Tax Insight: Tweaking the new thin cap rules

Treasury has released the text of proposed amendments to the Bill, currently before Senate, to enact changes to the thin capitalisation regime. Many of the proposed changes are welcome, but important problems in the Bill remain unremedied. Many of the changes are mere clarifications or highly technical or conceivably relevant to only a few taxpayers, and so this Tax Insight focuses on some of the highlights.

1     Background

 We have tracked the evolution of the thin cap changes in earlier Tax Insights:

• • our Tax Insight in August 2022 on Treasury’s Consultation Paper on the thin capitalisation measures, available here;
  • our Tax Insight in March 2023 on the text of the Exposure Draft released by Treasury for consultation, available here;
  • our Tax Insight in March 2023 on the unexpected proposal in the Exposure Draft to repeal s. 25-90, available here;
  • our Tax Insight in June 2023 on the text of the Bill presented Parliament, available here;
  • our Tax Insight in August 2023 on the debt creation regime, a late addition to the thin cap changes, available here;
  • our Tax Insight in September 2023 on the report of the Senate Economics Legislation Committee’s inquiry into the Bill available here. The Committee recommended passage of the Bill subject to “technical amendments” foreshadowed by Treasury, but apparently not shown to the Committee. The text just released sets out those changes.

Given the consultation on the draft changes ends on 30 October, we are unlikely to see much further movement to the legislation and so the basic design elements, as well as much of the detail, are probably now largely settled.

2    The big picture

The thin capitalisation regime will remain segmented with different rules applying to (the new category of) ‘general class investors’, Authorised Deposit-taking Institutions and “financial” investors.

 General class investors will be subject to one of three new tests:

• • the “fixed ratio test” [“FRT’]: a new thin capitalisation test based on adjusted earnings (in lieu of the existing test based on the ratio of asset values to debt);
  • the “group ratio test” [“GRT”] based on the adjusted earnings ratio of the worldwide group (in lieu of the existing worldwide gearing test); or
  • the “third party debt test” [“TPDT”] (in lieu of the existing arm’s length debt test).

General class investors must apply the FRT unless they qualify and elect to apply either the GRT or the TPDT.

Deductions denied under the FRT (but not the other tests) can be carried forward for up to 15 years. Denied deductions will potentially be lost if there is a change of ownership of a company with carry-forward  denied deductions, and complex rules are proposed to handle the entry of a company with carry-forward denied losses into a tax consolidated group.

The treatment of the category of “financial” investors is left largely unaffected by these rules except for replacing the existing arm’s length debt test with the TPDT. The treatment of Authorised Deposit-taking Institutions is left largely untouched.

Once enacted, new rules are backdated, applying for income years commencing on or after 1 July 2023 with no grandfathering of existing debt or transition period to allow for the reorganisation of existing structures.  However, the new provisions will delay the start of the debt deduction creation rules for financial arrangements on foot at 22 June 2023: for these arrangements, the debt creation rules will only apply to debt deductions being deducted in income years beginning on or after 1 July 2024.

3    Elections

3.1   Conflicting choices

General class investors are exposed to three tests: the FRT, the GRT and the TPDT. The FRT is the presumptive rule which applies unless the taxpayer is able, and chooses, to apply either the GRT or the TPDT. (This is different to current law where the taxpayer automatically gets the best outcome under any of the three tests.)

While the applicable regime seems, at first glance, entirely at the taxpayer’s election, if one taxpayer in an “obligor group” has chosen to apply the external debt test, that test must be applied by any associate which is also a member of the group, which can create an obvious conflict between actual choice and imputed choices.

New provisions clarify that the TPDT choice imputed to a taxpayer defeats an earlier GRT choice, but only for the relevant year.

3.2   Revoking choices

The Bill also contained detailed provisions about the circumstances in which a taxpayer might revoke a choice to apply the GRT or TPDT. Where a taxpayer qualifies to revoke, the revocation has retrospective effect. The new measures remove most of the conditions on seeking revocation and the instead test will be simply whether “it is fair and reasonable, having regard to matters the Commissioner considers relevant, to allow the entity to revoke the choice.”

And because revocation has retrospective effect, taxpayers will not be allowed to seek revocation after 4 years.

4    Changes to the FRT

4.1   Technical changes

The measures just released make a number of technical changes to the operation of the FRT. Some of the most important are:

• • even though companies choose the amount of tax losses to be deducted in an income year when calculating taxable income, when calculating tax EBITDA, it is assumed that the company has chosen to deduct all of its available tax losses;
  • under the first version of the rules, dividends were excluded from “E” in the definition of “tax EBITDA”. Under the revised version, dividends from foreign subsidiaries will still be excluded but dividends that are assessable under s. 44 (typically from local companies or in respect of portfolio shareholdings in foreign companies) will only be removed if the dividend is paid by a company in which the taxpayer holds a 10% or greater interest; and
  • special adjustments are made to the calculation of “tax EBITDA” for forestry and R&D deductions.
  • existing provisions which deal with the calculation of tax EBITDA for trusts and their beneficiaries will be accompanied by parallel provisions just for AMITs.

