17 March 2023
In brief
On 16 March 2023, Treasury released for comment draft law and explanatory materials to implement the Federal Government’s proposed new interest limitation rules that will replace the existing thin capitalisation safe harbour, worldwide gearing and arm’s length debt tests. These new rules will apply for income years commencing on or after 1 July 2023.
The measures included in the draft legislation will:
Replace the safe harbour test (an asset based test) for most taxpayers with a new earnings based “fixed ratio test” that limits an entity’s net debt deductions to 30 per cent of its tax determined earnings before interest, taxes, depreciation, and amortisation (EBITDA), with the ability to carry forward denied deductions for up to 15 years subject to an integrity rule.
Replace the worldwide gearing ratio test for most taxpayers with a new earnings based “group ratio test” that allows an entity in a group to claim debt-related deductions up to the level of the worldwide group’s net interest expense as a share of earnings.
Replace the arm’s length debt test (ALDT) with a new “external third party debt test” that allows interest expenses to be deducted where those expenses are attributable to genuine third party debt which is used wholly to fund Australian business operations, while entirely disallowing third party debt deductions that do not meet the requisite conditions and all related party debt deductions.
The draft legislation released for consultation also included a few surprises in the form of previously unannounced proposed amendments. Some major surprises include:
the repeal of interest deductions relating to the derivation of non-assessable non-exempt distributions from foreign non-portfolio investments
amendments which require general class investors to demonstrate their actual debt quantum is arm’s length for the purposes of the transfer pricing provisions, even if debt deductions are less than the threshold under the fixed and group ratio tests
amendments to narrow the scope of entities that are and will continue to be subject to the existing safe harbour and worldwide gearing tests as a “financial entity”.
For a deep dive on the impacts of these measures for certain industries, please refer to these alerts:
In detail
Unfortunately, for impacted entities, there is no change to the proposed start date. The new rules will apply from the first income year commencing on or after 1 July 2023 as was announced in the October 2022 Budget.
Who is affected by the new rules?
The new fixed ratio and group ratio tests will apply to a newly introduced category of entities referred to as “general class investors” which represents a consolidation of the existing inward and outward ‘general’ classes of entities. In addition, the new external third party debt test will apply to general class investors as well as financial entities that are not authorised deposit-taking institutions (ADIs) (in other words, all entities that were previously eligible to apply the arm’s length debt test).
Financial entities will continue to be able to access the existing safe harbour and worldwide gearing tests. However, as explained below, the definition of financial entities will be narrowed. ADIs, which are subject to a different thin capitalisation regime to non-ADI financial entities, will generally not be impacted by the proposed legislative changes.
Importantly, the ‘de minimis’ exemption from the thin capitalisation rules (applicable where the total debt deductions of an entity and all its associate entities for an income year does not exceed $2 million) is unchanged. The existing Australian asset based exemption for outward investing entities (i.e. where average Australian assets of the entity and its associates represent, in the aggregate, at least 90 per cent of the average total assets) will also continue to apply. In addition, the securitisation exemption continues to apply.
General class investors
Notwithstanding the introduction of a new concept, there is broadly no change to the scope of the entities subject to the thin capitalisation rules. As noted earlier, the new concept of “general class investors” represents a consolidation of the following existing general classes of entities:
Outward investor (general)
Inward investment vehicle (general)
Inward investor (general).
In brief, an entity will be considered to be a general class investor for an income year provided:
it is not, for all the year, a financial entity or an ADI that is either an outward or inward investing entity; and
on the assumption that the entity were a financial entity, it would be either an outward or inward investing financial entity that is not an ADI for the income year.
Revised definition of ‘financial entity’
An entity that previously was classified as a financial entity due to being a registered financial corporation under the Financial Sector (Collection of Data) Act 2001 will no longer meet the definition of a financial entity under the new proposals. This is explained to be an integrity measure to restrict the application of the existing financial entity thin capitalisation provisions to a limited number of taxpayers.
Those taxpayers that no longer qualify will be general class investors and subject to the rules summarised below.
How will the fixed ratio test work?
The draft rules replace the existing safe harbour test with a new earnings based “fixed ratio test” that limits an entity’s net debt deductions for an income year to 30 per cent of its tax EBITDA for the year. Debt deductions disallowed over the previous 15 years as a result of this test may be claimed under a “special deduction” rule (discussed later).
It is notable that the fixed ratio test operates only to reduce the allowable debt-related deductions and does not provide taxpayers with a safe harbour. In other words, a taxpayer will still need to consider other tax rules (e.g. transfer pricing provisions) even if it has a total amount of debt-related deductions that is less than 30 per cent of its tax EBITDA.
Net debt deductions
An entity’s net debt deductions for an income year is determined by working out the sum of the entity’s debt deductions and subtracting amounts included in the entity’s assessable income relating to interest, an amount in the nature of interest or any other amount that is calculated by reference to the time value of money.
Debt deductions
The existing definition of debt deduction will be amended so that a cost does not need to be incurred in relation to a debt interest issued by the entity in order to be treated as a debt deduction. In effect, the concept of debt deduction will be broadened to include both interest and amounts economically equivalent to interest.
