Australia’s New Thin Capitalisation regime: Debt deductions

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Major reforms to Australia’s thin capitalisation regime are now law. In addition to introducing new earnings-based tests for most taxpayers, the new law also broadens the definition of ‘debt deduction’ (meaning more costs are potentially in scope of the new rules) and introduces a new concept of ‘net debt deduction’ which is central to the new fixed ratio and group ratio tests. In this Tax Alert, we examine the meaning of ‘debt deduction’ and ‘net debt deduction’ for the purposes of the new provisions.

2 July 2024

In Brief

Major reforms to Australia’s thin capitalisation regime – which mostly take effect for income years commencing on or after 1 July 2023 – are now law following the enactment of Treasury Laws Amendment (Making Multinationals Pay Their Fair Share - Integrity and Transparency) Act 2024 on 8 April 2024.

In addition to introducing new earnings-based tests for most taxpayers, the new law also broadens the definition of ‘debt deduction’ (meaning more costs are potentially in scope of the new rules) and introduces a new concept of ‘net debt deduction’ which is central to the new fixed ratio and group ratio tests. In this Tax Alert, we examine the meaning of ‘debt deduction’ and ‘net debt deduction’ for the purposes of the new provisions.

For an overview of the new thin capitalisation regime, refer to our earlier Tax Alert.

In Detail

Under Australia’s new thin capitalisation regime “general class investors” are subject to one of three new tests - fixed ratio test, group ratio test or third party debt test. The terms ‘debt deduction’ and ‘net debt deduction’ are relevant for the new tests as follows:

Under this test…	The amount of debt deduction disallowed is…
Fixed ratio test	The amount by which an entity’s *net debt deductions* exceed 30% of its “tax EBITDA” for the income year
Group ratio test	The amount by which an entity’s *net debt deductions* exceed its “group ratio” multiplied by its tax EBITDA for the income year
Third party debt test	The amount by which an entity’s *debt deductions* exceed debt deductions attributable to debt interest that satisfy the third party debt conditions for the income year

A general class investor with nil or negative net debt deductions will have no deductions denied under the fixed ratio test or group ratio test. However, in those circumstances, it would be important to be alert to scenarios in which the entity may be deemed to have made a choice to use the third party debt test.

The amended definition of ‘debt deduction’ is also relevant for financial entities and authorised deposit-taking institutions, notwithstanding these entities remain subject to the former tests (except for the arm’s length debt test which has been replaced with the third party debt test for all entities).

Definition of ‘debt deduction’ – what has changed?

Costs incurred by an entity that are economically equivalent to interest

The definition of ‘debt deduction’ has been expanded so that it includes an otherwise deductible cost incurred by an entity that is interest, an amount in the nature of interest, or any other amount that is economically equivalent to interest (previously, this covered “any other amount that is calculated by reference to the time value of money”). In addition, it is no longer necessary for these amounts to be incurred in relation to a debt interest issued by the entity for that cost to be a ‘debt deduction’.

According to the Explanatory Memorandum (EM) to the amending Bill, these amendments are intended to align Australia’s thin capitalisation provisions with Organisation for Economic Cooperation and Development (OECD) best practice guidance for addressing issues in relation to base erosion and profit shifting (BEPS) using interest. The OECD recommended that these rules should capture interest on all forms of debt as well as all financial payments that are economically equivalent to interest.

The OECD’s BEPS Action 4 Report provides the following examples of amounts that are interest or economically equivalent to interest:

payments under profit participating loans
imputed interest on instruments such as convertible bonds and zero coupon bonds
amounts under alternative financing arrangements, such as Islamic finance
capitalised interest included in the balance sheet value of a related asset, or the amortisation of capitalised interest, and
amounts measured by reference to a funding return under transfer pricing rules, where applicable.

Removal of hedging exclusion

Prior to the enactment of the new regime, losses and outgoings directly associated with hedging or managing the financial risks in respect of a debt interest were excluded from the definition of ‘debt deduction’. However, this exclusion has been removed with effect for income years commencing on or after 1 July 2023.

The removal of the hedging exclusion, combined with the other changes to the definition of debt deduction, effectively means that interest related costs under swaps – such as interest rate swaps – are now included in the broadened definition of debt deduction. This is in line with the OECD best practice approach.

‘Debt deduction’ – what has not changed?