4.2  Transfers of excess tax EBITDA between trusts

The treatment of trust structures was seen as a major problem in the Bill, and the report of the Senate Committee alluded to the need for “technical amendments to thin capitalisation rules so they better accommodate trust structures.” Consequently, a new provision has been inserted which transfers excess “tax EBITDA” between resident unit trusts. Given how prevalent trusts are in infrastructure and real estate projects, and the likelihood that debt will be located in special-purpose non-operating entities, these changes are potentially very important.

The process is intended to allow the excess tax EBITDA of a lower-level unit trust to be claimed by a unit trust which holds at least 50% of its units when calculating its tax EBITDA for the fixed ratio test. Both trusts must be resident and using the fixed ratio test. The calculation can be repeated if the recipient unit trust is itself owned as to 50% by another unit trust and has excess tax EBITDA available (whether its own excess or excess EBITDA transferred to it).

The amount of excess tax EBITDA which is transferred is based on the transferee trust’s average level of ownership for the income year.

Since tax EBITDA excludes distributions from trusts in which the taxpayer holds a 10% or greater interest, taxpayers that hold an interest in a trust of between 10% and 49.9% will not be able to include any amount in their tax EBITDA in relation to the trust.

It is not clear what the policy reasons are as to why the ability to transfer excess tax EBITDA is only available to trusts holding 50% or more of the underlying trusts or more generally why the transfer of excess tax EBITDA only applies to trusts and not companies. While it seems these changes will be beneficial to typical real property structures, it would not be available to infrastructure consortium projects with consortium members holding typically around 20%.

5    Changes to the TPDT

Many taxpayers, especially if most of their funding ultimately comes from financial markets (rather than say, on-lent retained earnings or equity), will want to apply the TPDT as a simpler alternative to calculating tax EBITDA and applying the FRT. But the conditions attached to the TPDT have meant it is not easily accessed, especially for intra-group on-lending of debt which is ultimately externally-sourced. The new measures address a few of the problems in the TPDT.

5.1   Jurisdictional aspects

One preoccupation of the original version of the TPDT was to insist that a lender could only have recourse to Australian assets. Treasury was apparently concerned that debt would be raised by an Australian entity to fund operations outside Australia the income of which would likely be protected from Australian tax by an exemption or FITO. This preoccupation could be seen in requirements that –

1. 1. the borrower must use all, or substantially all, of the debt raised “to fund its commercial activities in connection with Australia …” and
   2. the lender’s recourse must be limited to the “Australian assets [of] the [borrowing] entity …”

The revised draft still insists on the first requirement but the second is relaxed slightly: the lender can now have recourse to any and all of:

1. 1. the “Australian assets” of the borrower (as in the current test);
   2. the parent’s shares in the borrower, provided the borrower does not have rights to any foreign assets (to reflect the fact that lenders often want recourse to both the borrower’s assets and the parent’s shares in the borrower); and
   3. any “Australian assets” held by other Australian entities which are also members of the “obligor group” (which is defined to mean the lender, the borrower and any other entity whose assets are available to the lender).

The rules permit the lender to have access to the Australian assets of any member of the “obligor group.” This may be a borrower, but need not be: it includes any entity which has given security to support the debt. The impact seems to be, a foreign lender can be given security over any Australian assets without offending the TPDT.

One curious feature of the current drafting is, the lender can’t have recourse to the parent’s shares in the borrower [item 2] if the borrower has rights to any foreign assets. But the lender can have recourse to any “Australian assets” of the borrower [item 1]. This would seem to include membership interests in Australian entities even if they hold foreign assets. This seems odd.

Nevertheless, the changes are welcome and go a little way to addressing the criticism that the strictness of the first version only served to drive up unnecessarily the cost for Australian borrowers of debt being raised from financial markets.

5.2  Limits on recourse in conduit financing

Under the first version, the TPDT contained a regime for conduit financing structures, which could overcome the prohibition on (i) borrowing from an associate (or an associate coming to hold the receivable) (ii) lending to or buying equity in an associate and (iii) the limits on the range of assets against which the creditor could have recourse.

Under the revised version, the external lender can have recourse to:

• • he Australian assets of the initial borrower and each borrower in the chain; and
  • shares in any of those entities (unless the entity has a legal or equitable interest, whether directly or indirectly, in an asset that is not an Australian asset); and
  • Australian assets of any member of the obligor group (see above).

