After an extensive consultation process, the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share - Integrity and Transparency) Bill 2023 (referred to as The Bill) was presented to Parliament on 22 June 2023. The Bill includes measures that are set to bring substantial changes to Australia's thin capitalisation rules, resulting in a reduction of the allowable scope for interest deductions for a broad spectrum of taxpayers.
Thin capitalisation refers to a financial strategy that involves a company financing its operations primarily through debt rather than equity. This approach allows the company to benefit from the tax advantages of interest deductions on the debt. However, tax authorities in many countries have implemented thin capitalisation rules to prevent multinational corporations from using excessive interest payments to reduce their tax liabilities artificially. These rules require comprehensive tax technical analysis and calculations to evaluate the thin cap position of a company, which ultimately determines the level of interest deductions a company can have based on its level of assets.
What has changed?
The Bill introduces earnings-based tests for a new group of taxpayers called general class investors. In particular, a fixed ratio test replaces the existing safe harbour test, while a group ratio test replaces the existing worldwide gearing test. This approach follows the OECD’s earnings-based interest limitation rule in its 2016 Update to Action of Base Erosion and Profit Shifting (BEPS) Action Plan, bringing Australia in line with major jurisdictions including the United Kingdom and the United States.
The fixed ratio test allows an entity to claim net debt deductions up to 30% of its “tax EBITDA”, that is, 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 the entity’s net debt deductions are less than 30% of its tax EBITDA for an income year. Debt deductions disallowed over the previous fifteen years could be claimed under this special deduction rule if relevant conditions are met.
As an alternative, the group ratio test allows an entity in a sufficiently highly leveraged group 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 that are disallowed is the amount by which the entity’s net debt deductions exceed the entity’s group ratio earnings limit for the income year.
The Bill introduces the concept general class investor to consolidate the existing general classes of entities, that is, “outward investor (general)”, “inward investment vehicle (general)” and “inward investor (general)”. It specifically excludes financial entities and authorised deposit-taking institutions (ADIs).
Meanwhile, financial entities and ADIs will continually be subject to the existing asset-based debt deduction safe harbour and worldwide gearing tests. According to the OECD, the earnings-based test would unlikely be effective for these types of entities, partly as they are net lenders and subject to regulatory capital rules.
Further, a third-party debt test is being introduced as an Australian-specific rule to replace the existing arm’s length debt test for general class investors and financial entities that are not ADIs. This 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 will be disallowed.
In addition, 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 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 proposed amendments are consistent with ch9 of the OECD’s BEPS Action 4 report (paras 173–174), which recognises the need for supplementary rules to prevent debt deduction creation.
Unless you are a financial entity, thin capitalisation rules may apply if you are Australian entity investing overseas, or an Australian entity that is foreign controlled with debt deductions. The rules take effect retrospectively from 1 July 2023. Practitioners and advisors should therefore familiarise themselves with these changes as a priority.
How technology can help tax professionals manage thin capitalisation
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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).
