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New thin capitalisation regime – are you ready for your first year end?
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  • 8 minute read
  • June 03, 2024

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With 30 June fast approaching, June-balancing taxpayers will be the first group of taxpayers that need to consider the impact of the new thin capitalisation rules and, where necessary, understand the tax accounting reflexes where there may be debt deductions disallowed. In this Tax Alert, we highlight some of the issues that June-balancing taxpayers should consider when working through the new thin capitalisation rules in preparation for their first-year end.

3 June 2024

In Brief

Key components of the reforms to Australia’s thin capitalisation regime apply to taxpayers with effect for income years commencing on or after 1 July 2023.

With 30 June fast approaching, June-balancing taxpayers will be the first group of taxpayers that need to consider the impact of the new thin capitalisation rules and, where necessary, understand the tax accounting reflexes where there may be debt deductions disallowed.

In this Tax Alert, we highlight some of the issues that June-balancing taxpayers should consider when working through the new thin capitalisation rules in preparation for their first-year end.

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

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 which will apply one year later).

Preparing for the first year end – where to start?

For June-balancing taxpayers that are subject to the new thin capitalisation regime, reviewing your capital structure and financing arrangements before year end, and determining indicative debt deductions and net debt deductions for the year ended 30 June 2024 is a great place to start. Additional steps may include:

1. Scope of the new thin capitalisation rules

All taxpayers should confirm, or reconfirm, that they are subject to the thin capitalisation rules. Some taxpayers that may paid little attention to the thin capitalisation rules in the past given they were safely within the safe harbour debt amount (effectively assuming that they were subject to the (former) thin capitalisation rules). These taxpayers should use this opportunity to validate whether they are in fact subject to the new thin capitalisation regime.

Similarly, taxpayers that were not subject to thin capitalisation due to the availability of certain exemptions should also consider which exemption they relied on and whether the basis for relying on this exemption still applies.

As an example, many June-balancer taxpayers are Australian headquartered business with offshore operations that previously were exempt from the thin capitalisation regime by relying on the 90% Australian asset exemption. Whilst this exemption is still available in respect of the thin capitalisation rules, the debt deduction creation rules (which apply from income years commencing on or after 1 July 2024) can potentially affect debt deductions arising from both existing and new arrangements.

Further, assessing who a taxpayer’s associate entities are is an important step in not only confirming whether the thin capitalisation rules apply, but also how these new rules apply. For example, this may be relevant to whether a deemed choice to apply the third party debt test may be taken to be made for a taxpayer as a result of someone else’s choice to use this test. The process of validating the relevant factual circumstances and undertaking analysis on this point can be a time-consuming process and should commence pre-year end.

2. Considering the impact of other provisions that may limit deductions for interest

Before modelling the potential impact of the new thin capitalisation regime, it is important to consider the various other relevant Australian tax rules:

(i) Transfer pricing for cross-border related party borrowing
  • For taxpayers with cross-border related party loans, the first step is to determine whether the quantum and pricing of the related party borrowing is arm’s length.
  • This step is important as any deduction denied under the transfer pricing rules is permanent.
(ii) Hybrid mismatch rules
  • Similarly, for taxpayers with related party loans and deductions denied under the hybrid mismatch rules, any denial under Division 832 is also permanent.
(iii) The debt deduction creation rules (apply to existing and new arrangements for income years on or after 1 July 2024)
  • Whilst not applicable for this year end, for future years this rule applies in priority to the thin capitalisation interest limitation rules.
  • The interaction of the thin capitalisation rules and the debt deduction creations rules means that for most taxpayers, these rules should be considered together, rather than waiting until next year to consider the impact of the debt deduction creation rules.
  • Any debt deduction denied under these rules is also permanent.
(iv) Withholding tax obligations
  • Deductions will be denied where withholding tax obligations in relation to the payment of interest to foreign residents are not met.
  • While this denial can be temporary (that is, the deduction is restored once the withholding tax obligation is met), this rule still needs to be assessed before applying the thin capitalisation rules.

After considering the above rules, any (net) debt deductions that remain can then be tested under the new thin capitalisation rules.

