Background
The thin capitalisation rules aim to prevent multinational enterprises shifting profits out of Australia by funding their Australian operations with high levels of debt and relatively little equity in order to reduce their Australian taxable income. These rules were overhauled by Treasury Laws Amendment (Making Multinationals Pay Their Fair Share—Integrity and Transparency) Act 2024 (the Act) to largely follow the Organisation for Economic Cooperation and Development’s (OECD) recommendations, as well as bring Australia in line with major jurisdictions. This article discusses the major changes.
Overview of earnings-based tests in thin capitalisation provisions
The Act introduces earnings-based tests to the thin capitalisation provisions in Div 820 of the Income Tax Assessment Act 1997 for “general class investors”. A fixed ratio test replaces the safe harbour test, while a group ratio test replaces the worldwide gearing test. This approach follows the OECD’s earnings-based interest limitation rule in its 2016 Update to Action Plan 4 of Base Erosion and Profit Shifting (BEPS), bringing Australia in line with major jurisdictions including the United Kingdom and the United States. A third-party debt test is also introduced as an Australian specific rule to replace the arm’s length debt test for general class investors and financial entities that are not authorised deposit-taking institutions (ADIs). These changes apply retrospectively to income years commencing on or after 1 July 2023.
The new concept “general class investor” consolidates several general classes of entities, i.e. “outward investor (general)”, “inward investment vehicle (general)” and “inward investor (general)”. The broad definition effectively includes the following types of entities:
- An Australian entity that carries on a business in a foreign country at or through a permanent establishment or through an entity that it controls
- An Australian entity that is controlled by foreign residents, and
- A foreign entity having investments in Australia.
The definition specifically excludes financial entities and ADIs. Instead, financial entities and ADIs continue to be subject to the existing asset-based debt deduction safe harbour and worldwide gearing tests. According to the OECD, the new earnings-based test would unlikely be effective for these types of entities, partly as they are net lenders and are subject to regulatory capital rules.
For general class investors, the fixed ratio test applies by default to allow them to claim net debt deductions up to 30% of its “tax EBITDA”, i.e. taxable earnings before interest, tax, depreciation, and amortisation. A special deduction is allowed for debt deductions that were previously disallowed under the fixed ratio test if an entity’s net debt deductions are less than 30% of its tax EBITDA for an income year. Debt deductions disallowed over the previous 15 years can be claimed under this special deduction rule if relevant conditions are met.
As an alternative, an entity in a sufficiently highly leveraged group may choose to apply the group ratio test to deduct net debt deductions in excess of the amount permitted under the fixed ratio rule, based on a ratio that relies on the group’s financial statement. If this test applies, the amount of debt deductions for an income year disallowed is the amount by which the entity’s net debt deductions exceed the entity’s group ratio earnings limit for the income year.
In addition, a third-party debt test is an Australian-specific rule that replaces the arm’s length debt test for general class investors and financial entities that are not ADIs. The new test allows debt deductions to be made where those expenses are attributable to genuine third-party debt that is used to fund Australian business operations. Deductions for related party debt are entirely disallowed. General class investors are deemed to have chosen this test if certain conditions are satisfied, in order to prevent a group of related entities from choosing different tests to maximise their tax benefits. Broadly speaking, if the entity issuing a debt interest chooses to use the third-party debt test, then their associate entities in the “obligor group” in relation to the debt interest are all deemed to have chosen this test. Additionally, entities that have entered into a cross staple arrangement together are also deemed to have chosen the third-party debt test if one of those entities chooses this test.
New debt deduction creation rules to apply from 1 July 2024
New debt deduction creation rules disallow deductions to the extent that they are incurred in relation to debt creation schemes that lack genuine commercial justification. According to the explanatory memorandum to the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share—Integrity and Transparency) Bill 2023 (the originating Bill), the new Subdiv 820-EAA of the Income Tax Assessment Act 1997 is a “modernised version” of the debt creation rules in former Div 16G of the Income Tax Assessment Act 1936. The new rules are consistent with ch 9 of the OECD’s BEPS Action 4 report (paras 173–174), which recognises the need for supplementary rules to prevent debt deduction creation.
Subdivision 820-EAA only applies to entities that are subject to the thin capitalisation rules and are not exempt under s 820-35. Broadly speaking, it deals with 2 types of situations:
- An entity acquires a CGT asset, or a legal or equitable obligation, from its associate. The entity, or one of its associates, then incurs debt deductions relating to the acquisition. The debt deductions are disallowed to the extent that they are incurred in relation to the acquisition, or subsequent holding, of the asset.
- An entity enters into a financial arrangement with its associate to fund certain payments or distributions to that, or another, associate. The entity then incurs debt deductions relating to the financial arrangement. The debt deductions are disallowed to the extent that they are incurred in relation to the financial arrangement.
The parliament agreed to delay the start date of Subdiv 820-EAA to income years starting on or after 1 July 2024, instead of 1 July 2023. Notably, there are no grandfathering provisions so taxpayers must assess the application of these new rules to pre-existing transactions.
Parliament agreed to changes to the originating Bill
The parliament agreed to amendments to the originating Bill from the government (as amended by the Australian Greens), Pauline Hanson’s One Nation and Independent Senator David Pocock.
The government amendments relate to matters including:
- clarifying the ordering of choices under Subdiv 820-AA on thin capitalisation rules for general class investors
- clarifying the meaning of the new concept "obligor group"
- updating the meaning of "tax EBITDA" to allow, among other things, new deductions for (1) forestry establishment and preparation costs and (2) deductions for capital costs of acquiring trees. These changes incorporate an amendment from the Australian Greens to exclude from the calculation of tax EBITDA deductions for forestry establishment and preparation costs if they relate to the clearing of native forests.
- increasing the flexibility of the third-party debt test, and
- narrowing the range of arrangements that may fall within the debt deduction creation rules in Subdiv 820-EAA. In addition, the start date of Subdiv 820-EAA was deferred to income years commencing on or after 1 July 2024 instead of 1 July 2023.
Further, the parliament agreed to insert savings provisions from Pauline Hanson's One Nation to provide that the old law on thin capitalisation continues to apply to entities that are Australian plantation forestry entities for a period that is all or part of the income year, as if the amendments had not been made.
The amendments from Independent Senator David Pocock require the Minister to cause an independent review of the operation of the amendments to commence no later than 1 February 2026 and for the reviewer to report to parliament within 17 months of the commencement of the review.
Key considerations for retrospective changes
Practitioners and taxpayers should familiarise themselves with the amendments as a matter of priority. Most of the thin capitalisation amendments in the Act apply retrospectively to assessments for income years starting on or after 1 July 2023. The new debt deduction creation rules in Subdiv 820-EAA apply to assessments for income years starting on or after 1 July 2024. Pre-existing arrangements are not grandfathered. Meanwhile, the ATO noted in its National Tax Liaison Group meeting on 13 December 2023 that it will seek input on public advice and guidance with respect to the amendments.
How technology can help tax professionals manage thin capitalisation
Wolters Kluwer’s Thin Capitalisation Workpaper is available to customers as an “add-on” out of the box solution as part of the CCH Integrator corporate tax management product. The solution enables companies to automatically capture required data and calculate their thin capitalisation position.
The solution leverages Wolters Kluwer’s in-depth, in-house tax technical content and tax product expertise ensuring confidence in managing and monitoring thin capitalisation. These workpapers will always stay up to date with any legislative changes and integrated into your CCH Integrator Direct Tax module(s).
