New thin capitalisation rules finalised

Update: Amendments to thin capitalisation legislation now law

Both houses of Parliament have passed the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share— Integrity and Transparency) Act 2024 with the Act having received the Royal Assent on 8 April 2024

The legislation was passed with only minor additional amendments made by the Senate which broadly provide for the grandfathering of the old safe harbour balance sheet method for Australian plantation forestry entities. Additionally, the legislation requires an independent review of the new rules to be commenced no later than 1 February 2026 and completed within 17 months thereof.

For those not considered to be financial entities, the new regime is set to apply for income years commencing on or after 1 July 2023 and is based on earnings. It replaces the previous asset-based safe harbour which allowed for full deductibility of interest for gearing of up to 60%. A new integrity rule relating to debt deduction creation schemes, will have a deferred start date, applying to income years commencing on or after 1 July 2024. The new rules are likely to have a significant impact on taxpayers that are part of multinational groups and incur debt deductions in Australia. Given the retrospective start date of 1 July 2023, taxpayers subject to the thin capitalisation regime should consider how the rules affect their Australian financing arrangements.

What are the new rules about?

The new thin capitalisation rules apply to entities (referred to as “general class investors”) that are neither financial entities nor Authorised Deposit-taking Institutions (“ADIs”). The rules will operate to limit a general class investor’s debt deductions for an income year based on one of three tests:

• The fixed ratio test (“FRT”) (the default test);
• The group ratio test (“GRT”) (if the entity chooses to apply it for that year); and
• The third party debt test (“TPDT”) (if the entity chooses, or is deemed to have chosen, to apply it for that year).

Which entities are subject to the new rules?

The scope of the new rules has largely remained unchanged. An entity will be subject to the thin capitalisation rules if they are either:

• An inward investing entity (i.e. a foreign entity or a foreign controlled Australian entity);
• An outward investing entity (i.e. an Australian controller of an Australian controlled foreign entity or an Australian entity that carries on business through an overseas permanent establishment); or
• An Australian entity that is an associate entity of an outward investing entity.

Entities belonging to purely domestic groups should generally not be within the scope of the rules.

Further, no significant changes have been to the existing $2 million de minimis, the 90% Australian asset exemption for outward investing entities or the exemption for insolvency-remote special purpose entities. However, the 90% Australian asset exemption for outward investing entities does not apply to the new debt deduction creation rules (see further detail below), such that outbound groups with a small overseas presence may be affected by the new rules.

Fixed Ratio Test

Overview

This test (the default test) limits an entity’s net debt deductions to 30% of its tax EBITDA for the year. Tax EBITDA is calculated using an entity’s taxable income (or loss) for the year and making the following adjustments:

Adding net debt deductions;

Adding certain tax depreciation deductions¹ (excluding simplified depreciation for small business entities and deductions provided for entire capital expenditures);

Adding deductions relating to forestry establishment and preparation costs and deductions for capital costs of acquiring trees;

Excluding amounts to the extent they relate to assessable distributions from companies, trusts or partnerships² that are associate entities (on a 10%+ basis);

Excluding assessable amounts attributable to franking credits³ from any entity (whether related or not);

Subtracting an R&D entity’s notional deductions for R&D activities; and

Adding any excess tax EBITDA amount a 50%+ subsidiary entity attributes up to the taxpayer for the year (see further detail below).

If the amount is calculated as a negative amount, it is taken to be zero.

Debt deductions denied under the FRT can be carried forward for up to 15 years subject to satisfying the same tests that apply to utilisation of tax losses, depending on whether the entity is a company or trust. For partnerships, it appears that the partnership carries forward disallowed deductions, but no testing applies for their utilisation in a later year.

Carry forward amounts may be deducted in later years to the extent an entity has excess capacity (i.e. its FRT limit for the year exceeds its net debt deductions). However, an entity with carry forward FRT disallowed amounts that chooses to use either the GRT or TPDT in a later income year will permanently forfeit all their FRT disallowed amounts for use in later years.

Example 

Assume an entity is established and acquires an asset for $1 million funded by $600,000 of debt and $400,000 of equity and the asset generate $80,000 of gross rental income for the year. If the only deductions were interest and depreciation (including the building allowance), the entity’s tax EBITDA would be $80,000. On that basis, the entity would only be able to deduct $24,000 of net debt deductions. If the interest costs for the year $30,000, $6,000 would be denied under the FRT and carried forward for potential utilisation in a later year.

