Five weeks after Treasury’s release of exposure draft legislation to amend the thin capitalisation rules, as announced in 2023 Federal Budget (Exposure Draft), the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share – Integrity and Transparency) Bill 2023 (Cth) (Bill) is now before Parliament.
The Bill is largely consistent with the Exposure Draft, the key feature being to limit debt deductions to 30% of EBITDA, as opposed to its asset-based predecessor. However, the Bill includes a number of surprises, including but not limited to a requirement for disclosure of subsidiaries in public company financial reporting and a new debt creation anti-avoidance rule.
This Bill does not address the other two key aspects of the Government’s multinational tax integrity package (the enhanced transparency and public disclosure of country-by-country reports and the denial of deductions for payments relating to intangibles and royalties).
The impact of the new thin capitalisation rules is expected to be far reaching, we anticipate:
that taxpayers will need to exercise greater caution when entering into transactions giving rise to debt deductions involving associates, as this could trip up the new debt creation deduction limitation rule. Existing arrangements should also be reviewed in light of this new rule.
The Bill significantly overhauls the thin capitalisation rules and will have a considerable impact on the financing arrangements of multinationals with Australian business operations.
Whilst it is not news that the Government intended to align the thin capitalisation rules with OECD best practice guidance, the Exposure Draft contained a number of surprises and modifications in response to issues identified in the Exposure Draft. Following 5 weeks of consultation, the Bill generally remains faithful to the Exposure Draft with a surprise addition of a rule to deny debt deductions otherwise allowable under the thin capitalisation regime that arise from ‘debt creation schemes’.
If the Bill is enacted in its current form, the amendments will apply for income years beginning on or after 1 July 2023, and will commence the quarter after Royal Assent. As currently drafted, there is no deferred start date, no transitional relief and generally no grandfathering (which is different to many similar regimes overseas). Taxpayers will need to act fast to consider the impact of these rules on their business.
The Bill does not include the measure to repeal the existing ability for entities to claim interest deductions relation to the derivation of non-assessable non-exempt (NANE) dividend income from foreign non-portfolio investments. Government has indicated that it will consider this via a separate process.
As with the Exposure Draft, the Bill retains the new concept of a “general class investor”, which replaces and consolidates the existing categories of general entities that were already within scope of the thin capitalisation regime.
Broadly, an entity would be a general class investor for an income year if:
Importantly, not all entities that are currently considered to be financial entities will necessarily continue to be financial entities under the new rules. The Bill would remove corporations registered under the Financial Sector (Collection of Data) Act 2001 (Cth) from the definition of financial entity. This change was not accounted for as part of the Federal Budget. Entities that are currently financial entities for the purposes of the thin capitalisation rules solely because of their registration under that Act will now need to consider the impact of the new rules as general class investors.
As foreshadowed in the Federal Budget and consistent with the Exposure Draft, the Bill introduces three new tests:
The FRT allows a general class investor to claim net debt deductions up to 30% of its tax EBITDA.
Tax EBITDA is the sum of an entity’s:
but, disregarding:
The Bill also includes additional drafting that clarifies how tax EBITDA should be calculated for the purposes of a trust or partnership. Importantly, for the purposes of these calculations, the associate entity threshold has been reduced to 10% (from the normal more than 50% threshold).
Consistent with the Federal Budget announcement and the Exposure Draft, the Bill incorporates a deduction carry-forward rule, which would allow a general class investor applying the FRT to deduct in a later income year its previously denied debt deductions. As announced, the maximum carry forward period is 15 years.
Some important points related to this rule include the following:
The inclusion of this carry forward deduction rule may address concerns of businesses that have inconsistent levels of profitability from year-to-year and to cater for entities (such as start-ups and infrastructure projects) that may be required to make significant upfront capital investments relative to their initial income levels.
A general class investor may choose to apply the GRT in working out its allowable debt deductions if:
A GR Group is comprised of a worldwide parent entity and each other entity that is consolidated on a line-by-line basis in its audited consolidated accounts.
Similar to the current worldwide gearing test, the GRT could permit an entity to claim debt deductions in excess of what would be allowable under the FRT, broadly aligned with the entity’s group ratio. This rule is expected to be particularly relevant to entities that are part of a highly leveraged global group.
