Australian Federal Budget Update 2022-2023

The new Albanese Government delivered its first Australian Federal Budget this evening with the centrepiece being more details on its promised Multinational Tax Integrity Packaged and expanded funding for the ATO Tax Avoidance Taskforce.

While the Budget Announcements include certain new initiatives, the overall highlights include the following:

• Strengthened and stricter Thin Capitalisation rules limiting debt related deductions; principally replacing the safe harbour and worldwide gearing tests with an earnings-based test (30% of profits/EBITDA) and, while retaining the arm’s length debt test as a substitute/alternative test, limiting its application only to third party unrelated debt;
• New anti-avoidance rule to prevent significantly global entities from claiming tax deductions for payments made to related parties in relation to intangibles located in low or no tax jurisdictions (with a tax rate of less than 15% or a preferential patent box regime);
• Stricter tax transparency rules (including public disclosure) for international businesses;
• Expanded funding for and an extended period (1 year) for ATO Tax Avoidance Taskforce;
• Removing flexibility for taxpayers to self-assess the effective lives of intangible depreciating assets;
• Clarifying that digital currencies (e.g. Bitcoin) are excluded from ‘foreign currency’ treatment in Australia;
• Aligning the tax treatment of off-market share buy-backs undertaken by listed public companies with the tax treatment of on-market buy-backs;
• Confirming/noting new Double Tax Treaty with Iceland (signed 12 October 2022);
• Certain FBT and import tariff concessions for electric cars; and 
• Clarifying the new Government’s position on certain tax measures, proposed or commenced by the former Coalition Government.

We are pleased to provide more details on these important Budget initiatives below

Gearing levels and interest deductions – significant changes to Australia’s thin capitalisation rules

As widely expected, the Budget affirmed the Government’s commitment to tighten Australia’s thin capitalisation rules, mainly by introducing an EBITDA based limit on interest deductions.

Currently, Australia’s thin capitalisation rules limit debt deductions based up to the maximum of three different tests: a safe harbour test (debt to asset ratio – up to 60% LVR) test, an arm’s length debt test and a worldwide gearing (debt to equity ratio) test.

The Budget announced the following significant changes to the thin capitalisation rules:

• replacing the current safe harbour test limit with a test limiting debt deductions up to 30% per cent of EBITDA;
• importantly, any debt deductions denied under the 30% EBITDA test can be carried forward and claimed in a subsequent income year (for up to 15 years);
• replacing the current worldwide gearing test with a test limiting debt deductions (for an entity in a group) up to the level of the worldwide group’s net interest expense as a share of earnings (which may exceed the 30% EBITDA ratio); and
• amending the arm’s length debt test, so it is only available for an entity’s external (third party) debt – this test will no longer be available for related party debt.

The proposed changes would apply to income years commencing on or after 1 July 2023.

The proposed changes would apply to multinational entities operating in Australia and any inward or outward investor, in line with the existing thin capitalisation regime. However, financial entities will continue to be subject to the current thin capitalisation rules.

The changes are likely to present imminent challenges for businesses and their funding decisions.  In particular:

• The safe harbour test (a balance sheet test) will be completely replaced with the 30% EBITDA test (a P&L test).  It is unclear whether or to what extent there will be any transitional concessions for existing debt arrangements. 
• EBITDA could also be a more volatile metric, which is harder to predict, than a business’ debt to asset ratio. 
• The arm’s length debt test will not be available for related party debt, even if the debt is commercially supportable and in line with market practice. While retaining the arm's length debt test for non-related party debt (eg. bank debt), businesses and investment funds that currently rely on the arm’s length debt test for shareholder/unitholder debts would need to apply the 30% EBITDA test for thin capitalisation purposes.

In addition, many aspects remain to be clarified in the enabling legislation, when it is released (none at the time of writing).  These include:

• whether EBITDA will be based on accounting or tax concepts;
• whether the carry forward of denied deductions will be subject to specific tests (e.g., ownership and/or business continuity tests); and
• whether the current A$2m de minimis will be retained or amended (to bring Australia’s rules more in line with other jurisdictions, such as various EU jurisdictions).

