A significant revamp of our thin capitalisation rules is on the horizon

Exposure Draft legislation released 10 min read

On 16 March 2023, Treasury released an Exposure Draft of the legislation to amend Australia's interest limitation rules—the thin capitalisation rules—contained in Division 820 of the Income Tax Assessment Act 1997 (Cth) (the 1997 Act).

The Exposure Draft proposes a significant revamp of Division 820 in line with the Government's 2022-23 October Federal Budget announcement to address risks to the Australian tax base arising from the use of excessive debt deductions. The amendments are intended to reflect international best practice by shifting the focus to a profits-based (rather than assets-based) test for most entities, so as to better align with taxable profits and economic activity conducted in Australia. The existing 'arm's length test' will also be replaced with an 'external third party debt test'.

The proposed amendments apply to income years commencing on or after 1 July 2023 and do not include any grandfathering for existing debt arrangements or any transitional relief. Given the wholesale nature of the amendments proposed, taxpayers subject to the thin capitalisation regime should carefully consider the potential application of the changes to their circumstances.

Key takeaways

• For taxpayers with significant upfront expenditure (such as greenfield investments) or entities that may not generate taxable income for some years (such as startups), we expect the move to earnings-based (rather than asset-based) tests will result in a significant decrease in the debt deductions available to those entities (but with an ability to carry forward unused deductions).
• Taxpayers who have historically relied on the arm's length debt test will now generally be required to consider a more binary external third party debt test. The existence of certain related party debt, or related party credit support, will generally prohibit an entity from being able to access this test, forcing taxpayers to apply the new earnings-based tests instead. We expect highly leveraged taxpayers (such as those in the infrastructure and real estate sectors) are likely to be most affected. A limited look-through rule applies for conduit finance vehicles that provide direct funding to other group entities on back-to-back terms, where certain conditions are satisfied.
• The definition of an 'associate entity', which is relevant to the external third party debt test, will be amended to reduce the relevant control test from 50% to 10% for most entities. Entities that were not 'associate entities' under the current arm's length debt test may become so under this new test (eg minority investors and joint venture entities may now be captured).
• Taxpayers will no longer be able to claim a deduction for interest expenses incurred in deriving non-assessable non-exempt (NANE) income under section 768-5 of the 1997 Act. This change was not announced in the 2022-23 October Federal Budget and has the potential to be material for taxpayers who incur interest expenses in relation to their foreign corporate investments. This change is also not limited to taxpayers who are subject to the thin capitalisation rules.

So, what's changing?

Division 820 is Australia's main way of limiting the debt deductions otherwise available to a taxpayer by disallowing a portion of debt deductions where it is too highly leveraged and, therefore, 'thinly capitalised'. Generally, only entities with inbound or outbound foreign investment should be captured by these rules.

Under the current law, there are three tests available depending on the circumstances of the taxpayer:

• the safe harbour test
• the arm's length test
• the worldwide gearing test.

One or more of these tests will be changing for most entities.

New classes of taxpayers

Under current law, Division 820 differentiates between outward and inward investors, as well as general, financial and authorised deposit-taking institutions (ADI) investors. This results in many categories of entities with different rules applying to each.

The amendments introduce a concept of 'general class investors' which captures all non-financial entities that are currently subject to the thin capitalisation rules. Financial entities¹ and ADIs will remain subject to the existing, asset-based thin capitalisation tests (ie the existing safe harbour test and worldwide gearing test). This approach is consistent with OECD best practice, recognising that earnings-based tests are unlikely to be appropriate for these entities. In addition, ADIs will continue to apply the existing arm's length test, however other financial entities will be required to apply a new external third party debt test (discussed below).

Existing tests
	General class investors	Financial entities (non-ADIs)	ADIs
Safe harbour test
Worldwide gearing test
Arm's length test
Proposed tests
	General class investors	Financial entities (non-ADIs)	ADIs
Fixed ratio test
Group ratio test
External third party debt test

What are the three new tests?

The new 'fixed ratio test' (generally replacing the safe harbour debt test)

The amendments will introduce a fixed ratio test, replacing the existing safe harbour debt test for 'general class investors', allowing an entity to claim net debt deductions up to 30% of its 'tax EBITDA'. 'Tax EBITDA' is an entity's taxable income or tax loss adding back 'net debt deductions', the total Division 40-B (decline in value) and Division 43 (capital works) deductions and prior year losses.² The test focuses on an entity's 'net debt deductions', meaning the amount added back to taxable income, and the denial of deductions, is limited to the excess of debt deductions over amounts included in the entity's assessable income which are interest or of an interest nature.

Special deduction rule

Any debt deductions that are disallowed under the fixed ratio test can be carried forward over a 15-year period, referred to as the 'special deduction' rule.

The special deduction rule is particularly relevant for entities with significant upfront expenditure or entities that may not generate taxable income for some years. Amounts denied under the fixed ratio test essentially become loss balances which may be utilised in future years, provided the entity satisfies certain conditions, including a modified version of the continuity of ownership test relevant for utilisation of carried-forward company tax losses. Unlike the general company tax loss rules, however, there is no alternative 'business continuity test' meaning, if there is a relevant change in ownership, historical debt deductions carried forward under this measure will no longer be available. For trusts, there does not appear to be a requirement to apply the trust loss rules to carry forward these amounts.

The amendments also align the special deduction with the existing interaction between tax losses and the tax consolidation regime. This means that, where an entity with eligible carried-forward debt deductions joins a tax consolidated group, those amounts may be transferred to the head company of the group, subject to a utilisation test in the trial year (generally the year finishing immediately after the joining time).

