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22 June 2023
In brief
On 22 June 2023, legislation to implement new tax measures for multinational enterprises (MNEs) was introduced into Federal Parliament. These measures, which will apply as early as 1 July 2023, make significant changes to Australia’s thin capitalisation regime, and introduce new tax transparency obligations for public companies.
The Bill does not include the previously foreshadowed amendment which would deny interest deductions relating to the derivation of non-assessable non-exempt (NANE) distributions from foreign non-portfolio investments. There is however, a new rule to disallow deductions to the extent they are incurred in relation to so-called ‘debt creation’ arrangements.
All multinational enterprises operating in Australia should consider the impact of these changes as a matter of priority.
In detail
Treasury Laws Amendment (Making Multinationals Pay Their Fair Share - Integrity and Transparency) Bill 2023 (the Bill) was introduced into the House of Representatives on 22 June 2023. This Bill contains several of the key components of the Government’s multinational tax package, as announced in the lead up to the 2022 Federal Election. These components are:
- replacing the current thin capitalisation safe harbour, worldwide gearing and arm's length debt tests for most taxpayers with new interest limitation rules, and
- introducing new transparency rules requiring Australian public companies to disclose information about subsidiaries in their annual financial reports.
Interest limitation rules
The proposed changes to the thin capitalisation regime are the most significant since their introduction in 2001, and for most taxpayers (other than financial entities and authorised deposit-taking institutions (ADIs)) involve a move away from the current asset-based tests to new earnings-based tests. The proposed changes which will apply with effect for income years commencing on or after 1 July 2023 will:
- Replace the safe harbour test (an asset based test) 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 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 “third party debt test” that allows all debt deductions that are attributable to genuine third party debt which is used 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.
Other related changes included in the Bill will:
- require general class investors to demonstrate their actual quantum of debt is arm’s length for the purposes of the transfer pricing provisions, even if debt deductions are less than the threshold set under the fixed and group ratio tests; and
- narrow the scope of entities that will continue to be subject to the existing safe harbour and worldwide gearing tests as a “financial entity” (but note that the definition has been revised as compared to the exposure draft law).
Key changes since the draft legislation
As compared to the exposure draft legislation which was released in March 2023, the overall structure of the proposed new provisions remains, as does the proposed start date of income years commencing on or after 1 July 2023.
The new rules still comprise the three tests - the fixed ratio test, the group ratio test, and the third party debt test - with taxpayers required to make a choice each year to apply one of these tests. Whilst the choice remains irrevocable, a taxpayer may request that the Commissioner of Taxation allow it to revoke a choice in certain circumstances.
There have been a number of important changes to the legislation since it was released in draft for consultation earlier this year. These are summarised below.
Fixed ratio test
The fixed ratio test remains broadly the same, limiting net debt deductions to 30 percent of tax EBITDA. Deductions denied under this test may be carried forward for up to 15 years, provided the taxpayer does not make a choice in a later year to use the group ratio test or third party debt test.
To claim a deduction for any carried forward amount (referred to as the “FRT disallowed amount”), a company must satisfy integrity measures similar to those applying to carried forward tax losses. This now includes both the continuity of ownership test and the business continuity test. Trusts are also now subject to similar integrity rules (i.e. the trust loss rules) for FRT disallowed amounts.
Calculating tax EBITDA
Both the fixed ratio and group ratio tests use the concept of tax EBITDA to determine allowable debt deductions. Whilst the basic framework for tax EBITDA remains the same, the following changes have been made in the final legislation:
- The adjustment for depreciation deductions now includes deductions for capital works (Division 43) and all capital allowances (Division 40) except those that give rise to immediate deductions.
- The calculation of tax EBITDA no longer includes an add back for prior year tax losses that were deducted in the current year.
- Dividends and franked distributions are disregarded in calculating tax EBITDA.
- The share of net income from a trust and/or share of net income or loss from a partnership is disregarded in calculating tax EBITDA if the partnership or trust is an associate entity of the taxpayer (with ‘associate entity’ determined using a lower 10 per cent interest threshold).
