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Australia’s New Thin Capitalisation regime: Group Ratio Test – not as easy as it looks!
Thin Cap Series: Group Ratio Test – not as easy as it looks!
  • 7 minute read
  • August 23, 2024

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The group ratio test, part of Australia’s new thin capitalisation regime, allows an entity to claim net debt deductions up to the level of the worldwide group’s net interest expense as a share of earnings. In this Tax Alert, we unpack this test in more detail and highlight some of the key issues to consider.

23 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.

The new regime replaces asset-based tests with earning-based tests for general class investors. One of the three new tests is the group ratio test, which allows an entity in a group to claim net debt deductions up to the level of the group’s net interest expense as a share of earnings. In this Tax Alert, we review the group ratio test and highlight some of the issues that taxpayers should be considering when looking at this test as an alternative to the default fixed ratio test or the third party debt test.

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

In Detail

Broadly, the group ratio test limits a “general class investor’s” net debt deductions to the “group ratio earnings limit”, which is determined by multiplying a calculated “group ratio” by the entity’s tax EBITDA.

The group ratio test will result in a higher level of debt deductions as compared to the fixed ratio test where the “group ratio” is greater than 30%. However, there are several tricks and traps to consider before making the choice to apply this test.

Firstly, not all entities will be able to use the group ratio test. Whilst there are no restrictions or conditions to be met for a general class investor to choose this test, they may not actually be able to calculate a group ratio, so practically this test is of no use. Furthermore, even where a group ratio can be calculated, some will find that it is less than 30% or it is highly volatile year-on-year as it is based on accounting principles. Some entities may calculate a group ratio of more than 30%, but have no tax EBITDA themselves, and so may be better off using the fixed ratio test and carrying forward denied debt deductions to future years. 

Who can use the group ratio test?

To use the group ratio test, an entity will need to be able to calculate its “group ratio”. In order to do this:

  • the entity must be a member of a “GR group” (broadly, a group of entities that are consolidated for accounting purposes)
  • the GR group must prepare audited consolidated financial statements, and
  • the entity must be fully consolidated in those statements on a line-by-line basis.

These requirements mean that certain entities will not be able to calculate a group ratio. Of these, there are three main stand outs:

  1. A single entity that is not controlled by another entity and does not control any other entities for accounting purposes. This may also exclude a single tax consolidated group that is treated as a single entity for income tax purposes.
  2. An entity whose parent applies the “investment entity” exception to accounting consolidation. Such an entity is not fully consolidated in the financial statements of its parent, nor is it a parent in its own right, for the purposes of these rules.
  3. An entity whose parent has not prepared audited consolidated financial statements because, for example, it is located in a jurisdiction that does not have a requirement to do so or is a type of entity that is excluded from such requirements.

Will the group ratio test give a better result than the fixed ratio test?

As noted above, an entity would usually only choose to use the group ratio test if its group ratio is more than 30% (which is the level of the fixed ratio test). As the group ratio earnings limit is calculated by multiplying the group ratio by the entity’s tax EBITDA, if an entity has no or very low tax EBITDA, the group ratio test is unlikely to improve its ability to claim debt deductions.

In addition, unlike the fixed ratio test, the group ratio test does not permit the carry forward of denied debt deductions, nor does it allow excess tax EBITDA from downstream entities to “flow up” to a parent or other controlling entity.

The group ratio is broadly calculated as the GR group’s net interest expense divided by its EBITDA, with both inputs based on accounting principles. Some things to look out for that may have the effect of decreasing the group ratio include:

  • Any entities within the GR group that have negative EBITDA are excluded from the group’s EBITDA in calculating the group ratio. This increases the denominator, hence decreasing the group ratio.
  • Interest expense paid to, or received from, certain associate entities outside of the group is excluded from the numerator in calculating the group ratio. Excluding this interest expense from the numerator will decrease the group ratio.
  • As the group ratio is based on accounting principles, it can be highly volatile and may include unrealised gains where these are included in profit and loss under the accounting standards. Unrealised gains increase the group’s EBITDA, thereby decreasing the group ratio.

In practice, a degree of care is necessary to accurately calculate the group ratio. The requirement to calculate the EBITDA for each individual group entity, to determine if any have negative EBITDA, practically can be difficult for groups with a large number of entities in the group. In addition, the group’s net interest expense must include amounts that are ‘economically equivalent to interest’ so it is not sufficient to only capture amounts disclosed as interest in the financial statements.

So, when might the group ratio be useful? The group ratio test may be useful for groups with a high level of external gearing, where that translates to a high proportion of interest expense to earnings. It may also be useful as an alternative to the third party debt test where the majority of the debt in a group is provided by third parties, however it may fail the third party debt test (for example, due to the existence of prohibited guarantees) or the third party debt test is considered too restrictive as it results in some associate entities being deemed to have chosen to use this test as well.

The Takeaway

Much like the former worldwide gearing test, it is likely that there are only limited circumstances in which the group ratio test will be useful due to the structure of the test and its limitations.

Where this test is chosen, it is important to remember that any cross-border related party debt must be on arm’s length terms – with respect to both pricing and quantum – even if the interest would otherwise be deductible under the thin capitalisation rules. An entity that uses the group ratio test will also need to consider the debt deduction creation rules that apply to income years commencing on or after 1 July 2024.

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

Email

Patricia Muscat

Director, Tax, Sydney, PwC Australia

+61 282 667 119

Email

Clement Lui

Director, Tax, Sydney, PwC Australia

+61 414 821 023

Email

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