Taxpayers who elect to apply the 'group ratio test' or the 'external third party debt test' (discussed below) will not be permitted to carry forward historical debt deductions under the 'fixed ratio' test.

The new 'group ratio test' (generally replacing the worldwide gearing test)

The amendments will introduce a group ratio test, replacing the existing worldwide gearing test for 'general class investors', allowing an entity to deduct net debt deductions in excess of the amount permitted under the fixed ratio rule (relevant for highly leveraged groups). The limit is based on a financial ratio of the worldwide group—referred to as the 'group ratio earnings limit'—which is calculated by reference to the audited consolidated financial statements of the group parent.

The new 'external third party debt test' (generally replacing the arm's length debt test)

The amendments will also introduce a third party debt test, replacing the arm's length debt test, for 'general class investors' and financial entities. ADIs may continue to apply the existing arm's length test.

Under this test, debt deductions (rather than net debt deductions) of an entity, which are not attributable to external third party debt, are disallowed. The debt deductions must also satisfy other conditions, notably that the debt deductions are attributable to debt interests in respect of which:

• the proceeds from issuing the debt interest were used wholly to fund investments in Australian operations or to fund assets held for producing assessable income (which will require taxpayers to undertake a robust tracing exercise)
• the debt interests are not issued to, or held by, 'associate entities'
• the lender to the entity has recourse only to the assets of the entity (and not any recourse to assets of another entity, eg certain credit support provided by another entity). This may be problematic in the context of arrangements such as joint ventures, stapled structures or large groups with a parent entity that provides credit support to the borrower entity. A limited look-through rule applies for conduit finance vehicles that provide direct funding to other group entities on back-to-back terms, where certain conditions are satisfied.

Importantly, the explanatory materials indicate that an entity will not be permitted to apply the third party debt test if it has 'associate entities' that are subject to the thin capitalisation rules (ie not exempt from Division 820) and have not also elected to apply this test, ie there is a one-in all-in requirement within an entity's group of associate entities. We expect that the draft legislation will be revised to achieve this outcome (and to appropriately extend the exemptions from the existing thin capitalisation provisions to capture the new provisions) as part of the consultation process.

The amendments also alter the definition of 'associate entities' to capture entities where there is a certain control interest of 10% or more for most entities; the previous threshold was 50% or more for these entities. This has the potential to capture a significant number of related entities (eg minority investors and joint venture entities may now be captured).

Making the choice

Each year, general class investors and financial entities (non-ADIs) will be required to consider which of the tests they wish to apply. Although the choice is made each year, providing flexibility for taxpayers, any carry-forward tax losses under the special deduction rule otherwise available to a general class investor (discussed above) will be lost if it ceases to use the fixed ratio test.

If no choice is made by a general class investor by the lodgement time of the tax return (the earlier of the actual lodgement or the deadline for lodgement), the fixed ratio test will apply. If no choice is made by a financial entity (non-ADI) within the same timeframe, the higher of the outcomes under the relevant existing safe harbour and worldwide gearing tests will apply.

As any choice is irrevocable, taxpayers will not be able to amend this choice at a later time.

What else is changing?

There is a new, expanded definition of 'debt deductions'

The amendments extend the definition of 'debt deductions' in section 820-40 of the 1997 Act to capture both interest and amounts economically equivalent to interest, consistent with the OECD best practice guidelines. The definition has been amended such that it may now capture costs incurred by an entity which are not incurred in relation to a debt interest issued by that entity but are considered to be economically equivalent to interest.

The definition of 'associate entity' now excludes complying superannuation funds

The amendments narrow the definition of 'associate entity' in section 820-905 of the 1997 Act to expressly exclude a trustee of a complying superannuation entity (other than a self-managed superannuation fund). The rationale for this is that these entities are subject to a robust regulatory regime and do not generally exercise control over entities that would otherwise be 'associate entities' and so should not be captured by the 'associate entity' definition in the thin capitalisation rules.

The scope of Australia's transfer pricing regime will be expanded to cover the quantum of intragroup debt

The Australian transfer pricing provisions are currently modified in their application for entities that are subject to Division 820. In particular, section 815-140 of the 1997 Act essentially provides that the transfer provisions apply to work out the arm's length conditions and rate, which is then applied to the debt interest actually issued by that entity (not a hypothetical debt interest that would have been issued).

The amendments will alter this for general class investors and financial entities using the fixed ratio test, who will now be required to ensure that the quantum of their intragroup debt is arm's length. In other words, interest deductions may be denied under Australia's transfer pricing regime (Division 815) where the interest is paid on a quantum of debt that, under the terms of Division 815, is considered to exceed an arm's length quantum of debt.

Removing the deduction for NANE income

Section 768-5 of the 1997 Act provides that certain foreign equity distributions are NANE income. Under current law, sections 25-90 and 230-15 of the 1997 Act also provide that interest expenses incurred to derive this income are deductible, notwithstanding the general principle that expenses incurred in deriving NANE income are not deductible.

The amendments will ensure that taxpayers are no longer able to claim a deduction for interest expenses incurred in deriving NANE income under section 768-5. This change was not announced in the 2022-23 October Federal Budget and has the potential to be material for taxpayers who incur interest expenses in relation to their foreign corporate investments. This can apply to all taxpayers with section 786-5 NANE income, not just those subject to the thin capitalisation rules. Once again, the new rules will require taxpayers to have an ability to trace the use of funds in their business.

Actions you should take now

The proposed amendments represent a wholesale change to the thin capitalisation rules in Australia, providing taxpayers with a very short period for consultation and review of the rules prior to their enactment.

Taxpayers should review their related party debt dealings and debt structures to ensure compliance with the new thin capitalisation rules.