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28 March 2024
In Brief
On 27 March 2024, Treasury Laws Amendment (Making Multinationals Pay Their Fair Share - Integrity and Transparency) Bill 2023 completed its passage through Federal Parliament. This Bill contains the amendments to introduce a new thin capitalisation regime that will apply to most taxpayers with effect for income years commencing on or after 1 July 2023.
These measures have been through a number of iterations over the past year. In this Tax Alert, we provide an overview of the final rules – including the new debt deduction creation rule that will come into effect one year later – that will officially become law when the Bill receives Royal Assent.
In Detail
The new thin capitalisation regime for “general class investors” will broadly apply to income years commencing on or after 1 July 2023 (except for the new debt deduction creation rules, see further below, which will now apply one year later).
A general class investor is a new concept that combines the old law concepts of inward investors and outward investors. Broadly, this includes:
General class investor does not include a “financial entity” (as defined in the tax law) and an authorised-deposit taking institution (ADI). Changes to the definition of financial entity as part of the amendments to introduce this new regime have narrowed the scope of entities that qualify as financial entities and therefore have access to the existing tests for financial entities (other than the arm’s length debt test, which has been replaced with the third party debt test for all taxpayers).
The following exemptions are available:
Exemption | Available for: | |
---|---|---|
Interest limitation rules | Debt deduction creation rules | |
$2 million associate entity-inclusive debt deduction de minimis exemption | Yes | Yes |
90% Australian asset exemption | Yes, but for outward investors only | No |
Special purpose entity exemption | Yes | Yes |
Due to amendments to the Bill made by the Senate, Australian plantation forestry entities will not be required to apply these new rules and will continue to apply the thin capitalisation provisions as in force immediately before this Bill took effect.
The regime to apply to general class investors contains three tests – the default fixed ratio test, and two elective tests being the group ratio test and the third party debt test. These are summarised in the table below.
Test | Key features |
---|---|
Fixed ratio test |
|
Group ratio test |
|
Third party debt test |
|
The choice to use a test for an income year is generally irrevocable, although the Commissioner of Taxation may permit a choice to be revoked in certain limited circumstances.
The determination of tax EBITDA which is relevant to the fixed ratio test and group ratio test is a relatively straight-forward calculation with the following steps:
Step 1: Work out the entity’s taxable income (or net income in the case of a trust or partnership) or tax loss for the income year (disregarding the operation of Division 820 other than the debt deduction creation rules and treating a loss as a negative).
Step 2: Add the entity’s net debt deductions for the income year (this can be a negative amount).
Step 3: Add the sum of the following deduction for the income year:
Step 4: If permitted, add the excess tax EBITDA from controlled entities.
If the result is less than zero, treat the amount as zero.
For the purposes of Step 1 (working out the entity’s taxable income or tax loss), special rules apply with respect to deductions for prior year losses and for any notional deduction for research and development activities. The Step 1 amount must also be calculated disregarding franking credit gross-ups, and dividends, distributions, and partnership income or loss from companies, trusts or partnerships that are associate entities.
The fixed ratio and group ratio tests rely on a new concept of ‘net debt deductions’, which broadly takes into account interest (and similar) income, as well as deductible interest (and similar) expenses. A taxpayer that has nil or negative net debt deductions will not have any amounts denied under the fixed ratio or group ratio tests.
These concepts broadly follow the OECD best practice guidance for interest limitation rules and include amounts that are economically equivalent to interest such as notional interest paid or received on interest rate swaps.
The Bill also introduces 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 will apply to income years commencing on or after 1 July 2024 and can affect debt deductions arising from both existing and new arrangements.
The debt deduction creation rules will apply to general class investors, outward investing financial entities (non-ADIs) and inward investing financial entities (non-ADIs). ADIs, securitisation vehicles and entities that apply the third party debt test will exempt from the operation of the debt deduction creation rules.
There are broadly two types of arrangements that may fall within scope of the debt deduction creation rules:
The acquisition of the following CGT assets will not be within scope of the Type 1 rules:
There is no exemption for purchases of trading stock under Type 1, meaning that debt deductions will be denied where an entity uses related party debt to fund the acquisition of trading stock from an associate. This is likely to capture situations where intercompany payables on stock purchases are left outstanding and begin to accrue interest.
Type 2 arrangements are related party debt which funds, or facilitates the funding of, the following types of payments only:
The debt creation rules also include a targeted anti-avoidance rule for schemes that have a principal purpose of avoiding application of the debt deduction creation rules.
Whilst there is no change to the thin capitalisation rules applying to financial entities and ADIs, a change to the definition of financial entity, which applies to income years commencing on or after 1 July 2023, will result in some entities that were previously classified as financial entities now being classified as general class entities, and therefore subject to the new interest limitation rules.
The new definition of financial entity requires an entity to be a registered corporation under the Financial Sector (Collection of Data) Act 2001 but will also require that it:
The transfer pricing rules are amended so that a general class investor will be required 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 involve additional arm’s length analysis not previously required to be undertaken by taxpayers that have relied on the old thin capitalisation tests to support their debt quantum.
If an entity has an amount of cross-border related party debt deductions that exceeds an arm’s length amount, which may arise if the debt quantum is not arm’s length, it will be required to self-assess a disallowance of the non-arm's length debt deductions when preparing its income tax return. This will apply even if the entity is paying an arm’s length rate of interest and its net debt deductions are less than the threshold under the fixed ratio or group ratio rules (i.e. these tests are not safe harbours).
The Takeaway
For many taxpayers, we are already 9 months into the first year of operation of these thin capitalisation changes. With the form of the rules now finally confirmed, taxpayers who have not yet assessed the impact of these rules should do so without further delay. This should include:
For those taxpayers seeking to rely on the default fixed ratio test, it will be necessary to review all related party debt to ensure the debt quantum is an arm’s length amount, something that has generally not been required before now. And whilst the debt deduction creation rule is not yet in effect, the additional time afforded by the deferred start date should be used to review all related party debt and trace its original use to ensure that debt deductions can continue to be claimed once these rules kick in.
The Bill as passed by both Houses of Parliament requires the Government to undertake a review of the thin capitalisation amendments to commence no later than 1 February 2026. This process will hopefully provide an opportunity to assess the impact of these changes, including whether the amendments have had any impact on Australia’s ability to attract foreign investment.
In working through the draft rules over the past few months we have encountered a number of complexities and challenges applying the rules to the wide variety of commercial arrangements. In many instances, it has required consultation with technical accounting and banking experts. As some taxpayers may find anomalous outcomes where genuine commercial arrangements result in debt deduction denials, or uncertainty in tax positions that may require disclosures in financial accounts, it will be important for taxpayers to take action as soon as possible. ATO guidance and engagement in due course will be encouraged and welcome for many.
If you would like to further discuss the thin capitalisation regime, reach out to our team or your PwC adviser.
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