By way of comparison, the current asset-based safe habour would result in no deduction being denied given the entity’s debt does not exceed the 60
60% safe harbour amount.

In order for the full $30,000 of interest to be deductible under the FRT, the entity would need to have generated $100,000 of gross rental income for the year. Therefore, to maximise deductibility of interest expenses the entity may need to generate additional taxable income or reduce its gearing levels.

Net debt deductions

One major change under the new rules is that the FRT places a limit on an entity’s net debt deductions rather than gross debt deductions. Any amounts of interest income or amounts in the nature of interest are taken into account and netted off against an entity’s gross debt deductions to determine its net debt deductions for the year.

Taking the example above, if the entity instead generated $70,000 of rental income and $10,000 of interest income for the year then its net debt deductions would be $20,000 and its FRT limit for the year would become $21,000 (i.e. 30% of $70,000). This would result in its total interest expenses of $30,000 being deductible.

The adoption of a net debt deduction test means that entities which are net lenders (but which are not financial entities) are more easily be able to claim debt deductions in full where they make a profit and thus have no net debt deductions for the year, irrespective of how thinly capitalised they may be.

Excess tax EBITDA amount

While not contained in the March 2023 exposure draft or the June 2022 Bill, an overwhelming number of submissions appear to have convinced Treasury to include a transfer of excess capacity rule, similar in nature to the associate entity excess rule that applied under the former rules.

This complements the rule that excludes related party distributions from an entity’s tax EBITDA. Comparable outcomes may therefore arise between consolidated and non-consolidated groups by allowing a parent entity to claim debt deductions where it has borrowed to fund equity in a subsidiary entity (e.g. the subsidiary entity may have no debt deductions of its own and therefore has substantial excess capacity with the parent entity not having any tax EBITDA other than its share of the subsidiary’s excess amount).

The excess tax EBITDA rule allows Australian companies, partnerships, unit trusts and managed investment trusts (“controlling entities”) to pick up any excess interest capacity for the year from other Australian companies, partnerships, unit trusts and managed investment trusts (“controlled entities”) in which control interests of 50% or more are held. As they cannot be controlling entities, discretionary trusts and individuals cannot benefit from this rule. Both the controlling and controlled entities must be general class investors that apply the FRT for the year.

A controlled entity works out the excess of its net debt deductions for the year over its FRT limit (i.e. 30% of its current year tax EBITDA) less any amount of carry forward FRT disallowed amounts it has at the start of the year. This amount is grossed up by dividing it by 0.3 to work out the final excess tax EBITDA amount which is then transferred up based on the average controlling interest held throughout the year for each day the controlling entity held a 50% or greater interest. This amount forms part of the controlling entity’s tax EBITDA and may be transferred further up the chain to other entities that hold 50% or more in the controlling entity.

Example 

On 1 July 2024, Sub Co Pty Ltd is 100% owned by Holding Unit Trust which in turn 50% owned by each of Parent Unit Trust A and Parent Unit Trust B. Parent Unit Trust A acquires an additional 20% of the units in the Holding Unit Trust half-way through the 2025 income year. Assume all entities are Australian entities and general class investors using the FRT for 2025 income year.

In the 2025 income year. Sub Co Pty Ltd derives $10 million of sales income and incurs $1 million of interest deductions. In the 2024 year it was denied $500,000 of debt deductions under the FRT method. Holding Unit Trust derived $2 million rental income and incurred $1.8 million of debt deductions.

Sub Co Pty Ltd will have an excess Tax EBITDA amount of $1.5 million/0.3 or $5 million for the year. This worked out by taking the excess of its FRT limit year ($10 million x 30%) less its net debt deductions ($1 million) less its prior year disallowed amount deducted the year ($500,000). This $1.5 million excess is grossed up to $5 million by diving the excess by 0.3. As Sub Co Pty Ltd. has a single shareholder for entire year, 100% of the excess tax EBITDA amount is transferred to Holding Unit Trust.

Holding Unit Trust’s tax EBDITA for the year therefore becomes $7 million (i.e. $2 million of rental income plus 5 million by diving the excess by 0.3. As Sub Co Pty Ltd). Its FRT limit for the year will therefore be $2.1 million (i.e. 30% of its tax EBITDA) with all its debt deductions allowable in full. Holding Unit Trust’s $300,000 excess of its FRT limit over its net debt deductions is grossed up to $1 million and may be allocated to its unitholders.

