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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

Who is covered by these new rules? 

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: 

  • Foreign controlled Australian entities 
  • Foreign entities with Australian permanent establishments 
  • Australian controllers of controlled foreign entities (and their associates). 

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 new interest limitation rule for general class investors 

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 
  • Limits net debt deductions to 30% of an entity’s tax EBITDA (a defined term that is broadly based on the concept of taxable income before interest, depreciation and other specific adjustments – see further below). 
  • Disallowed deductions may be carried forward for up to 15 years subject to an integrity rule, and subject to the entity continuing to use the fixed ratio test (i.e. carry forward disallowed amounts will be lost if the entity switches to another test). 
  • Flow-through of “excess tax EBITDA” is permitted in certain circumstances from controlled entities to controlling entities where broadly: 
    • both the controlled entity and controlling entity are Australia entities and use the fixed ratio test, and 
    • the controlling entity has an interest of 50% or more in the controlled entity. 
Group ratio test 
  • Allows an entity in a group to claim net debt deductions up to the level of the worldwide group’s net interest expense as a share of earnings. 
  • The calculation of the group ratio is broadly based on accounting figures, with this ratio then applied to the entity’s tax EBITDA. 
  • The calculation of the group ratio includes a number of specific adjustments including for example, to remove interest paid to and from associate entities that are not part of the group, and to disregard entities with negative EBITDA. 
  • Carry forward of disallowed deductions is not permitted.
Third party debt test 
  • Allows all debt deductions that are attributable to genuine third party debt only (that is, debt that satisfies the third party debt conditions) while entirely disallowing debt deductions that do not meet the requisite conditions (including all related party debt deductions). 
  • The third party debt conditions are broadly: 
    • The debt was not issued to, and not held by, an associate entity of the borrower.
    • Disregarding minor or insignificant assets, the lender has recourse only to Australian assets (excluding certain guarantees, security and credit support) of the borrower or an Australian entity that is a member of the borrower’s obligor group or Australian assets that are membership interests in the borrower. 
    • The debt is used to fund the commercial activities of the borrower in Australia. 
    • The borrower is an Australian entity. 
  • Special rules exist to allow for conduit financing in limited circumstances. 
  • Carry forward of disallowed deductions is not permitted. 
  • Whilst this test is generally elective, an entity will be deemed to have made a choice to use the third party debt test for an income year where it: 
    • is a member of an obligor group in relation to a debt where the issuer of the debt has made a choice to use the third party debt test and is an associate entity of the issuer of the debt; or 
    • has entered into a cross stapled arrangement with one or more other entities, and one or more of the other entities has made a choice to use the 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. 

What is tax EBITDA? 

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: 

  • General deductions relating to forestry establishment and preparation costs (unless those relate to the clearing of native forests) 
  • Deductions under Division 40 (depreciating assets) and 43 (capital works), other than where a deduction for the entire amount of an expense is permitted in the income year 
  • Deductions under section 70-120 for the capital costs of acquiring trees. 

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. 

Debt deductions and net debt deductions 

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. 

Debt deduction creation rules 

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:  

  • 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 (Type 2).  

The acquisition of the following CGT assets will not be within scope of the Type 1 rules:  

  • New membership interests in an Australian entity or foreign company. This means that the use of related party debt proceeds to acquire newly issued shares in a company will not trigger the debt deduction creation rule.   
  • New tangible depreciating assets, which the acquirer expects to use within Australia, within 12 months, for a taxable purpose, and that have not previously been installed ready for use or used for a taxable purpose by the acquirer or its associates. This is intended to allow an entity to bulk-acquire tangible depreciating assets on behalf of its associates.  
  • New debt interests issued by associates. This is intended to ensure that mere related party lending by an Australian taxpayer is not caught by the debt deduction creation 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:  

  • a dividend, distribution or non-share distribution  
  • a distribution by a trustee or partnership  
  • a return of capital, including a return of capital made by a distribution or payment made by a trustee or partnership  
  • a payment or distribution in respect of the cancellation or redemption of a membership interest in an entity  
  • a royalty, or a similar payment or distribution for the use of, or right to use, an asset
  • a payment or distribution that is referable to the repayment of principal under a debt interest if, broadly, the original debt was used to make a payment or distribution that would have attracted the operation of the Type 2 debt deduction creation rules  
  • a payment or distribution of a kind similar to a payment or distribution mentioned in the preceding paragraphs, and  
  • a payment or distribution prescribed by Regulations (yet to be made, but no doubt to enable additional arrangements found to be of concern to be readily captured).  

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.  

Narrowing of definition of financial entity 

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: 

  • carry on a business of providing finance but not predominantly for the purposes of providing finance directly or indirectly to or on behalf of the entity’s associates, and 
  • derives all, or substantially all, of its profits from that business in the relevant income year. 
Transfer pricing and debt quantum 

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: 

  • review their capital structure and model the impact of the changes on their tax position 
  • consider whether they are eligible to apply the group ratio test or third party debt test, and if so, understand the different outcomes under these tests,  
  • maintain transfer pricing documentation to confirm that both the interest rate and the quantum of their cross-border borrowings are arm’s length, and 
  • ensure key stakeholders have been briefed. 

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. 

Contact us

If you would like to further discuss the thin capitalisation regime, reach out to our team or your PwC adviser.

Chris Morris

Partner, Tax & Legal Leader, Sydney, PwC Australia

+61 2 8266 3040

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