Businesses and investment funds are urged to review and prepare for these imminent changes, to ensure that their funding structures and decisions (both current and proposed) will be in line with the announced changes. We expect that the Government will further consult with interested parties on these comprehensive reforms in the coming months. 

Denial of deductions for payments for intangibles

The Budget papers gave some further details on this previously announced measure.  The scope of the measure has been limited to payments made to “related parties” and it has been confirmed that the measures will be limited to “significant global entities” (broadly, those with global annual income of A$1 billion or more).

The scope of the economic penalty in the provision also seems to be limited to a “denial of deductions”.  The consultation process had raised questions around whether there might be application of royalty withholding taxes to the relevant payments as well.  This created a potential conflict with our treaties, which define the sorts of payments which may be subject to withholding tax.  
The reference to “intangibles” continues the Government’s proposed approach of extending the scope of these provisions to “embedded royalties” and potentially to payments relating to other intangibles such as marketing intangibles, all of which are not normally within the scope of the treaty definition of a royalty.

Payments within scope are those directly or indirectly in relation to “intangibles” held in low or no-tax jurisdictions.  These jurisdictions are those with:

• a tax rate of less than 15%; or
• a tax preferential patent box regime without sufficient economic substance.

The measures will have application to payments made on or after 1 July 2023.

The Treasury consultation process leading up to the Budget was extensive and it is clear that a number of submissions have been accepted.  There remain, however, important areas where more detail is needed.   The questions of what is a “tax preferential patent box” regime, what is “sufficient economic substance”, the nature of the intangibles affected, for instance. There is a need to determine whether a payment is “indirectly in relation to an intangible”, and there are questions of whether the payment will be apportioned and the basis on which this will be done.   The relationship between these rules and the other avoidance provisions of the Act will also need to be clarified. 

It will also be interesting to see the approach taken by the ATO in relation to these measures and existing ATO activities in these areas, such as Taxation Ruling 2021/D4, Taxpayer Alert 2018/2 and the “Pepsi” Diverted Profits Tax litigation.

We expect to see draft legislation in relation to the proposals and hope that it will be presented for consultation. Taxpayers may need to consider whether any changes are required to their existing IP ownership arrangements following the release of the draft legislation.

Tax Transparency – Further reporting requirements

The Australian Government confirmed that it will be introducing additional reporting requirements for certain types of taxpayers, increasing the level of tax related information they are required to publicly disclose.

In particular:

• “Significant global entities” (broadly, those with global annual income of A$1 billion or more) will be required to release to the public certain tax information on a country-by-country basis, including their approach to taxation.  The precise details of the information required to be disclosed has not yet been announced.
• Australian public companies (both listed and unlisted) will be required to disclose information regarding the number and tax domicile of their subsidiaries.
• Entities tendering for Australian Government contracts with a value of more than A$200,000 will be required to disclose their country of tax domicile.

These measures reflect the growing focus by Australia, and internationally, on the public disclosure of tax information by large multinationals and other taxpayers to enhance tax compliance and minimise the use of international structures to minimise tax.  Taxpayers should closely monitor the details of the information they are required to disclose to the public under these measures.

These measures are to apply from 1 July 2023.

Digital currency – exclusion from foreign currency treatment for tax purposes

The Budget affirmed the Government’s commitment, to introduce legislation to ensure that digital currencies (such as Bitcoin) continue to be excluded from the Australian income tax treatment of foreign currency. This follows the Government’s announcement in June 2022 and exposure draft legislation release in September 2022.

The measure is intended to remove uncertainty following the decision of the Government of El Salvador to adopt Bitcoin as legal tender, which may have resulted in Bitcoin being taxed as a foreign currency under Australia’s foreign currency tax rules.

From a practical perspective, this measure:

• is intended to maintain the current tax treatment of digital currencies, such that their tax treatment is based on factors including a taxpayer’s profile and activities - including the capital gains tax treatment where the digital currencies are held as an investment;
• will not apply to digital currencies issued by, or under the authority of, a government agency, which continue to be taxed as foreign currency under Australia’s foreign currency tax rules.

The measure will be backdated, to apply to income years that include 1 July 2021.
 
