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Treasury has released for public consultation proposed amendments to the Bill which is currently before the Senate and contains the Government’s reforms to Australia’s thin capitalisation rules. The amendments are largely welcome as they address many of the issues raised by stakeholders during the recent Senate Economics Legislation Committee inquiry into the Bill.

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18 October 2023

In Brief

Treasury has released for public consultation proposed amendments to Treasury Laws Amendment (Making Multinationals Pay Their Fair Share - Integrity and Transparency) Bill 2023 (the Bill), which is currently before the Senate and contains the Government’s reforms to Australia’s thin capitalisation rules.

The amendments are largely welcome as they address many of the issues raised by stakeholders during the recent Senate Economics Legislation Committee inquiry into the Bill. Of particular note is the ability for certain trusts to utilise excess downstream tax EBITDA in the calculation of their fixed ratio earnings limit, changes to the third party debt test (TPDT) to broaden the arrangements that are able to benefit from this test, and new exemptions and a transitional rule in relation to the debt deduction creation rules.

In Detail

The proposed amendments released on 18 October 2023 cover a wide range of issues that taxpayers have been grappling with since the Bill was introduced into Parliament - ranging from the calculation of tax EBITDA for different types of entities, the third party debt test conditions, and the broad nature of the debt deduction creation rules. Below, we highlight the key proposed changes in the draft amendments released by the Treasury.

The start date for these reforms is broadly unchanged, with the majority of the amendments to apply to income years commencing on or after 1 July 2023. The only exception to this date is a one year transitional rule in respect of the debt deduction creation rule for financial arrangements entered into before 22 June 2023 (see further below).

For further background on these rules, see our Tax Alert regarding the introduction of the Bill into Parliament.

Clarifications and new exemptions to the debt deduction creation rules

The debt deduction creation rules included in the Bill were a surprise when it was introduced into Parliament as they had not been part of previous consultation on this package of measures. The broad scope of these rules was a concern for many stakeholders, and as such it is pleasing to see a number of clarifications and exemptions now being proposed.

Under the proposed amendments, the following entities will be exempt from the debt creation rules:

Special purpose entities that are able to apply the existing thin capitalisation exemption for insolvency-remote vehicles in section 820-39 of the Income Tax Assessment Act 1997;
Authorised deposit taking institutions; and
Securitisation vehicles.

The debt deduction creation rule as originally proposed broadly captures two types of debt:

1) Debt that funds the acquisition of a CGT asset or a legal or equitable obligation from an associate.

and

2) Debt issued to an associate where the proceeds of issuing the debt are used to fund payments or distributions to an associate.

Under the proposed amendments, the tests for both types of debt potentially subject to the debt deduction creation rules will now include a “related party debt condition” that requires the debt deduction to be referable to an amount paid or payable to (in the first case) an associate of the acquirer or disposer, or (in the second case) an associate of the payer or the recipient. This is a significant change in respect of the first case as it effectively limits the rule to an acquisition from an associate that is funded by related party debt.

In respect to the first type of debt noted above, the proposed amendments to the Bill carve out acquisitions of the following CGT assets from the scope of this rule:

New membership interests in an Australian entity or foreign company. This means that the issue of new shares by a company will not trigger the debt deduction creation rule.
New tangible depreciating assets which the acquirer expects to use within Australia, within 12 months, for a taxable purpose, and has not previously been installed ready for use or used for a taxable purpose by the acquirer or its associates. This is intended to allow an entity to bulk-acquire tangible depreciating assets on behalf of its associate.
Debt interests issued by associates. This is intended to ensure that mere related party lending by an Australian taxpayer is not caught by the debt deduction creation rules.

With respect to the second type of debt, this test has been both broadened to apply to financial arrangements instead of debt interests (aligned with the proposed broader definition of debt deduction) and also narrowed by the introduction of two exceptions. These exceptions will cover payments or distributions that are referable to “mere on-lending” to an Australian associate, or that is referable to the repayment of principal under a debt interest where the recipient of the payment is an Australian entity.

Two other key changes to the proposed debt deduction creation rule include the introduction of a one-year transitional period for existing debt and clarification of the interaction of these rules with the general thin capitalisation provisions. Whilst the debt deduction creation rules will broadly apply to income years commencing on or after 1 July 2023, for debt deductions that relate to financial arrangements entered into before 22 June 2023 (when the Bill was introduced into Parliament), the debt deduction creation rules will apply to income years commencing on or after 1 July 2024, regardless of when the financial arrangements to which the debt deductions relate were entered into.