Tax EBITDA
Tax EBITDA, which will be a new defined term, is broadly the entity’s taxable income or tax loss adding back deductions for interest, decline in value, capital works and prior year tax losses.
Carry forward of disallowed deductions - the “special deduction”
The new rules allow general class investors a special deduction for debt deductions disallowed under the fixed ratio test (FRT disallowed amounts) over the previous 15 years in certain circumstances. This will be particularly relevant to those entities that have low earnings in their earlier years of operations.
For an income year, the special deduction is calculated through the following steps below.
| Step 1 | Work out the amount by which the entity’s fixed ratio earnings limit exceeds its net debt deductions for the income year. |
| Step 2 | Apply against that excess each of the entity’s fixed ratio test disallowed amounts for the previous 15 income years (to the extent that they have not already been applied under this step in a previous income year). |
| Step 3 | The amount of the deduction is the total amount applied under Step 2. |
Companies must pass a modified version of the continuity of ownership test (COT) in relation to each of the FRT disallowed amounts they are seeking to apply. The test will be applied in the same manner as the COT rules for carried forward company tax losses, i.e. an FRT disallowed amount will broadly be prevented from being applied as a special deduction unless the company maintains the same majority owners.
There are also special rules to allow FRT disallowed amounts to be brought into a tax consolidated group when an entity joins the group. Such amounts will also reduce the entry Allocable Cost Amount (ACA) for a joining entity.
An entity will effectively forfeit its FRT disallowed amounts if it chooses to use an alternative method (either the group ratio rule or the new external third party debt test) in a subsequent year. That is, entities must continue to use the fixed ratio test every income year to maintain access to their carried forward FRT disallowed amounts.
The alternative group ratio rule
The worldwide gearing ratio test will be replaced with a new earnings based “group ratio test” that allows an entity in a group to claim debt-related deductions up to the level of the worldwide group’s net interest expense as a share of earnings. This test may be particularly relevant to a highly leveraged group.
This test will only be available if the entity is a member of a GR group and the GR group EBITDA for the period is not less than zero, and the entity will be required to make an irrevocable choice to apply this test (see further below regarding the choice to apply a test).
Where an entity chooses to use this test, its net debt deductions will be limited to its group ratio multiplied by tax EBITDA. There is no ability to carry forward denied deductions under this test, and in addition, if an entity uses the fixed ratio test and then changes to the group ratio rule, any brought forward denials from previous years calculated under the fixed ratio test will be forfeited.
GR group
A GR group is the group comprised of the relevant worldwide parent entity and, generally, all other entities that are fully consolidated on a line-by-line basis in the parent’s audited consolidated financial statements. The worldwide parent entity is referred to as the GR group parent and must have financial statements that are audited consolidated financial statements for the period. Each other entity in the GR group is referred to as a GR group member.
Group ratio
The group ratio is broadly calculated as the GR group net third party interest expense, divided by the GR group EBITDA. At a high level, both of these amounts are derived from the GR group’s audited consolidated accounts, as set out in the table below.
| GR group net third party interest expense | Broadly equal to the GR group’s net third party interest expense, as disclosed in the audited consolidated financial statements. |
| GR group EBITDA | Broadly, the sum of the following amounts:
as disclosed in the audited consolidated financial statements |
There are a number of complex adjustments that are required to the above amounts before calculating the group ratio. This includes:
treating amounts in the nature of interest or calculated by reference to the time value of money as interest for these purposes
reducing the group’s net third party interest expense for any payment made to an associate entity, using a relatively low threshold of only 10 per cent ownership to determine who is an associate entity.
The replacement ALDT - the new external third party debt test
The new “external third party debt test” effectively disallows an entity’s debt deductions to the extent that they exceed the entity’s debt deductions attributable to external third party debt and which satisfy certain other conditions. This new test is notably more limited in application than the ALDT that it replaces (e.g. it will not be available for Australian businesses that raise external debt with a guarantee from their global parent, even if the debt amount is arm’s length based on the stand alone borrowing capacity of the Australian business, nor if any amount of the debt is used to acquire shares in a foreign entity).
If the external third party test applies for an income year, the test will disallow debt deductions for the amount by which the entity’s debt deductions exceed the entity’s ‘external third party earnings limit’ for the income year.
External third party earnings limit
For an income year, the external third party earnings limit is the sum of each debt deduction of the entity for the income year that is attributable to a debt interest issued by the entity that satisfies the following external third party debt conditions:
the entity issued the debt interest to an entity that is not an associate entity of the entity
the debt interest is not held at any time in the income year by an entity that is an associate entity of the entity
the holder of the debt interest has recourse for payment of the debt only to the assets of the entity; and
the entity uses the proceeds of issuing the debt interest wholly to fund:
its investments that relate only to assets that are attributable to the entity’s Australian permanent establishments or that the entity holds for the purposes of producing assessable income; and
its Australian operations.