- A regulation making power included to provide for adjustments to the calculation of tax EBITDA. The Explanatory Memorandum explains that this is appropriate to ensure the tax EBITDA calculation can be readily updated should further adjustments be desirable.
Group ratio test
The group ratio test provides an alternative to the fixed ratio test that will broadly allow a taxpayer to claim net debt deductions up to the level of the worldwide group’s net interest expense as a share of earnings. This test remains largely unchanged, other than some minor clarifications.
Third party debt test
The third party debt test seeks to limit debt deductions of the taxpayer by reference to genuine third party debt. Some of the key changes in the final legislation in relation to this test include:
- Limiting the test to Australian residents only.
- The holder of the debt must only have recourse to the Australian assets of the relevant entity (the earlier exposure draft did not require those assets to be Australian). The Bill does not provide for any adjustment where recourse may be available to non-Australian assets of the entity. Therefore, the third party debt test will operate to deny all debt deductions attributable to a third party debt interest that is secured over both Australian and non-Australian assets of the borrower.
- The permissible recourse assets do not include assets that are rights in the form of a guarantee, security or other form of credit support. However, an exception exists where the right relates wholly to the creation or development of a CGT asset that is, or is reasonably expected to be, real property situated in Australia (including a lease of Australian land). The Explanatory Memorandum explains that this can include an arrangement under which the borrowing entity has the right to a commitment from investors to provide equity capital on a fixed and capped investment timeline wholly in relation to creating or developing real property.
- The borrower is no longer required to use the proceeds from the debt “wholly” to fund both its Australian investments and Australian operations. The corresponding condition in the Bill only requires that “all, or substantially all” of the proceeds of the debt are used to fund “commercial activities in connection with Australia”.
- In relation to the conduit financing exception, both the conduit financier and borrowers must be Australian residents, and the requirement for the terms of the relevant debts to be identical has been somewhat loosened.
One of the issues with the previous draft legislation was the restriction on using this test where all of the relevant taxpayer’s “10% associate entities” did not use this test. This requirement has now been changed, such that when an entity makes a choice to use this test, the following entities will be deemed to have made the same choice:
- associate entities within an “obligor group” (which is a new concept) where the issuer of the debt has chosen to use the third party debt test (and for this purpose, a higher 20% threshold for associate entity will apply), and
- all entities that have entered into a cross-staple arrangement with an entity that has chosen to use the third party debt test.
Meaning of debt deduction and net debt deduction
The definition of debt deduction and net debt deduction are critical to the application of the proposed interest limitation rules. The draft legislation had proposed changes to the existing definition of debt deduction to expand the scope of costs captured by removing the link to debt interests. The Bill continues to do so, however it also now includes an amount that is “economically equivalent to interest”. The Explanatory Memorandum clarifies that the definition of debt deduction is intended to capture interest related costs under swaps, such as interest rate swaps, and to facilitate this, the existing provision that excludes losses associated with hedging or managing the financial risk from debt deductions will be removed.
Meaning of financial entity
The Bill has adjusted the definition of financial entity by continuing to include an entity that is a registered corporation under the Financial Sector (Collection of Data) Act 2001 but now also requiring that the entity:
- carry on a business of providing finance but not predominantly for the purposes of providing finance directly or indirectly to or on behalf of the entity’s associates, and
- derives all, or substantially all, of its profits from that business in the relevant income year.
This change from the draft legislation should mean more taxpayers are able to continue to use the existing thin capitalisation tests for financial entities.
New debt creation rule
The Bill introduces a new “debt creation rule” which will apply to all entities subject to the thin capitalisation rules and will disallow debt deductions to the extent that they are incurred in relation to debt creation schemes that lack genuine commercial justification. In brief, these rules, which are drafted very broadly, can apply to debt deductions in relation to:
- the acquisition of assets, or legal or equitable obligations, from associates of the acquirer; and
- a debt interest that is issued predominantly to fund payments or distributions to associates of the issuer, or of the entity to which the relevant debt interest was issued.
