed on changing the mechanics of the thin capitalisation safe harbour and a suite of other measures directed to multinationals; there was no mention of any change to s. 25-90.

So, the inclusion of 2 brief paragraphs in the Draft released yesterday, effectively repealing the ability of companies to deduct interest incurred to earn NANE dividends, was truly remarkable. The Explanatory Memorandum said that decision was made because:

 The rules … go against the policy underlying the new rules as it gives rise to a double benefit; the benefit of the income being NANE income and the benefit of a  deduction for the interest expenses incurred to derive such NANE income.

This bland statement doesn’t explain why that very position was acceptable tax policy for the last 20 years, why a thin capitalisation rule based on cash flows requires a different rule to one based on asset values, nor why the newly-tightened thin capitalisation rules will apparently be inadequate to protect the Australian tax system – especially when NANE income is excluded when calculating tax EBITDA for the purposes of the new 30% of EBITDA fixed ratio thin capitalisation test.

The measure

The Draft contains a simple 2-line proposal to remove references to s. 768-5 from s. 25-90 and the equivalent provision in the TOFA regime (s. 230-15). (Interest would still be deductible if incurred in connection with NANE dividends paid out of income already attributed from a CFC or FIF, but these dividends are made NANE because the profits out of which they are paid have already been attributed and taxed).

Assuming it is passed as drafted, the new measure will start for interest incurred in income years starting on and after 1 July 2023. There is currently no provision which would “grandfather” existing debt structures or allow a grace period for taxpayers to unwind them before the change applies.

The future

Assuming it is passed as drafted, we will return to 2000: a world of tracing of loan funds and apportionment for interest expense. One reason for the 2001 amendments was to get rid of the compliance nuisance that “the debts of an outbound investor are traced to an end use to determine the treatment of the interest expense.”

We will also likely return to a world of cash damming, quarantining funds and similar self-help practices to mitigate against the impact of the rule. It would a brave decision to put in place the kind of 2-tier structure struck down by the High Court in the Consolidated Press case in 2001, but no doubt variations will emerge over time.

The Draft is open for submissions until 13 April 2023.