Conduit financier arrangements
Additional rules allow certain conduit financier arrangements to satisfy the external third party debt conditions. Conduit financier arrangements exist where an entity (a ‘conduit financer’) issues a debt interest to another entity (an ‘ultimate lender’) and that debt interest satisfies the external third party debt conditions. The conduit financier then on-lends the proceeds of that debt interest to one or more associate entities on the same terms as the debt interest issued to the ultimate lender (other than as to the amount of debt).
The draft explanatory material acknowledges that conduit financier arrangements are relatively common commercial arrangements which are generally implemented to allow one entity in a group to raise funds on behalf of other entities in the group. It is noteworthy that many multinational groups may raise debt externally overseas and on-lend within the group on terms that are closely aligned with (but not the same as) the terms of the upstream external debt. These arrangements would not be able to benefit from the additional rules for conduit financier arrangements.
Restrictions on applying the external third party debt test
This test is available for general class investors as well as non-ADI financial entities. However, general class investors cannot make this choice if:
it has one or more associate entities that are general class investors
those associate entities are not exempt from the thin capitalisation rules; and
at least one of the associate entities does not make a choice to use the external third party debt test.
A modified definition of “associate entity”, which replaces the requirement of an “associate interest of 50% or more” with a “TC control interest of 10% or more”, applies for the purposes of this restriction.
Choice of tests
The fixed ratio test is the default test that applies for general class investors that do not make a choice to use either of the two alternative tests.
For an income year, the entity can choose to either use the group ratio test or external third party debt test on or before the earlier of the day it lodges its return for the relevant year or the day it is required to lodge the relevant tax return. A choice for an income year cannot be revoked, and the entity will not be able to revise or make a new choice in a tax return amendment as the time period for making the choice will have lapsed.
Taxpayers can choose to use a different test in each income year. However, if a taxpayer uses the fixed ratio test in an income year and does not use the fixed ratio test in a subsequent income year, the taxpayer loses the ability to carry forward any existing FRT disallowed amounts for income years going forward.
Removal of interest deductions for non-assessable non-exempt dividends
Another large surprise included in the draft legislation is the proposed removal of deductions for interest incurred in respect of foreign equity distributions that are non-assessable non-exempt (NANE) income under Subdivision 768-A of the Income Tax Assessment Act 1997.
Broadly, a distribution is NANE income under Subdivision 768-A if:
it is made by a non-resident company to an Australian resident corporate tax entity (directly or indirectly), and
the Australian resident entity has at least a 10 per cent interest in the non-resident company.
The ability to claim interest deductions in respect of distributions that are non-assessable non-exempt income under this Subdivision has been a long standing feature of the income tax law, and previous attempts to repeal it have been unsuccessful.
This measure was not previously announced, and will have application from as early as 1 July 2023 for June balancers. All entities with existing funding arrangements that relate to foreign corporate investments will need to review the after-tax cost of such arrangements, and regardless of whether or not they are subject to the new interest limitation rules.
Interaction with the transfer pricing rules
Section 815-140 of the Income Tax Assessment Act 1997 modifies the operation of the transfer pricing law to debt deductions for entities that are subject to the thin capitalisation rules. This modification provides that, in working out the costs that are debt deductions if “arm’s length conditions” applied and those costs involve applying a rate to a debt interest, the costs should be calculated by applying the arm’s length rate to the debt interest actually issued (i.e. the actual quantum of debt). The effect of this is, putting aside the anti-avoidance provisions, taxpayers did not need to demonstrate that their actual debt quantum was arm’s length provided they were subject to the thin capitalisation rules and could demonstrate they would have had at least some amount (i.e. a dollar) of debt.
As a result of proposed changes included in the draft legislation to limit the categories of entities that can benefit from the section 815-140 modification, general class investors will need to ensure that the quantum of cross-border related party borrowings is consistent with arm’s length conditions under the transfer pricing rules, even though it is paying an arm’s length rate of interest and its total debt deductions are less than the threshold under the fixed ratio or group ratio rules.
Consequential amendments included in the draft law indicate that section 815-140 will continue to apply only to entities that are not general class investors and have not made a choice to use the external third party debt test for the income year. In other words, the section 815-140 modification will continue to apply to ADIs and financial entities that have not chosen to use the external third party debt test.
What happens next?
Submissions on the draft legislation can be made until 13 April 2023. We anticipate that following this round of consultation, the Government will be aiming to have the measures introduced into Federal Parliament in the Winter Sittings, which commence on 9 May 2023. However, it is possible that the law will not be enacted prior to 1 July 2023, the earliest start date of these measures.
The Takeaway
With only a little over three months before the earliest start date, there is not much time for taxpayers to assess the impact that the new measures will have on their capital structure and any consequential impacts of refinancing, if required.
A key focus for many corporate taxpayers will be working out the quantum of related party debt that is permitted under the new limitation rules as well as for the first time the transfer pricing rules. Certain sectors like infrastructure and property, which historically have been heavily reliant on the asset-based safe harbour may be negatively impacted given the changed focus on earnings. This is particularly relevant to greenfield projects where earnings may not arise for a number of years. The operation of the conduit financing rules will also need careful attention in light of how projects are currently financed.
