Tax Insight: Thin Capitalisation Bill – In More Detail

This Tax Insight gives a fuller analysis of the changes to the thin capitalisation measures contained in the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share – Integrity and Transparency) Bill 2023 introduced into Parliament last week. The Bill departs from the Exposure Draft, which was released for consultation in March 2023, in important respects. This Tax Insight focuses on five key rules and concepts that have changed since March.

Calculating the Fixed Ratio

The new thin capitalisation test will cap the “net debt deductions” of a general class taxpayer in any year at 30% of the taxpayer’s “tax EBITDA” (unless it qualifies for, and elects to use, one of the other tests).

The Exposure Draft defined these terms and the Bill has adjusted the definitions slightly:

• the amount of “net debt deductions” put in jeopardy by the new rules has been reduced slightly: that is, more amounts will now potentially reduce the deductions at risk of being denied;
• the amount of “tax EBITDA” has been amended so the 30% test is now measured against a different number. For example:

• • depreciation deductions allowed under any Subdivision of Div 40 will be added back (increasing the “D” component of EBITDA). The March Bill had limited the add-back just to amounts claimed under Subdivision 40-B, but the expansion in the Bill will mean deductions like project pool amounts and black hole expenses will now increase the size of tax EBITDA;

• • however, amounts which are immediately deductible under Division 40 will not be added back. This would mean some mining expenditure and amounts claimed under instant asset write off provisions will not be added back;

• • similarly, assessable dividends (including from portfolio investments) and franking credits (which would have increased the “E” component of EBITDA) are now excluded. And, for trusts, distributions from other trusts will usually not be included in the “E”, which means head trusts which borrow to capitalise sub trusts will often have difficulty in deriving any earnings under this formula as drafted; and

• • prior year losses are no longer reversed out (so losses will now decrease the “E” component of EBITDA).

In addition, new provisions have been added in the Bill to accommodate the calculation of “net income” which is the concept applicable to trusts and partnerships.

Carry forward of debt deductions denied under the FRT

The Exposure Draft contained provisions which allowed a taxpayer to carry forward deductions denied under the Fixed Ratio Test (but not the other tests) for up to 15 years. This was particularly important for entities with little cash flow in the early years of their operations or where earnings are highly volatile.

However, the Exposure Draft, proposed that the ability to carry forward deductions would be lost if either:

• the taxpayer switched from using the Fixed Ratio Test to either the External third-party debt test or the Group ratio test at some point, or
• there was a change to the majority ownership of a company (although no equivalent loss had been proposed for trusts).

As a result of the consultations, the Bill has adjusted these rules. Carry forward deductions will now be available if the business continuity test has been met for companies and the trust loss rules have been passed for trusts.

External Debt Test

The Exposure Draft revealed that the existing arm’s length debt test would be repealed for general class investors, which was something of a surprise given the ALP’s election commitment to, “maintaining the arm’s length test.” Instead, the new external debt test would permit the deduction of all interest expense provided it was being paid to third parties.

A taxpayer who makes this election can deduct their interest expense up to the amount of interest incurred on external debt. If the taxpayer has only external debt, this means the taxpayer can deduct all its interest expense. If the taxpayer has a modest amount of related party debt, it might still want to make this election, knowing that the election comes at the cost of abandoning the deduction for interest on the related party debt. But the Bill has improved that calculus somewhat by specifically adding amounts incurred on hedging with non-associates in the total that can be deducted.

The version in the Exposure Draft imposed a number of restrictive conditions, some of which have been tweaked in the Bill. Debt will not qualify as “third party” debt if:

• borrower: the issuer is a non-resident;
• lender: the debt interest was issued to an associate of the entity, or the debt interest is held by associate of the entity at any time during the income year;
• recourse: the holder of the debt interest has recourse to assets beyond the Australian assets of the entity; or
• use of funds: the debt is used to fund the entity’s Australian operations, and is not –

• • used to fund a foreign PE, or

• • lent to an associate, or injected as debt or equity into a controlled foreign entity.

The revisions made in the Bill have focussed mostly on cross-border aspects of the test:

• the requirement that only residents can elect to use the external debt test is new;
• the requirement that residents must be using the debt to fund “commercial activities [being conducted] in Australia” is new; the previous version allowed a taxpayer to fund any “assets [held] for the purposes of producing assessable income …” which would have extended to offshore operations if they did not amount to a branch;
•  the holder must not be able to access the borrower’s rights under a guarantee or other form of credit support (most likely given by a related parent entity). Presumably this acts as an indirect constraint on the amount of debt unrelated lenders are willing to advance; and
• the debt cannot generally be secured although there are exceptions. The interaction between various rules seems to produce these outcomes:

• •  the debt can be secured if the security is over the borrower’s own assets in Australia (whether land or not);

• • the debt can also be secured by a resident associate of the borrower, provided the security is only over land in Australia; but
  • a non-resident associate cannot give security even if it is only enforceable against the non-resident’s Australian land (and definitely not if it is enforceable against the non-resident’s foreign assets).