Under the Exposure Draft, the choice to apply the GRT or TPDT was irrevocable. The Bill now includes a new mechanism that gives the Commissioner a discretionary power to revoke a choice made by an entity to apply the GRT or TPDT with the effect of treating the entity as if it had never made that choice, where certain conditions are met, including that it would be “fair and reasonable”.
The TPDT is specifically designed to be narrow, to accommodate only genuine commercial arrangements relating only to Australian operations and investments. Very broadly, under the TPDT, a general class investor or financial entity’s debt deductions, other than debt deductions that satisfy the third-party debt conditions (referred to as the third party earnings limit), are denied.
Importantly, a general class investor is deemed to have made a choice to apply the TPDT, where:
A debt interest would satisfy the third party debt conditions (and therefore be deductible) if:
It is clear that the Government’s intention is to limit the ability of taxpayers to claim debt deductions on related party debt (if such debt is not supportable under either the FRT or GRT). Importantly, the TPDT denies excess debt deductions, as contrasted with net debt deductions as is the case in the FRT and GRT. The Explanatory Memorandum explains that this approach was deliberately taken to ensure that all debt deductions attributable to related party debt would be denied under the TPDT.
As discussed above, under the Bill, the Commissioner has the discretion to revoke a previously made choice to apply the TPDT.
The new rules allow for on-lending via conduit financier arrangements, which are intended to allow an entity in a group to raise third party finance to on-lend to other group members and the interest on those loans can remain deductible.
However, the requirements for these rules are prescriptive. For example, in order to qualify, the amount being on-lent must be financed only with proceeds from the funds received from the ultimate lender and the terms of each on-loan must be the same as the third party loan from the ultimate lender (other than terms as to the amount of the debt). Practically, the terms of the on-loans are likely to be different to those of third party loans, such as due to such loans being subordinated to external loans.
The Bill would insert Subdivision 820-EAA into the ITAA 1997, which is a new debt creation deduction limitation rule, which denies debt deductions arising from ‘debt creation schemes’, where artificial interest-bearing debt is created in two scenarios:
This new integrity rule applies to entities that fall within the ambit of the thin capitalisation rules.
The new rules also contain an integrity measure that allow the Commissioner to make a determination where a principal purpose of a scheme was to circumvent the application of the debt creation deduction limitation rule.
The application of the existing transfer pricing rules to arrangements involving debt deductions has historically been limited to section 815-140 of the ITAA 1997 where these rules only adjusted the interest rate based on arm’s length principles, but not the quantum of debt.
With the new rules, a general class investor that seeks to apply the FRT, would not only need to show that its interest rate is consistent with arm’s length conditions under the transfer pricing rules, but also that its quantum of international related party borrowings is consistent with arm’s length conditions. This additional compliance burden is expected to apply even if no debt deductions are denied under the FRT or GRT.
Very broadly, section 768-5 of the ITAA 1997 provides that certain equity distributions from non-portfolio foreign subsidiaries are NANE income. Under the current laws, sections 25-90 and 230-15 of the ITAA 1997 provide that interest expenses incurred in deriving such income are deductible, notwithstanding the general principle that expenses incurred in deriving NANE income are non-deductible.
One significant change proposed in the Exposure Draft, which was not flagged in the Federal Budget, are proposed amendments to sections 25-90 and 230-15 of the ITAA 1997, to deny debt deductions in respect of such income. This change would have affected all taxpayers with income that is NANE under section 768-5 of the ITAA 1997, and not just taxpayers that are subject to the thin capitalisation rules.
While the Bill excluded this change following the Exposure Draft consultation process, the explanatory memorandum makes clear that the Government still intends to consider this measure, albeit as part of a separate process.
Similar regimes around the world (eg the United Kingdom) typically have a significant number of exemptions for industries that are usually highly leveraged, such as infrastructure transactions.
Regrettably, the Bill does not include any exemptions for highly leveraged industries, which is a disappointing turn of events.
The proposed amendments represent a significant change to the thin capitalisation rules in Australia and, with an imminent start date of 1 July 2023, taxpayers have very little time to plan, particularly given the significant addition of the new debt creation deduction limitation rule.
In particular, we expect that inbound and outbound investors alike will want to review their capital and legal structures, including considering the need to restructure existing related party debt to third party financing.
For additional information with respect to this insight, please contact us.
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