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Australia’s New Thin Capitalisation regime: Have you got your debt quantum right?
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  • 5 minute read
  • August 19, 2024

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Recent amendments to the tax law removed a key provision that prevented the transfer pricing rules from applying to limit the amount of related party debt to an arm’s length amount where the thin capitalisation rules applied. For income years commencing on or after 1 July 2023, general class investors will need to ensure that the quantum of cross-border related party borrowings is consistent with arm’s length conditions under the transfer pricing rules.

19 August 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 amendments removed a key provision of the tax law that prevented the transfer pricing rules from applying to limit the amount of related party debt to an arm’s length amount where the thin capitalisation rules applied. For income years commencing on or after 1 July 2023, general class investors will need to ensure that the quantum of cross-border related party borrowings is consistent with arm’s length conditions under the transfer pricing rules. This will be particularly important for taxpayers who are relying on the fixed ratio or group ratio tests for the current income year and going forward as it could operate to permanently deny debt deductions.

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

In detail

Prior to the amendments made by Treasury Laws Amendment (Making Multinationals Pay Their Fair Share - Integrity and Transparency) Act 2024, section 815-140 of the Income Tax Assessment Act 1997 prevented the transfer pricing rules from operating to alter the amount of cross-border related party debt a taxpayer had where the thin capitalisation rules applied to the taxpayer. This meant in practice, the thin capitalisation rules set the maximum amount of debt a taxpayer could have, whilst the transfer pricing provisions set the arm’s length pricing of that debt (albeit with regard to a hypothetical arm’s length quantum of debt). 

The amendments, which apply to income years commencing on or after 1 July 2023, remove the operation of section 815-140 for general class investors (that is, broadly, foreign controlled entities and outbound investors that are not financial entities or authorised deposit taking institutions). This means that the transfer pricing provisions are required to be considered in determining the arm’s length price and the quantum of the debt, and then the thin capitalisation rules apply to the remaining arm’s length debt deductions (i.e. the 30% fixed ratio test is not a safe harbour / debt ceiling where cross-border loans subject to transfer pricing are involved). 

This is a key consideration for taxpayers with cross border related party borrowings who have focused primarily on the outcomes under the fixed ratio or group ratio tests, given the rules may operate to deny deductions before applying the thin capitalisation tests. In instances where an entity has excess tax EBITDA, or thinks it is able to carry forward denied debt deductions under the fixed ratio test, they may find they have a permanent denial under the transfer pricing rules before even applying the thin capitalisation rules if the quantum of the loan is not arm’s length. 

How will the arm’s length debt amount be determined? 

The ATO has indicated it is working on releasing guidance on the new thin capitalisation rules, including updating its existing guidance in Practical Compliance Guideline (PCG) 2017/4 to take into account these changes and the factors that are relevant to the assessment of risk on cross-border related party borrowings. While this represents one of the initial focus areas announced by the ATO in relation to the release of guidance, the timing of release of any guidance is currently unknown. 

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Given these changes are applicable to the current income year for affected taxpayers, steps will be required now to assess and support the arm’s length quantum of any cross-border related party debt. The OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the OECD Guidelines), which are incorporated as relevant interpretive material under Australia’s transfer pricing rules, will therefore be key guidance material. The approaches adopted in considering the application of Australia’s previous arm’s length debt test (ALDT) provisions and in other jurisdictions globally which have similarly required consideration of the arm’s length quantum of debt may also provide helpful insights on a supportable approach to establishing an arm’s length quantum of debt. 

There is no universal list of factors that an independent party would consider in establishing the amount of debt they would be willing to lend or borrow, and this will require consideration in light of the specific industry and circumstances of a taxpayer. Nonetheless, we expect that some of the key factors that may be relevant to the assessment of an arm’s length quantum of debt may include:

  • the general creditworthiness of the borrower, and the key financial metrics analysed by independent lenders or credit ratings agencies in assessing creditworthiness 
  • the borrower’s history of meeting (or failing to meet) previous debt payments, and forecast serviceability of the relevant related party debt arrangement
  • the purpose of the debt arrangement
  • the availability of collateral / security, including parent guarantees
  • the presence of senior ranking debt
  • any key covenants imposed under debt arrangements for the borrower or broader group
  • the availability of comparable debt observations amongst industry peers, and
  • the ‘loan to value’ or ‘debt to equity’ ratio of the borrower after drawing the debt.

In addition to the above, a key consideration for taxpayers under the transfer pricing rules is to understand and assess the impact of the borrower’s position as a member of the broader global multinational group. This is distinct from the operation of the ‘factual assumptions’ that were required to be considered under the previous ALDT provisions and has been a key focus area for the ATO as well as recent case law in relation to the arm’s length pricing of related party debt arrangements. In this context, understanding the broader group’s treasury policies and funding arrangements may be particularly instructive in establishing an arm’s length quantum of debt going forward. Consideration of any alternative funding options available to the borrower at the time of entering related party debt arrangements will also be critical to further support this assessment and the ‘options realistically available’ to the borrower. 

The takeaway

Following the repeal of section 815-140 for general class investors, taxpayers will need to consider the arm’s length quantum of any cross-border related party debt arrangements in order to avoid potential permanent denial of deductions under Australia’s transfer pricing rules. The transfer pricing rules will apply prior to the application of the fixed ratio or group ratio test under the thin capitalisation rules. Given this will apply for the current income year for affected taxpayers, we recommend considering:

  • available comparable data or observations considering the specific circumstances and industry of the Australian borrower, including the key terms and conditions and purpose of any cross-border related party debt arrangements
  • evidence of the options realistically available to the Australian borrower at the time of entering the related party debt arrangement (which may have been several years earlier), and intervening periods, and
  • the broader funding practices and policies of the Australian borrower’s broader global group. 

Consideration of the above factors will be critical for any new related party debt arrangements, as well as existing related party debt held by a general class investor. Taxpayers with related party debt arrangements will also be required to consider the application of the debt deduction creation rules going forward, which can apply separate to the transfer pricing rules. Therefore, we recommend taxpayers with related party debt arrangements consider the potential application of the new thin capitalisation rules holistically and continue to monitor for the release of ATO guidance to further refine or support the positions adopted going forward.

Contact us

If you would like to further discuss the draft legislation, 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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Hiral Mistry

Partner, Tax, Melbourne, PwC Australia

+61 415 234 754

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