Practically, a debt deduction can only be denied once under the tax rules so any taxpayers balancing budgeting and resource constraints should consider the order of priorities of the rules.

3. Modelling

Modelling the impact of the new thin capitalisation rules to remaining net debt deductions can then be undertaken. Where modelling was undertaken based on previous draft versions of the rules, ensure that the latest assumptions and changes are applied including the amendments expanding the scope of debt deductions subject to the thin capitalisation rules.

Tax Accounting – is there any permanent impact on ETR?

Where debt deductions are denied under the thin capitalisation rules, this will impact the effective tax rate (ETR). However, this does not mean all debt deduction denied under the new thin capitalisation regime will have a permanent impact on the taxpayer’s ETR as there may be opportunities to have a timing benefit where the Fixed Ratio Test is applied.

Where taxpayers apply the Fixed Ratio Test (broadly limiting net debt deductions to 30 per cent of their tax EBITDA) any disallowed deductions may be carried forward for up to 15 years. This is subject to an integrity rule and the entity continuing to use the Fixed Ratio Test. The availability of any carried forward disallowed deductions also practically may be influenced by whether a taxpayer has current or prior year tax losses and its future forecast earnings.

Whether the carried forward disallowed deductions may qualify as a deferred tax asset subject to meeting the recognition criteria under AASB 112 Income Taxes is a new question that should be discussed with auditors early. Some considerations could include:

  • forecasting future excess fixed ratio limit capacity to utilise the disallowed amounts within the 15-year limit, and
  • factoring in potential failure of the integrity rules which would limit the ability to utilised carry forward disallowed amounts (e.g. similar to the integrity rules to carry forward tax losses).
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Pillar Two interaction

Some June-balancing taxpayers may be subject to the Pillar Two measures for their next fiscal year commencing on 1 July 2024. Fluctuations in permanent and timing differences may have a flow on impact to the Income Tax Expense amount for Transitional CbC Report Safe Harbour calculations (under the Simplified ETR test) or GloBE calculations (where safe harbour is not available).

Under the draft Pillar Two transitional rules, pre-existing deferred tax assets and deferred tax liabilities can only be transitioned into the regime to the extent that they are reflected or disclosed in a Constituent Entity’s financial accounts at the beginning of the Transition Year (i.e. the year ending immediately prior to the first year in which no safe harbour is relied on and the full Pillar Two Rules apply). This can include unrecognised deferred tax assets or those with a valuation allowance against them, so long as they are reflected or disclosed.

Explore Pillar Two services

OECD Pillar Two Readiness

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Read our latest Pillar Two Alert

Exposure draft legislation released for Pillar Two in Australia

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The Takeaway

The new thin capitalisation rules can be difficult to navigate and will require careful and due consideration. At a minimum, it is recommended that taxpayers should consider the following thin capitalisation issues for the year ended 30 June 2024:

  • confirm if they do in fact fall within the new thin capitalisation rules and / or if any exemptions continue to apply
  • identify debt deductions and net debt deductions taking into account the changes to the definition of net debt deductions
  • work through the order of priority of the various tax provisions that may apply to deny all or a portion of the debt deductions for the income year
  • model the impact of the new thin capitalisation rules and consider which test they will choose to use for the year ended 30 June 2024
  • consider the tax accounting reflex and impact on ETR for any potential denial under the new thin capitalisation rules, such as any permanent impact on the ETR or potential to book a deferred tax asset for deductions denied under the Fixed Ratio Test that can be carried forward to future income years, and
  • consider the impact of the debt deduction creation rules from 1 July 2024.

It is important to note that any restructure of financial arrangements in light of the new thin capitalisation rules should consider the potential application of the general anti-avoidance rules.

Contact us

If you would like to further discuss this alert, reach out to our team or your PwC adviser.

James Nickless

Partner, Global Tax, Sydney, PwC Australia

+612 8266 3246

Email

Bianca Wood

Partner, Global Tax, PwC Australia

+61 (2) 8266 2792

Email

Chris Stewart

Partner, Tax, Brisbane, PwC Australia

+61 407 005 521

Email

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