Australia’s new thin capitalisation regime: impacts for private groups

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.

Whilst much of the focus for these new rules has been on large multinationals and collective investment vehicles, private groups which are foreign-owned or hold foreign investments are often caught within scope of these rules and need to consider the impacts on the deductibility of interest costs. In this Tax Alert, we unpack some of the key focus areas for private groups, including which groups and entities are within scope of the rules, how they apply, and the impact of the new debt deduction creation rules.

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

When are private groups subject to the thin capitalisation rules?

The recent amendments introduced a new concept of a ‘general class investor’ which is broadly subject to the new thin capitalisation rules in Australia. In simple terms, entities that are not financial entities or authorised deposit-taking institutions (ADIs), and were classified as an ‘outward investor’, ‘inward investment vehicle’ or ‘inward investor’ under the old rules should now be classified as a general class investor.

The practical effect of the definition of ‘general class investor’ is that the following entities, where they are not financial entities or ADIs, will be general class investors:

• an Australian entity that carries on a business in a foreign country at or through a permanent establishment
• an Australian entity that controls a foreign entity
• an Australian entity that is controlled by foreign residents; and
• a foreign entity that has investments in Australia.

As the operations of many private groups become globalised, the concept of a ‘general class investor’ will begin to capture more private groups. For these groups, it will be important to understand what exemptions may be available. Broadly, there are three main exemptions that private groups should consider when assessing whether the thin capitalisation rules apply to entities within the group:

1. Private and domestic exemption – Assets that are used (or held for use) wholly or principally for private or domestic purposes, and non-debt liabilities that are wholly or principally of a private or domestic nature, are excluded from a taxpayer’s thin capitalisation calculations. For general class investors subject to the new thin capitalisation rules which apply for income years commencing on or after 1 July 2023, this exemption is of little relevance as the new tests do not rely on the value of assets and/or non-debt liabilities. (Note: debt that is used for private or domestic purposes is generally not deductible under ordinary tax principles, and therefore not subject to the thin capitalisation rules).
2. 90% Australian asset threshold – This exemption excludes Australian entities from the thin capitalisation regime where, broadly, at least 90% of the total assets of the entity and its associates are ‘Australian assets’. This exemption is not available to foreign entities or foreign-controlled Australia entities, and importantly, does not exempt a taxpayer from the new debt deduction creation rules (discussed in more detail below).
3. $2m debt deduction de minimis exemption – This exemption is available where an entity, and all its associate entities, have combined total debt deductions of $2m or less for an income year. Where the exemption is available, the thin capitalisation rules (including the new debt deduction creation rules) do not apply, and thus there should be no disallowance of debt deductions under these rules.

It is important that private groups regularly assess their ability to rely on any of these exemptions. With the rapid rise of interest rates over the last 24 months, the cost of debt has significantly increased and as a result, some private groups that have historically relied on the de minimis exemption may no longer be able to do so. In addition, recent amendments have broadened the concept of ‘debt deduction’ such that more costs need to be counted towards the $2m de minimis threshold. More details on the expanded definition of debt deduction can be found in this Tax Alert.

How do the general thin capitalisation rules apply to private groups?

For income years commencing on or after 1 July 2023, where an entity within a private group is a general class investor and no exemption is available, one of the following three tests are available to determine the amount of debt deductions allowed: 

1. The fixed ratio test (the default test)
   
2. The group ratio test (an elective test); and
3. The third party debt test (an elective test).

The key features of each test are summarised in our earlier Tax Alert.

The most appropriate test for a particular entity will depend on a range of factors. The table below highlights some factors that an entity within a private group may wish to consider in determining which test to use.

How do the debt deduction creation rules impact private groups?

The reforms enacted earlier this year included the introduction of new debt deduction creation rules, which are intended to disallow debt deductions to the extent that they are incurred in relation to certain debt creation schemes that typically lack genuine commercial justification. These rules apply to income years commencing on or after 1 July 2024 (one year later than the general thin capitalisation amendments discussed above) and importantly can affect debt deductions arising from both existing and new arrangements.

The debt deduction creation rules apply to general class investors. Importantly, as noted above, debt deductions of private groups that satisfy the 90% Australian assets threshold exemption can still be affected as this exemption does not apply for purposes of the debt deduction creation rule. As a result, the debt deduction creation rules will be highly relevant for private groups with debt deductions exceeding $2m.

There are broadly two types of arrangements that may fall within scope of the debt deduction creation rules:

• Related party debt used to fund the acquisition of a capital gains tax (CGT) asset or a legal or equitable obligation from an associate, subject to certain exemptions (Type 1); and
• Related party debt used to fund certain payments and distributions to associates, including dividends, distributions, returns of capital and royalties (Type 2).

Both domestic and cross-border related party arrangements may be within the scope of the debt deduction creation rules. These new rules apply before the general thin capitalisation tests discussed above, meaning that debt deductions from arrangement falling within scope of these rules are entirely, and permanently, disallowed.

A key risk area for private groups is the use of complying Division 7A loans, a related party funding arrangement commonly used by private groups, including those used in conjunction with unpaid present entitlements (UPE) to trust distributions. For example, a UPE that has been converted to a complying Division 7A loan is likely to fall within scope of the debt deduction creation rules as a Type 2 arrangement – that is, a loan from an associate that has been used to fund or facilitate the funding of a trust distribution to an associate. The Australian Taxation Office (ATO) has recently flagged this in draft Practical Compliance Guideline PCG 2024/D3. Examples 9 and 10 in the draft PCG involve the use of complying Division 7A loans used to finance the acquisition of a CGT asset from a related party, and to settle an outstanding UPE to trust income. The ATO has noted that in both cases, the borrower will need to consider the application of the debt deduction creation rules to the debt deductions arising on the complying Division 7A loan, and the ATO would likely apply compliance resources to review these arrangements.

All private groups should assess whether their complying Division 7A loans, and any other related party funding, falls within scope of the debt deduction creation rules, as this will result in debt deductions in relation to those loans being disallowed to the extent that the debt was used in the manner set out above.

In the current environment of increased interest rates and globalisation, the thin capitalisation rules have become more relevant for private groups.

Private groups should take the time to understand the impact of the new rules, including whether entities within the group will be classed as ‘general class investors’, whether any exemptions are available and which test is best suited to the group’s specific circumstances. The introduction of the debt deduction creation rules, which can apply to both existing and new debt arrangements, adds a new layer of complexity to this analysis, and will require many groups that have relied on the 90% Australia asset threshold exemption in the past to consider the thin capitalisation provisions for the first time.

Many areas of uncertainty remain with the new rules, and the ATO is currently preparing guidance on some of aspects. In the meantime, there may be several funding structures within private groups that need to be re-evaluated in the context of the new rules.