Whilst this measure is not expected to have material impact on businesses or other taxpayers that hold or invest in digital currencies, the enabling legislation – and the extent to which it incorporates public consultation comments to date – remains to be seen.

Separately, the Budget had no announcements on the Board of Taxation’s current "review of the tax treatment of digital assets and transactions”.  Taxpayers remain subject to Australia’s current tax rules that originate from historic, non-digital periods. Taxpayers and key players in the digital assets space remain keenly wait for Australia’s holistic tax reform, for tax rules that cater for the specific and evolving characteristics of digital assets.

Double Tax Treaty Network – New Iceland Treaty

The Government signed a new Double Tax Treaty with Iceland on 12 October 2022 which, amongst other things, contains various features associated with the OECD/G20 Base Erosion and Freight Shifting (BEPS) initiatives. These include initiatives associated with transparent entities/Collective Investment Vehicles, permanent establishments, concessional dividend, interest and royalty withholding taxes, limitation of benefits/treaty abuse, mutual agreement procedure/dispute resolution/arbitration and non-discrimination provisions.

Australia, under the previous Coalition Government, commenced a significant expansion and update of Australia’s Double Tax Treaty Network with a view to concluding 10 new or updated Treaties by the end of 2023.

The new Albanese Government is yet to formally endorse this Treaty program. However, with the new Iceland Treaty and the recently proposed amendments to the India/Australia Treaty dealing with ‘technical services’, the expectation is that the new Government will progress and complete this Treaty expansion program.

Another notable feature of the Iceland Treaty is the non-discrimination article (Article 22), which contains a specific carve-out under Article 22(5). Where Article 22(5) applies, it operates to prevent the operation of Article 22 in so far as the discrimination relates to a “rate of taxation”. This appears to be a direct response to the High Court decision in Addy v Commissioner of Taxation [2021] HCA 34, which resulted in the taxpayer being subject to reduced tax rates under the backpacker tax rules pursuant to the operation of the non-discrimination article in the Australia- UK Treaty. Whilst the backpacker tax is unlikely to be relevant for this treaty, given that Icelandic nationals generally do not qualify for the relevant visas, it is likely that Australia may continue to adopt the same position in including an equivalent of Article 22(5) in its future tax treaties.

Off-market share buy-backs

The Government intends to change the tax treatment of off-market share buy-backs undertaken by listed public companies, to align it with the treatment of on-market share buy-backs. Previously, off-market share buy-backs were largely perceived as being more advantageous for shareholders from a tax perspective.  

Generally, in the case of an on-market buy-back, no part of the purchase price is treated as a dividend. Instead, the full amount of the purchase price is treated as the consideration for sale for both ordinary income and CGT purposes. Consequently, the benefits of franking credits could not be passed on to the shareholders. In contrast, off-market buy-backs generally allow for the splitting of the purchase price into dividend and capital components, with certain tax benefits for the shareholder- such as the potential franking of the dividend component, which may reduce the shareholder’s overall tax liability. 

This measure will apply from the time of announcement (7:30pm AEDT, 25 October 2022).

The intention behind this measure is to remove some of these perceived benefits associated with an off-market share buy-back and to result in greater symmetry between the tax implications of both on-market and off-market share buy-backs.  

Reverse the measure allowing taxpayers to self‑assess the effective life of intangible depreciating assets

The Budget stated that the Government will not proceed with the measure to allow taxpayers to self‑assess the effective life of intangible depreciating assets. previously announced in the 2021–22 Federal Budget.  

This means that the effective lives of intangible depreciating assets – such as patents, registered designs, copyrights and in-house software - will continue to be set by statute and cannot be self-assessed by taxpayers based on their specific circumstances.

This measure would have allowed taxpayers to self-assess their intangibles as having a shorter effective life thereby bringing forward tax deductions. Consistent with the Government’s aim to increase tax receipts, perhaps the Government has taken a stricter view and decided to abandon this measure as this reversal is expected to increase receipts by A$550 million over 4 years.