But even with these adjustments, the requirements may lead to odd outcomes. For example, the prohibitions on parental guarantees and credit support are doubtful. The Explanatory Memorandum says these requirements exist to –

… ensure that multinational enterprises do not have an unfettered ability to fund their Australian operations with third party debt. Given Australia’s relatively high corporate tax rate, multinational enterprises may seek to fund their Australian operations with high levels of debt relative to their operations in other jurisdictions.

Guarantees may indeed allow more debt to be borrowed, but they also mean any debt should be cheaper. Treasury no doubt believes that without this rule, the Australian operations will carry excessive debt; it may turn out that with this rule, the Australian operations will carry very expensive debt. One cannot predict ex ante which outcome will happen, or which will be better (or worse) for the Australian revenue.

Conduit financing structures and the Third Party Debt Test

The Exposure Draft contained a conduit financing regime to accommodate the common practice of using a “Fin Co” to raise external funds and on-lend to other members of the (non-consolidated) group. The rules allowed the on-lending of externally-raised debt to associates of the borrower by relaxing some of the conditions that would ordinarily prohibit this (the associate test and the recourse test). But even with these adjustments, the conditions which had to be met were very strict, in essence requiring a back-to-back loan arrangement of the borrowed funds (only) and on the same terms.

The Bill has relaxed some of the strictness of the former conditions relating to the “recourse” test and the “same terms” requirements, but a number of issues remain, including for stapled structures.

Associated entities

Multiple provisions (in the current law, the March Exposure Draft and in the Bill) turn on whether the parties involved in a structure or transaction are “associated entities.” For example,

•  the thin capitalisation provisions in Div 820 are only enlivened if an entity, all its associates, are claiming debt deductions greater than $2 m for the income year;
• the status of a financial entity or ADI attaches to every associate of the financial entity or ADI;
•  the debt creation rules (discussed below) are based on a test which uses the concept of an associate;
•  third party debt cannot be borrowed from, or held by, an associate;
•  the conduit financing regime requires that every party in the chain is an associate;

and so on.

In the Exposure Draft, the level of ownership which would make an entity an “associated entity” was to be reduced from the standard 50% to 10%. The Bill has relaxed this restriction for some rules to an interest of 20% or more. But the change to a 20% test is not universal – the definition of “associated entity” will need to be carefully monitored in each scenario to see whether the 10%, 20% or 50% threshold applies.

Debt creation regime

The biggest surprise in the Bill was the decision to revive the debt creation rules, a version of which existed as Div 16G ITAA 1936 and operated between 1988 and 2001. The Explanatory Memorandum makes it clear that the “targeted debt creation rules were progressed in … place [of the proposed repeal of s. 25-90, which was deferred.]” The Explanatory Memorandum also relies on the OECD’s Report on BEPS Action 4, “which recognises the need for supplementary rules to prevent debt deduction creation.” These measures were not included in the March Exposure Draft and so were not the subject of consultation.

The new provisions will disallow debt deductions to the extent that they are incurred in relation to “debt deduction creation.”  At its simplest, the Bill contemplates two transactions:

•  an entity acquires a CGT asset, or takes on a legal or equitable obligation from another entity which is an associate and the relevant entity incurs debt deductions in relation to the acquisition or holding of the CGT asset or obligation. The Explanatory Memorandum gives as examples,
• • issuing debt to acquire shares in a foreign subsidiary from a foreign associate or
  • issuing debt to acquire business assets from foreign and domestic associates in an internal reorganisation after a global merger;

• an entity borrows from an associate to fund a payment to that entity, or another associate. The Explanatory Memorandum gives the example of debt issued to allow an entity to make payments to a foreign associate as part of an entirely internal restructure.

The debt creation rules will affect financial entities and to ADIs, both of which were immunised from most of the other changes being made in the Bill.

The substantive rules are also buttressed by a dedicated anti-avoidance rule which allows the Commissioner to issue a determination negating a scheme “for more than one principal purpose that included the purpose of …” ensuring that the debt creation rules were not triggered.

The provisions will operate independently of the rest of the thin capitalisation provisions. Hence, an entity which may have only external third party debt may nevertheless fall foul of these rules. If both rules can apply, there will be an ordering issue, similar to the problem which currently exists between thin capitalisation and transfer pricing or between thin capitalisation and the debt-equity rules.

Because these rules exist inside Div 820, they will be subject to the same $2m de minimis threshold that applies to the rest of Div 820. But, unlike the rest of Div 820, and unlike the former Div 16G, there are no cross-border elements to these rules – once the relevant entity has the cross-border attributes which attract Div 820 (eg, it is owned by a non-resident), the rules can be triggered by entirely domestic transactions and reorganisations.

Finally, while these provisions were added as the price for deferring the repeal of s. 25-90, our crystal ball strongly suggests these provisions are now permanent features of the law and will not be reversed even if s. 25-90 is removed.

What hasn’t changed

The Bill has not addressed two matters in the Exposure Draft which drew detailed submissions:

• the transfer pricing rules will now require general class investors to demonstrate that the amount of debt they owe is not excessive (ie, even if the fixed ratio test is applied and debt deductions are less than 30% of tax EBITDA); and
• 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.