If the Commissioner is satisfied that a principal purpose of a scheme is to avoid the application of these new rules in relation to a debt deduction, then a separate anti-avoidance rule will empower the Commissioner to determine that the rules apply to that debt deduction.
Transfer pricing
The transfer pricing rules will be amended so that a general class investor will be required 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. Under the current rules, 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.
While these amendments contained in the Bill are consistent with those included in the earlier draft legislation, additional commentary has been included in the Explanatory Memorandum to make clear that, for cross-border debt arrangements that are subject to these rules, the calculation of debt deductions under the arm’s length conditions should be based on the arm’s length rate of interest applied to the arm’s length amount of debt worked out for that debt interest.
For further information, please refer to our previous Alert on the proposed new measures.
Transparency and public company subsidiary reporting
The Bill introduces one of the Government’s previously announced enhanced transparency measures. Specifically, the Bill proposes to amend the Corporations law to require that for each financial year commencing on or after 1 July 2023, Australian public companies (listed and unlisted) provide a ‘consolidated entity disclosure statement’ as part of their annual financial reporting obligations. This disclosure will include information in relation to entities within the consolidated entity, including the tax residency of each of those entities during the financial year. For further information, refer to our previous Alert.
What is next?
This Bill does not include all of the Government’s previously announced multinational integrity and enhanced tax transparency measures. In particular, the following measures are yet to be introduced to Parliament:
- The rule to deny a significant global entity’s tax deductions for cross-border payments made on or after 1 July 2023 relating to intangibles made directly or indirectly to an associate which results in the recipient (or another associate) deriving income in a low corporate tax jurisdiction.
- The tax transparency measure for Country by Country (CbC) reporting parent entities to publicly disclose the information in their CbC reports as well as other tax and financial information.
- The transparency measure to introduce a public register of beneficial ownership in Australia.
In relation to the proposal to enhance transparency under the public CbC reporting proposed measure, the Explanatory Memorandum to the introduced Bill notes that following the consultation on the exposure draft law, there may be some changes made. Notably, the following changes were flagged:
- a proposed deferred application by 12 months, so as to apply from 1 July 2024, and
- the additional data points in relation to related party expenses, effective tax rates and intangible assets may be removed from the final design.
Further consultation with industry on aspects of the public disclosures to be made (including disaggregated CbC reporting) and the measure more broadly is flagged.
The proposal to require tenderers for Australian government contracts (worth more than $200,000) to disclose their country of tax domicile does not require legislative amendment and will instead be implemented via administrative changes to the Commonwealth Procurement material.
In relation to the proposed measure that was included in the exposure draft law that would deny interest deductions relating to the derivation of NANE distributions from foreign non-portfolio investments, the Explanatory Memorandum to the Bill introduced indicates that this amendment has been deferred, with the Government to consider this further via a separate process.
Having regard to Parliamentary calendar, the Bill as introduced will not be enacted before 30 June 2023. The Bill will continue to be considered by Parliament following resumption for the Spring sittings which commence from 31 July 2023.
The Takeaway
With less than two weeks until the earliest start date for these measures, affected taxpayers have no time to lose in understanding the impact of these measures on their business.
With respect to the thin capitalisation changes, affected taxpayers should:
- review their capital structure and model the impact of the changes on their tax position,
- ensure their actual quantum of debt is arm’s length, even if priced correctly and net interest expenses are expected to fall below the FRT limit,
- consider whether they are eligible to apply the group ratio test or third party debt test, and if so, understand the different outcomes under these tests, and
- identify whether they have any arrangements that may fall within the scope of the new debt creation rule.
In relation to the increased transparency measure, Australian public companies should review their records and ensure they have the information required to be disclosed with their financial statements to be prepared for the forthcoming financial year.
James Nickless
Matt Budge
Julian Myers
Kirsten Arblaster
Trinh Hua
Sarah Saville
Chris Vanderkley
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