Thin Capitalisation Changes
The draft legislation proposes significant changes to Australia’s thin capitalisation rules for non-bank/non-financial entities.
All existing thin capitalisation tests will be replaced with new tests which are often likely to have the effect of limiting the amount of tax deductions available for interest expenses.
Primary test will be a “fixed ratio test”, where interest deductions are limited to 30% of the entity’s tax EBITDA. This test replaces the current 60% LVR “safe harbour” debt amount which is most commonly used in the market.
Changes are to apply from 1 July 2023, with no grandfathering/transitional concessions for existing debt arrangements, so both existing and proposed debt arrangements will need to be reviewed for compliance with the proposed new tests.
The proposed changes were open for public consultation and review until 13 April 2023, so further changes are possible.
The thin capitalisation rules limit the amount of tax deductions available for interest expenses. The current thin capitalisation limits (or tests) are broadly based on debt to asset ratios, or “gearing levels” of the taxpayer. Under the proposed amendments these existing tests will all be replaced with new tests that are generally based on EBITDA ratios and not linked to the gearing levels of the taxpayer.
The thin capitalisation rules generally only apply to taxpayers with cross-border arrangements, such as foreign-controlled Australian entities or Australian entities with foreign investments. The proposed amendments do not seek to change this position.
The amendments are proposed to apply to income years commencing on or after 1 July 2023. The draft legislation did not contain any grandfathering or transitional rules for existing arrangements. As such, any existing debt arrangements will not be exempted from the new proposed rules. With less than 2 months remaining before the proposed start date, there is not much time for taxpayers to assess and potentially restructure their current financing arrangements.
Changes to thin capitalisation tests
30% “tax EBITDA” limit to replace the current 60% LVR limit – Under the proposed fixed ratio test, an entity’s net debt deductions will be limited to 30% of the entity’s tax EBITDA. Broadly, “tax EBITDA” is the entity’s taxable income, adjusted for net debt deductions, tax depreciation and tax losses deducted.
- This may be problematic for the infrastructure industry which generally has longer lead times for earnings.
External third party debt test/limit to replace the current arm’s length debt limit – Under the proposed third party debt test, an entity’s debt deductions will be limited to those attributable to external third party debt. The external third-party debt must also satisfy certain requirements; e.g. in relation to recourse and debt fund usage requirements. This test can only be used by a taxpayer if all of its associate entities also use the same test.
- This would have significant ramifications for the infrastructure industry, in particular entities which currently finance investments using related party debt.
We note that it is common in the industry to set up special purpose financing entities in the group. Certain conduit financing arrangements may satisfy this new debt test, provided that the conduit financier/financing entity borrows from a third party, then on-lends the proceeds to its associate entities on substantially the same terms as the original third party loan. This may be difficult to satisfy in practice.
Group EBITDA ratio test to replace the current worldwide gearing test – Under the proposed group ratio test, an entity’s net debt deductions will be limited to an amount based on the relevant tax EBITDA ratio of its worldwide group.
15-year carry forward for deductions denied under the fixed ratio test – Any amounts denied under the fixed ratio test can be carried forward for 15 income years to be deducted in a future year, to the extent the fixed ratio test is satisfied for that year. Similar to tax losses, the entity will need to satisfy a continuity of ownership test to utilise the deductions (but no continuity of business test will be available). This may be problematic for private equity investments the in infrastructure space where majority shareholders may frequently change over a period of time.
Denial of tax deductions for interest paid in respect of foreign subsidiaries – Interest expenses incurred to derive dividends that are effectively tax exempt under Australia’s participation exemption rules will no longer be tax deductible. This will be relevant where an Australian entity holds a 10% or greater interest in a foreign subsidiary.
Transfer pricing for cross border debt – Since gearing levels will no longer be governed by the thin capitalisation rules for taxation purposes, the gearing levels of Australian entities (in addition to the interest rate for the debt) may also need to be reviewed from an arm’s length perspective under Australia’s transfer pricing rules, in respect of any cross border debt (including, particularly, shareholder or unitholder loans).