The amendments also clarify that the debt deduction creation rules apply before the other rules in Division 820. This means that debt deductions disallowed under the debt deduction creation rules are disregarded for the purposes of applying all other provisions in Division 820. The application of the remaining provisions in Division 820 (i.e. fixed ratio test, group ratio test, TPDT) can operate to further deny debt deductions.

Broadening of the third party debt test (TPDT)

The proposed amendments to the TPDT generally seek to expand the range of third party debt arrangements that will be able to benefit from the test.

The previous version of the TPDT required the borrowers (and where relevant, the conduit financer and members of the obligor group) to satisfy an ‘Australian resident’ requirement, which inadvertently excluded trusts and partnerships from benefiting from the test. The proposed amendments will replace the ‘Australian resident’ requirement with an ‘Australian entity’ requirement. ‘Australian entity’ (as defined in the Income Tax Assessment Act 1936 ) includes Australian trusts and Australian partnerships. Based on the existing definition, a trust is an ‘Australian trust’ if it has an Australian resident trustee, its central management and control is in Australia or it is a Division 6C public trading trust. However, for the purposes of the TPDT, an Australian partnership will only meet the ‘Australian entity’ requirement if at least 50% of its participation interests are directly held by Australian residents or Australian trusts.

Consistent with the previous version of the TPDT, the test is not available where the lender has recourse to non-Australian assets. This may be the case where the borrowing entity is an ‘Australian entity’ and the lenders have recourse over assets that are attributable to a foreign permanent establishment or foreign subsidiaries (e.g under a General Security Agreement commonly put in place with third party lenders which provides lenders with security over foreign subsidiaries held by the Australian group). Where Australian parented groups are not able to rely on the TPDT because of this recourse requirement, the Group Ratio test may become most relevant.
The TPDT places limits on the types of assets that the holder of a third party debt interest may have recourse to. The proposed amendments will broaden the kinds of assets that are permissible to include Australian assets that are membership interests in the borrower entity (or in an eligible conduit financing arrangement, Australian assets that are membership interests in the conduit financer and borrowers). This is a welcome change as it is common for a third party lender to require security not only over the borrowing entity’s assets but also the membership interests in the borrowing entity, which are assets held by the borrowing entity’s immediate parent.

However, membership interests in an entity will not be a permissible recourse asset if the entity has a legal or equitable interest, directly or indirectly, in an asset that is not an Australian asset.
The ‘greenfield exception’, which is present in the Bill, will be broadened. The exception in the Bill permitted the lender to have recourse over rights in the form of credit support where those rights relate wholly to the creation or development of a CGT asset relating to Australian ‘real property’ provided that the rights do not give recourse against a foreign associate. The proposed amendments will now extend this exception to ‘moveable property’ where that moveable property is incidental to and relevant to the ownership and use of the land and situated on the land for the majority of its useful life.
Amendments to provisions relating to the interest rate swap costs clarify that interest rate swap costs that relate to multiple debt interests or are incurred by a borrower in a conduit financer arrangement will be generally deductible under the TPDT “to the extent” that the costs are directly associated with hedging or managing the interest rate risk of the debt interest and not referable to an amount paid to an associate entity. The previous version provided for an “if” test rather than a “to the extent” test. Additionally, borrowers can recover these costs from other borrowers further down the ‘borrowing chain’.
The TPDT in the Bill appeared to inadvertently exclude all conduit financing arrangements from being eligible for this test on the basis that the proceeds of the ultimate debt interest would be used to fund the holding of associate entity debt (i.e. the on-lent debt interest between the conduit financer and the borrower(s)), and therefore would fail to satisfy the third party debt conditions. The proposed amendments will rectify this issue by excluding the on-lent debt from ‘associate entity debt’ for this purpose.
In addition, the definitions of ‘obligor group’ and ‘obligor entity’ will be refined. This is relevant for the application of the TPDT to conduit financing arrangements, and for certain entities within an obligor group that may be deemed to have made a choice to use the TPDT. Under the proposed amendments, where a creditor only has recourse to assets of an entity that are membership interests in the borrower, then that entity will not be an obligor entity. Further, the definition of obligor entity will be clarified so that the creditor does not need to have recourse to all of the assets of an entity for that entity (the lender only needs to have recourse to one or more assets of the entity).

Amendments for trusts

The application of the thin capitalisation reforms to trusts has been an area of significant concern for a number of stakeholders, particularly in the infrastructure and real estate industries. A number of amendments have now been made to address some of these concerns.