Parent Unit Trust A’s share of the $1 million excess tax EBITDA will 60%. This is based on holding 50% of the units in Holding Unit Trust for half of the income year and 70% for the other half of the year. Parent Unit Trust A will therefore include and additional $600,000 in its own tax EBIDTA for the 2025 income year.

Parent Unit Trust B’s share of the $1 million excess tax EBIDTA will be 25%. This is based on holding 50% of the units in Holding Unit Trust for half of the income ear. The part of the year for which it holds less than 50% does not count towards its share and therefore does not get any extra share from holding 30% of the units for half the year. Parent Unit Trust B will therefore include an additional $250,000 in its won tax EBIDTA for the 2025 income year.

$150,000 of Holding Unit Trust’s $1 million excess tax EBIDTA for the year is not allocated to any other entity and is essentially wasted capacity.

By contrast to the rule allowing for the carry forward of denied debt deductions for up to 15 years, there is no rule that provides for a carry forward of excess capacity. Where excess capacity for the current year is not transferred up to certain 50%+ parent entities, it is lost permanently.

The design of the rule does not assist an entity that holds 10% or more, but less than 50%, in a subsidiary. Distributions from the subsidiary are not included in the entity’s tax EBITDA and excess amounts from those <50% subsidiaries cannot be transferred to the entity.

As the excess tax EBITDA rule does not apply to parent entities that are discretionary trusts, many middle market taxpayers may have adopted structures that are no longer efficient under the new thin capitalisation rules. By way of contrast, the previous associate entity excess rule allowed for excess safe harbour amounts to be transferred to discretionary trusts.

Group ratio test

The GRT allows an entity to use its worldwide group’s net third party interest expense-to-EBITDA ratio (“group ratio”) which may assist taxpayers by providing for a better outcome than the FRT. This test essentially replaces the existing worldwide gearing test for non-financial entities. A choice to use the GRT for an income year can only be revoked if the Commissioner allows.

The group ratio must be calculated from information in the audited consolidated financial statements of the group to which the entity belongs. Various adjustments are required to be made to determine the group’s net interest expenses, including adjustments to interest income and expenses and the disregarding of dealings between group members and their related (on a 20%+ basis) non-group entities. Adjustments are also made to disregard group members who have a negative EBITDA.

As many private groups using trusts may not be structured in a way that lends itself to consolidation for accounting purposes, the GRT may not be practically available for many middle market taxpayers.

Deductions disallowed under the GRT are denied permanently and cannot be carried forward. An entity with carry forward FRT disallowed amounts that chooses to use the GRT in a later income year will permanently forfeit all FRT disallowed amounts for use in later years.

Third Party Debt Test 

Overview

The TPDT sets a limit on the entity’s gross debt deductions for the year equal to the amount of debt deductions attributable to debt interests issued to unrelated parties (on a <20% basis) that satisfy the “third party debt conditions”. Where a taxpayer elects to use the TPDT, all other debt deductions are denied in full and cannot be carried forward to later years. The choice can only be revoked for an income year if the Commissioner allows.

The TPDT replaces the arm’s length debt test for both general class investors as well as financial entities (other than ADIs), who may also elect to use the test for a given year. One particular benefit of the TPDT is that entities subject to it are broadly exempt from the debt deduction creation rules.

To satisfy the “third party debt conditions”, the borrower needs to be an Australian entity and substantially all the amounts borrowed from the unrelated party must be used to fund commercial activities in connection with Australia. Additionally, and most critically, the lender must only have recourse to the following Australian assets (with minor or insignificant assets disregarded):

• Assets held by the borrowing entity;
• Membership interests in the borrowing entity (unless the borrower has direct or indirect interests in foreign assets);
• Assets held by Australian members of an obligor group (broadly, any entities whose assets secure the repayment of the debt).

A lender cannot have recourse to assets (of either the borrower or an obligor) that consist of rights in relation to a guarantee security or other form of credit support. This is subject to an exception for where the rights relate to the creation or development (but not holding) of Australian real property⁴ or related moveable property and would not allow for recourse to the assets of foreign associate entities (on a 50%+ basis) if the rights were exercised.

Essentially, an entity whose Australian operations are wholly financed by external third parties (which meet the recourse test) should be able to deduct their interest expense in full under this test. If an entity is financed by a mix of both external and related-party debt, choosing to use this test should result in all debt deductions paid to related parties being denied (with such income still potentially being assessable to the lender).

While this new test may be somewhat simpler to apply than the arm’s length debt test, the limited recourse requirements are restrictive and may not accommodate many commercial lending arrangements in the middle market.