A targeted amendment is also made to allow a conduit financer and subsequent borrowers to on-lend borrowed amounts to associates (provided they are residents).

5.3  Guarantees

One thing that hasn’t changed is that debt with a (usually, parental) guarantee cannot satisfy the TPDT, even if the debt has been borrowed from an unrelated lender. The main effect of the parental guarantee would be to drive down the borrower’s interest cost – which should be a good thing!), but Treasury has insisted that the prohibition remain, “[as it] ensures that multinational groups do not have an unfettered ability to ‘debt dump’ third party debt in Australia that is recoverable against the global group.”

5.4  Technical amendments

The measures make a number of technical changes to the operation of the TPDT:

• • under the Bill, access to the TPDT was only available to an entity which was an “Australian resident”, a concept which makes no sense for trusts or partnerships. The reference to “Australian resident” will be replaced with “Australian entity”, a term drawn from the CFC rules, so that trusts and partnerships can access the TPDT;
  • some adjustments are made to accommodate interest rate swaps;
  • a current concession permitting credit support for loans that are used for the development of land in Australia has been extended to include moveable property situated on the land being developed.

6    Debt creation regime

The debt creation regime appeared unannounced in the Bill presented to Parliament in June 2023, and, because it was not the subject of prior consultation, has attracted robust and prolonged criticism. The proposed changes are, not surprisingly, substantial.

One set of changes deals with scope and ordering:

• • special-purpose insolvency-remote entities which are outside the thin capitalisation rules will also be outside the debt creation rules;
  • the debt creation rules will not apply to ADIs and securitisation vehicles;
  • a new ordering rule has been added which gives priority to the debt creation rules: the debt creation rules apply first; amounts which are denied under those rules will not be treated as debt deductions for the thin capitalisation rules; but if the debt creation rules do not eliminate a deduction, the thin capitalisation provisions can apply.

At its simplest, the debt creation regime disallows debt deductions arising under two transactions:

1. 1. an entity borrows from anyone to acquire a CGT asset from an associate and incurs debt deductions in relation to the acquisition or holding of the CGT asset;
   2. an entity borrows from an associate to fund a payment to that entity, or another associate.

Transaction 1. One important change being made in the revisions is to insert a related party requirement for the first transaction: if the entity is borrowing to acquire a CGT asset from an associate (or retain a CGT asset it acquired from an associate), it must now also be borrowing from an associate. This change will limit the debt creation regime to acquisitions from associates which are funded by related party debt.

Another series of changes exclude borrowing to acquire certain types of assets from associates. The debt creation regime will not be triggered by borrowing from an associate to acquire –

• • a newly-issued membership interest in an Australian entity;
  • a newly-issued membership interest in a foreign company;
  • debt issued by an associate. The Explanatory Memorandum accompanying the revisions says this change is a technical adjustment to ensure that related party lending is not caught by this rule;
  • new tangible depreciating assets to be used within 12 months. The Explanatory Memorandum says this change is being made, “to allow an entity to bulk-acquire tangible depreciating assets on behalf of its associate pairs.”

Transaction 2. The proposed amendments make two adjustments to the rules dealing with borrowings to fund payments. The debt creation regime will not be triggered by borrowing from an associate to fund –

• • on-lending of the borrowed money to an Australian associate on the same terms; although the on-loan itself may be problematic if it is used to fund a payment; and
  • the repayment of the principal under a debt interest (provided the debt being retired was on the same terms as the debt being taken on).

One other matter of legislative housekeeping is dealt with: the rules will now apply to a “financial arrangement” rather than a debt interest. The Explanatory Memorandum says this is being done to align the kinds of arrangements being described more closely with the definition of “debt deduction” used in the legislation.

Conduit financings: The explanatory memorandum suggests that if ultimately there is external debt then on-lending to associates should not be caught. However, the drafting does not seem to achieve this objective. It will be interesting to see whether this is picked up in the consultation process.

7    Commencement and transition

As was noted above, once the Bill, with the amendments, is enacted, the new rules will apply for income years commencing on or after 1 July 2023 with no grandfathering of existing debt or transition period to allow for the reorganisation of existing structures.

One exception was, however, added with respect to the debt deduction creation rules. For financial arrangements on foot at 22 June 2023, the debt creation rules will only apply to debt deductions being deducted in income years beginning on or after 1 July 2024.

As there is no grandfathering for the debt deduction provisions, taxpayers may have difficulty reconstructing the reason behind why the relevant debt was entered into and a tracing of funds. We understand that the ATO is considering their approach where there is an absence of records, given those records would not have been required at that time.

We understand that the ATO is also considering what guidance may be appropriate in relation to the application of Part IVA where a taxpayer undertakes any type of restructure to enable continued deductibility of interest under the new rules.