Changes will be made to the tax EBITDA calculation to allow eligible unit trusts to transfer their excess tax EBITDA amounts to other eligible unit trusts. Very broadly, the proposed amendments should only apply in relation to trusts that satisfy the following conditions:

The unit trust is a resident trust for CGT purposes or a managed investment trust.
The trust is a general class investor (for all or part of the income year) and is using the fixed ratio test for the income year.
The ‘transferee trust’ (i.e. the trust that receives excess tax EBITDA) has a direct control interest of 50% or more in the ‘transferor trust’ (i.e the trust that transfers its excess tax EBITDA) at any time in the income year.

An excess amount transferred to an eligible trust will be taken into account when considering whether that trust has an excess amount itself, which it can, in turn, transfer to another eligible trust. This amendment will ensure that existing structures with tiered trusts that meet the relevant conditions will not be significantly disadvantaged if the debt is held in a different entity to the operations generating taxable income.

Entities that hold less than 10% in a trust will generally be permitted to include trust distributions in tax EBITDA, and now entities that hold more than 50% will be able to benefit from this excess tax EBITDA amendment. However, entities that hold between 10% and 50% in a trust will not be able to benefit from either. This could have wide ranging implications for joint venture and consortium investments.

Other welcome amendments in relation to trusts include:

The proposed rules will be updated to ensure that the tax EBITDA calculation accommodates Attribution Managed Investment Trusts (AMITs). The amendments essentially mirror the current tax EBITDA adjustments for trusts and beneficiaries of trusts for AMITs.
For the purposes of the TPDT, the term ‘Australian resident’ will be replaced with ‘Australian entity’ to ensure that trusts and partnerships can access the test. Refer above for further detail on the TPDT.

Other proposed changes

The draft amendments also contain a wide range of additional amendments, including:

Changes to the calculation of tax EBITDA to include new “add-backs” for certain deductions relating to the forestry industry, limit the adjustments for dividends to circumstances where the entity receiving the dividend is an associate of the company paying the dividends (in line with the treatment of partnership and trust distributions), clarify the treatment of prior year tax losses for a corporate tax entity that has a choice whether to utilise its losses, and a new adjustment to subtract notional deductions of R&D entities from tax EBITDA.
Amendments to ensure that FRT disallowed amounts are appropriately dealt with under the allocable cost amount provisions for tax consolidated groups.
Minor clarifications and amendments in relation to choices to use the various new tests.

What’s next?

The draft amendments to the Bill have been released by Treasury for public consultation. The consultation period is relatively short, with submissions due by 30 October 2023. This is likely due to a desire to enact the changes as soon as possible to give taxpayers certainty in light of the 1 July 2023 start date for many taxpayers.

Following this consultation, the next step will be to introduce these amendments (including any changes arising from the current consultation process) into Parliament. Once the Bill has been passed by the Senate, it will need to return to the House of Representatives for the amendments to be considered.

Key takeaways

The implementation of the Government’s thin capitalisation reforms has been an 18-month journey. Although the new rules are not yet final, the proposed amendments released by Treasury provide taxpayers with further clarity on the likely application of the rules and should be considered carefully given that the proposed start date remains unchanged.

We are now at a critical point where the final version of these rules is taking shape, and all taxpayers should be aware of the implications for their business. The proposed amendments are a step in the right direction as they appear to address instances where the provisions of the Bill may have inadvertently resulted in a disallowance of deductions arising from commercial debt arrangements. Nonetheless, many taxpayers will find that further work is necessary to gather the internal data relevant for applying the new rules, conduct the statutory analysis to quantify their debt deduction thresholds, maintain records to demonstrate compliance and implement procedures to streamline their ongoing tax compliance processes.

Taxpayers that have already considered how they are impacted by the provisions of the Bill (including forecast tax modelling) should reassess their position having regard to these amendments. This will be particularly relevant for taxpayers that have determined their third party borrowings to be ineligible for TPDT or have estimated their tax EBITDA based on the provisions of the Bill. Many taxpayers may find that the amendments may permit them to support a higher amount of debt deductions. This should also be carefully considered in light of any anticipated refinancing or new debt arrangements being contemplated by taxpayers.

Further, given there have been no further amendments to the proposed expansion of Australia’s transfer pricing rules, taxpayers with cross-border borrowings will need to ensure that they are able to support the quantum of debt as an arm’s length debt quantum under the new rules, including where they expect to rely on the fixed ratio test (i.e. the fixed ratio test is not a safe harbour). This will involve additional arm’s length analysis not currently required to be undertaken by taxpayers that have relied on the existing thin capitalisation tests to support their debt quantum.

Contact us

If you would like to further discuss the proposed amendments, reach out to our team or your PwC adviser.

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Amendments proposed to thin capitalisation reforms