Obligor group and deemed TPDT choices

The significance of the obligor group concept is that certain members of the obligor group in relation to a particular debt, being associate entities of the borrower (on a 20%+ basis) that are required to lodge tax returns, are deemed to have chosen to use the TPDT if the borrower elects to do so.

This may therefore result in that obligor being denied debt deductions in full in respect of their own borrowings that do not meet the third party debt conditions. It may also result in more entities being deemed to apply the TPDT if they are associate entities and secure the borrowings of the first obligor that was deemed to have made a TPDT choice.

This deemed choice concept prevents related entities from utilising assets held throughout the group to maximise their borrowing capacity but with different tests applied by those entities in order to optimise the outcome under the new thin capitalisation rules. While complex, this is a more workable rule than the original “mutual choice requirement” proposed in the March exposure draft which required all associate entities of an entity seeking to make a TPDT election to also make the choice.

The deemed choice rule also extends beyond members of an obligor group for a particular debt and covers entities who have entered into a cross staple arrangement with an entity that has chosen to use the TPDT, even if those entities have not provided any security for the borrowings of the entity that chose to use the TPDT.

Conduit financer rule

The TPDT includes a conduit financer rule that allows loans between related parties to meet the third-party debt conditions where a central finance entity obtains third party debt and on-lends the amounts to Australian related-party borrowers on the same terms (to the extent those terms relate to costs).

Neither the conduit financer nor the ultimate borrower can use the FRT or GRT that year for the conduit financing rule to operate effectively. However, the conduit financer may be a financial entity that uses the balance sheet safe harbour method.

The conduit financing rule is applied on a debt-by-debt basis. While it allows for borrowings from a third party to be on-lent to multiple associate entities (e.g. $100 million bank loan which is used to make two $50 million loans to two related entities on the same terms), it does not allow for multiple sources of finance to be pooled or blended to make one loan to a related entity (e.g. it does not allow two $50 million bank loans to be used to make a single $100 million loan to a related entity).

To the extent that a particular loan made by a conduit financer to an associate fails to satisfy the requirements, that borrower may be denied debt deductions under the TPDT, but other loans made by the conduit financer will not be affected. Further, the conduit financer may still claim debt deductions in respect of external borrowings used to make loans to a related entity that fails to meet the “same terms” requirements.

The conduit financing rule also contains provisions to permit costs to hedge interest rate risk (e.g. under swaps) to be passed on to other borrowers and still be deductible under the TPDT.

Debt deduction creation rules

After withdrawing the proposed repeal of section 25-90 (originally included in the March 2023 Exposure Draft), the new rules have included an anti-avoidance rule intended to target related party transactions that result in the creation of debt deductions. While these are said to target schemes that seek to shift profits away from Australia, the wording of the rules is extremely broad and apply to permanently deny deductions of entities within the thin capitalisation regime. Importantly, the rules do not contain a tax purpose test and can apply to wholly domestic and arm’s length arrangements.

Outbound group that are generally exempt from thin capitalisation due to satisfying the 90% Australian assets test will not be exempt from these new rules. However, taxpayers that satisfy the $2 million de minimis and certain securitisation vehicles and insolvency remote entities are not subject to the debt deduction creation rules. Additionally, the rules do not apply to ADIs.

The debt deduction creation rules consist of two main rules:

• Asset acquisition rule – Where an entity borrows amounts from an associate to fund (directly or indirectly) the acquisition of an asset (or obligation) from an associate, debt deductions in relation to the borrowing may be permanently denied. Some specific exceptions are included, such as acquisitions of new membership interests in Australian entities or foreign companies, new debt interests in another entity and certain new depreciating assets that are to be used in Australia.
• Payments or distributions rule – Where an entity borrows amounts from an associate to fund certain payments or distributions to an associate, debt deductions in relation to the borrowing may be permanently denied. The kinds of payments or distributions within scope include dividends, distributions from trusts or partnerships, returns of capital, royalties and similar payments for the use of an asset and certain loan principal repayments to refinance debt that would have previously been within scope.

As the rules are intended to apply to related-party borrowings, taxpayers who have elected to use the TPDT are generally excluded from its scope.

While these rules have a 12-month deferred start date (i.e. application is to income years commencing on or after 1 July 2024) there are no grandfathering rules. When the rules commence, future debt deductions that arise under old debt instruments may be denied (e.g. loans used to fund acquisitions from associates before 1 July 2024). This lack of grandfathering may impose significant compliance costs for taxpayers in determining whether the purchase of any of their existing assets are funded by related-party debt.