Electric vehicles to be exempt from FBT and import tariffs

The Federal Government will be proceeding with the already introduced bill to exempt battery, hydrogen fuel cell and plug-in hybrid electric vehicles from fringe benefits tax (FBT).  It will also proceed with the previously announced proposal to remove import tariffs (currently 5%) for electric and fuel-efficient vehicles.  In order for a vehicle to qualify for the FBT and import tariff exemption, the vehicle must have a retail price (including GST) below the luxury car tax threshold for fuel efficient vehicles ($84,916 for FY22-23) and the vehicle must be first held or used on or after 1 July 2022.  This should allow a vehicle ordered prior to 1 July 2022, but delivered after that date, to be eligible. 
 
The measure is designed to increase the uptake of electric vehicles by businesses.  In particular, it is hoped that this will increase the proportion of electric and fuel-efficient vehicles in business fleets. The measure is also expected to increase the use of employers offering salary sacrifice arrangements involving electric vehicles.  While the provision of a qualifying vehicle from an employer to an employee for private use will be exempt from FBT (and associated benefits related to running the car may also be exempt from FBT), the employer will still need to include the exempt electric car fringe benefits in an employee’s reportable fringe benefits amount – this reportable amount is taken into account for a range of other fiscal tests, including the Medicare levy surcharge and health insurance rebates.
 
The bill introducing the FBT exemption contains specific definitions for battery electric vehicles, hydrogen fuel cell electric vehicles, and plug-in hybrid electric vehicles.  Employers will need to carefully check that their proposed vehicles fall within these definitions to be exempt.
 
The measure will cost Federal Government revenue nearly half a billion dollars over 4 years.  The measure will be reviewed after 3 years.

Unlegislated tax measures from the previous Government

The current Australian Government will not proceed with the following key tax measures that were announced but not legislated by the previous Government including:

• Amendments to the debt/equity tax rules;
• Amendments to the taxation of financial arrangements (TOFA) rules;
• Amendments to the taxation of asset-backed financing arrangements;
• The introduction of a new tax and regulatory framework for limited partnership collective investment vehicles;
• The proposed changing of the annual audit requirement for certain self-managed superannuation funds (SMSFs);
• The proposed introduction of a A$10,000 limit for cash payments made to businesses for goods and services;
• The proposed introduction of a requirement for retirement income product providers to report standardised metrics in product disclosure statements; and
• The proposed establishment of a deductible gift recipient category for providers of pastoral care and analogous well-being services in schools. 

Whilst no reasons were provided in the Budget as to why the current Government has decided not to proceed with these measures, some of these rules may have had inherent difficulties in being passed as legislation or there may have been less economic benefit than was initially anticipated. 

In particular, the proposed amendments to the debt equity rules date back to the 2013/14 Budget where the Board of Taxation initially released a paper on its review of current debt equity rules in Division 974 of the Income Tax Assessment Act 1997 (Cth). The then Government released exposure draft legislation in 2016 but it was never legislated. 

In the 2016/17 Budget, the previous Government announced the introduction of a corporate collective investment vehicle (CCIV) regime and a limited partnership collective investment vehicle (LPCIV) which was initially targeted to facilitate wholesale investment by large investors in order to encourage foreign investment and the export of funds management services into Australia. The CCIV regime was introduced effective from 1 July 2022 but it seems the current Government has no appetite to continue the with the LPCIV regime. 

Other tax related measures

There are a number of other tax related measures that were announced by the Government in this Budget, including:

• An increase in funding for the ATO Tax Avoidance Taskforce by around A$200 million per year over 4 years from 1 July 2022, and a further extension in the life of the Tax Avoidance Task Force to 30 June 2026.  The Budget papers state that the increased funding will support the ATO to pursue new priority areas of observed business tax risks (complementing the ongoing focus on multinational enterprises and large public and private businesses). There is no detail in any of the budget papers as to what these ‘observed business tax risks’ are.  The Budget sets out the Government’s expectation that the Taskforce activities would lead to an increase in revenue of A$2.8 billion over the four years 2023-26, against increased payments of A$1.1 billion.
• Certain state and territory COVID-19 grants are to be made non-assessable, non-exempt income for income tax purposes, subject to eligibility. This will exempt eligible businesses from paying tax on these grants.