The following payments and amounts continue to fall within the definition of ‘debt deduction’:

The difference between the financial benefits received (or to be received) by the entity under a scheme giving rise to a debt interest and the financial benefits provided (or to be provided) under that scheme.	Any amount directly incurred in obtaining or maintaining the financial benefits received, or to be received, by the entity under a scheme giving rise to a debt interest.
An amount in substitution for interest	A discount in respect of a security
A fee or charge in respect of a debt, including application fees, line fees, service fees, brokerage and stamp duty in respect of document registration or security for the debt interest	An amount taken under an income tax law to be an amount of interest in respect of a lease, a hire purchase arrangement or any other arrangement specified in that law
Any loss in respect of: a reciprocal purchase agreement (i.e. a repurchase agreement); a sell-buyback arrangement; a securities loan arrangement	Any amount covered by the definition of ‘debt deduction’ that has been assigned or is dealt with in any way on behalf of the party who would otherwise be entitled to that amount

In addition, while the hedging exclusion has been removed, the following exclusions from the definition of ‘debt deduction’ remain in place:

foreign exchange losses on borrowings and instruments connected with the raising of finance
rental expenses for a lease if the lease is not a debt interest
salary or wages, and
an expense specified in the regulations (to date, no regulations have been made for this purpose).

What are ‘net debt deductions’?

An entity’s ‘net debt deductions’ are worked out as follows:

Method statement
Step 1	Work out the sum of the entity’s debt deductions for the income year (disregarding the thin capitalisation rules, but applying the new debt deduction creation rules).
Step 2	Work out the sum of each amount included in the entity’s assessable income for the year that is: interest, an amount in the nature of interest, or any other amount economically equivalent to interest; or any amount directly incurred by another entity in obtaining or maintaining financial benefits received, or to be received, by the other entity under a scheme giving rise to a debt interest; or any other expense incurred by another entity that is specified in the regulations (none have been issued to date).
Step 3	Subtract the amount in Step 2 from Step 1. The result is the entity’s net debt deductions for the income year.

Consistent with the OECD’s best practice guidance, Step 2 requires identification of amounts included the entity’s assessable income that are “economically equivalent to interest”. This step does not, however, mirror the specific exclusions that are incorporated into the definition of ‘debt deduction’ referred to earlier.

De minimis exemption

The amendments to the thin capitalisation regime have preserved the de minimis exemption under which the rules do not apply if the total debt deductions of the entity and all its associate entities for an income year are $2 million or less. Significantly, this exemption is only available if the total debt deductions – not net debt deductions – fall below the $2 million threshold.

The Takeaway

When reviewing the application of the new thin capitalisation rules for income years commencing on or after 1 July 2023, it will be necessary to review an entity’s financing arrangements to identify payments and amounts that should be included as a ‘debt deduction’ and ‘net debt deduction’.

The expanded scope of the definition of ‘debt deduction’ may mean a broader range of an entity’s costs fall within the scope of the new thin capitalisation regime than would have been the case under the predecessor rules.
In considering whether a payment or receipt may be economically equivalent to interest, it will be necessary to examine the substance of the arrangement giving rise to the payment or amount.
If relying on accounting figures to identify amounts that may constitute a ‘debt deduction’ it will be important to watch out for instances where a debt deduction is not reflected as an expense in the accounts. This can occur for various reasons such as where interest is capitalised to the cost of an asset.
Hedging arrangements will likely need additional scrutiny going forward. Challenges may arise where only some part of a payment under a hedging arrangement is economically equivalent to interest (e.g. under a cross-currency swap, the interest component).
If an amount is economically equivalent to interest, consider whether it is excluded from the definition of ‘debt deduction’, noting that the term ‘net debt deduction’ does not currently have any corresponding exclusions.
When working through the conduit financing rules under the third-party debt test, considering outgoings under back-to-back hedging arrangements constitute debt deductions.
Be mindful that the de minimis exemption only applies if the entity’s ‘debt deductions’ (and those of its associate entities) falls under the $2 million threshold (as opposed to its ‘net debt deductions’).

Contact us

If you would like to further discuss this alert, reach out to our team or your PwC adviser.

James Nickless

Partner, Tax, Sydney, PwC Australia

+61 411 135 363

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Patricia Muscat

Director, Tax, Sydney, PwC Australia

+61 282 667 119

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Michelle Parsons

Director, Tax, Perth, PwC Australia

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Australia’s new thin capitalisation regime: Debt deductions – what is in and what is out?

Definition of ‘debt deduction’ – what has changed?

‘Debt deduction’ – what has not changed?

What are ‘net debt deductions’?

De minimis exemption

Contact us

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