Other changes

The legislation also includes other items that are likely to impact many taxpayers.

• Expanding the scope of “debt deductions” – In a change that will affect all taxpayers subject to the thin capitalisation rules, the meaning of debt deductions will not be limited to certain costs that are incurred in relation to debt interests but will instead cover all interest costs and economically equivalent amounts even if they are not incurred in relation to a financing arrangement that is considered a debt interest. The “economically equivalent to interest” test is not used in existing tax legislation. This change may give rise to uncertainty and may bring additional costs within the scope of the rules. Costs associated with hedging (e.g. interest rate swaps) are expressly brought within scope and will now be considered debt deductions.
• Limiting the scope of “financial entities” – Citing integrity concerns, the Government proposes to remove from the definition of financial entities certain registered corporations under the Financial Sector (Collection of Data) Act 2001 (unless they are entities whose business predominantly consists of providing finance to unrelated parties). Such entities may therefore become subject to the new rules and not be able to continue to use the balance sheet test applicable to financial entities. However, such entities may obtain favourable outcomes under where their interest income exceeds their interest expenses as net debt deductions may be nil.
• Tax consolidation interaction – Deductions disallowed under the FRT can be transferred to a tax consolidated group (but seemingly, not a MEC group) when an entity with carry forward amounts joins the group. The ability to transfer these amounts to a tax consolidated group (or instead, cancel them) is tested using the same rules that apply to transferring tax losses with the same kind of impact on the entity’s allocable cost amount for tax cost setting purposes. However, no available fraction rules in respect of such transfers.
• Transfer pricing interaction – The transfer pricing provisions will no longer allow a taxpayer’s capital structure to be disregarded when determining whether a transfer pricing benefit arises. Previously, taxpayers were permitted to only consider the price of debt issues without considering the quantum of debt. From 1 July 2023, general class investors will be required to consider both the price and the quantum of debt in any transfer pricing analysis in respect of related-party cross-border debt.
• Complying superannuation fund exemption – Amendments are made to ensure that entities in which complying superannuation funds (other than self-managed super funds) invest are not to be considered associate entities of the fund. This may assist large super funds in their ability to borrow as they may no longer be considered subject to the thin capitalisation rules simply because they have investments in entities that are outward investors.

When do the changes apply from?

The new rules, other than the debt deduction creation rules, will apply for income years commencing on or after 1 July 2023 with no grandfathering or transitional provisions.

The debt deduction creation rules which apply to income years commencing on or after 1 July 2024. However, it appears that once the debt deduction creation rules commence, they may apply to arrangements entered into at any time so long as they continue to give rise to debt deductions after the commencement date (e.g. they may apply to deny debt deductions that related to a transfer of assets between related parties 20 years ago where the debt continues to be held).

What are the next steps?

It is critical that affected taxpayers consider their positions and how the new rules will apply going forward as these may result in materially different outcomes as compared to the former rules. This may involve undertaking forecasts to understand the impact of the rules on taxpayers’ after-tax cost of financing. As the rules are already in operation, taxpayers should undertake this analysis sooner rather than later or review calculations performed pursuant to earlier drafts of the rules as previous calculations may no longer be accurate (e.g. due to the changes to the way tax EBITDA is calculated).

Taxpayers should also consider whether one of the two elective methods may be suitable for their arrangements if the FRT is likely to result in a denial of deductions, as well as considering whether any changes need to be made to their financing arrangements. Any restructuring undertaken to maximise an entity’s debt deductions in line with the new rules should be carefully considered in light of the application of the general anti-avoidance rule in Part IVA and the new debt deduction creation rules, with ATO guidance on their potential application to such restructures being critical.

Taxpayers should contact their Pitcher Partners representative to review their existing arrangements and determine what action is required in light of these changes.

¹ Tax depreciation deductions including those in respect of depreciating assets (Division 40) as well as capital works (Division 43). This includes deductions for balancing adjustments arising from the disposal of depreciating assets. However, assessable amounts arising from a balancing adjustment do not appear to require a subtraction to tax EBITDA.

² In the case of a taxpayer that is a partner of a partnership, excluding the distribution would have the effect of adding to tax EBITDA the taxpayer’s deduction attributable to its share of a partnership loss for tax purposes.

³ This covers the franking credit gross-up under the general rule for direct dividends as well as those assessable as a result of franked distributions flowing indirectly though trusts or partnerships.

⁴ As well as certain offshore renewable energy infrastructure and offshore electricity transmission infrastructure.