Major changes to interest limitation rules in the Private Equity Sector

17 March 2023 

In brief

On 16 March 2023, the Australian Treasury released for comment draft legislation to introduce the previously announced changes to Australia’s interest limitation rules i.e. the thin capitalisation rules. 

These changes are intended to bring Australia’s thin capitalisation rules closer towards the Organisation for Economic Cooperation and Development (OECD) best practice guidance by introducing a default earnings-based ‘fixed ratio’ test (FRT) to replace the existing asset-based ‘safe harbour’ test, and an alternative ‘group ratio’ test (GRT) to replace the ‘worldwide gearing ratio’ test.

Further, Australia’s ‘arm’s length debt test’ (ALDT) will be replaced by a new ‘external third party debt test’ (ETPDT) that is much more limited in scope. Broadly, if applicable, this test will limit debt deductions to amounts borrowed directly from unrelated third party lenders (or via a related party conduit, but only if the loan is on exactly the same terms as the external debt).

This could have significant implications for the private equity industry, in particular funds which currently finance their Australian investments using related party debt. Net debt deductions disallowed under the FRT are also likely to be more volatile than under the current test, given the FRT’s reliance on earnings. This is likely to be an issue for industries with long-lead times for earnings (for example, the resources, infrastructure, property and start-up sectors), and especially having regard to the uncertain economic climate. This could impact deal models for both existing and proposed investments. 

These changes are intended to apply for income years commencing on or after 1 July 2023 and the draft legislation does not contain any transitional rules. Accordingly there is not much time for affected taxpayers to review their financing structures and to assess the impact of the new rules.

In detail

Under the proposed new interest limitation rules, an entity’s net debt-related deductions will be limited to 30% of tax EBITDA (earnings before interest, taxes, depreciation and amortisation). This will replace the existing safe harbour test (asset to debt ratio test). This is in line with the Organisation for Economic Cooperation and Development (OECD)’s recommended approach under Action 4 of the Base Erosion and Profit Shifting (BEPS) Action Plan. In most cases, financial entities will continue to be subject to the existing thin capitalisation rules. A high level summary is outlined below:

For a detailed breakdown of the Exposure Draft, please refer to our analysis here.

Practical Implications to the Private Equity Sector

Earnings will be key

The new FRT is the default test under the proposed thin capitalisation rules. Recognising that an earnings-based measure is likely to be more volatile than the current asset-based safe harbour test, the rules allow any debt deductions disallowed under the FRT to be carried forward over 15 years. 

However, the carry forward mechanism is subject to an important limitation. In order to access carry forward ‘FRT disallowed amounts’ (i.e. debt deductions denied in previous years), companies must pass a modified version of the continuity of ownership test (COT). This test broadly mirrors the COT for carrying forward company tax losses. As such, a company must broadly maintain the same majority owners in order for an FRT disallowed amount to be applied in future years. 

This could be problematic for industries with long-lead times for earnings (for example, the resources, infrastructure, property and start-up sectors) and in the context of private equity where majority shareholders may not remain constant for extended periods of time. Therefore, a FRT carried forward amount may not be regarded as a valuable tax attribute to a purchaser in a transaction. 

Alternatively, taxpayers could consider applying the group ratio test (GRT) where they are a member of a ‘GR group’. However our initial observation is that the GRT may have limited utility given it is also subject to earnings volatility, and appears to only benefit entities with EBITDA ratios that are below the average for the group. 

Further, relevantly, an entity will only be a member of a GR group if it is consolidated on a ‘line-by-line’ basis with the group for accounting purposes. Private equity funds which apply the ‘investment entity’ exception in IFRS 10 may therefore not be grouped with their ultimate parent entity for this purpose. However, funds which do consolidate their investments on a line-by-line basis should give consideration to whether the GRT could give rise to a different outcome.

External third party debt test - a limited ALDT 

Under the existing thin capitalisation rules, many taxpayers rely on the ALDT where they have gearing levels which do not fit within the more common 1.5:1 debt/equity safe harbour ratio. In the Consultation Paper for the thin capitalisation changes, the Government expressed concerns that ALDT was being used to support excessive deductions for related party debt.

Consequently, the new ETPDT is much more limited in scope than the ALDT. In summary, the ETPDT disallows an entity’s debt deductions to the extent that they exceed the entity’s debt deductions attributable to external third party debt. That is, if an entity makes the choice to use the ETPDT, any debt deductions on related party debt will be denied (unless it is a conduit financier arrangement - discussed further below).

In order to qualify for the ETPDT, the third party debt must satisfy certain conditions as set out in further detail in our Tax Alert here. This includes ensuring that the debt is not issued by an associate entity of the borrower, the holder of the debt interest has recourse for payment of the debt only to the assets of the borrower, and the borrower uses the proceeds of the debt to wholly fund its Australian operations. This will therefore require a careful assessment of the terms of the external debt and the use of the funds to ensure compliance, particularly for groups which have overseas operations which are within the security net of the group.

Certain conduit financier arrangements will also qualify for the ETPDT but only if the conduit financier borrows from a third party, then on-lends the proceeds of that debt interest to one or more associate entities on the same terms as the debt interest issued by the ultimate lender (other than as to the amount of debt). This may be difficult to satisfy in practice as the terms of internal debt may not be exactly aligned with external debt. 

Further an entity choosing to access the ETPDT can only do so if the entity, along with its associate entities, each make a choice to apply this test. The associate entity definition for this purpose is a 10% or more thin capitalisation control interest test (rather than 50%). In the context of private equity, this could become problematic if for example one portfolio company proposes to use the ETPDT, however another ‘associate entity’ portfolio company wishes to rely on the FRT. Alignment in these circumstances will therefore be critical.

The Takeaway

With only a little over three months before the earliest start date (1 July 2023), there is not much time for taxpayers to assess the impact that the new measures will have on their capital structure. 

A key focus for taxpayers who currently rely on the ALDT will be assessing whether they will be eligible to apply the ETPDT, particularly if they finance their investments using related party debt. If taxpayers do choose to restructure their debt, they will need to be mindful of other tax issues for example, transfer pricing and withholding tax considerations.

For taxpayers who currently rely on the SHDT, applying the new rules is likely to change the timing of debt deduction disallowances, impacting deal models for both existing and proposed investments.

Furthermore, private equity owners will need to be aware of any positions taken under these measures by their portfolio companies as this could have the potential to impact on the thin capitalisation positions of other portfolio companies which meet the definition of ‘associate entity’ for these provisions. 

There are also a number of other surprises contained in the draft legislation that were not previously announced, including an expansion of the types of debt deductions that can be denied by the thin capitalisation rules, as well as interest deductions no longer being allowed on amounts used to fund investments in non-portfolio foreign companies which derive non-assessable non-exempt (NANE) dividend income. Taxpayers should therefore review the proposed new law closely to confirm its impact on their tax profile.