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Final amendments to the Bill containing the proposed reforms to Australia’s thin capitalisation regime have been released. This is likely to be the final round of changes before the Bill completes its passage through Parliament, and, as such, offers the complete picture of how the new thin capitalisation regime will operate.

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29 November 2023

In Brief

On 28 November 2023, amendments to Treasury Laws Amendment (Making Multinationals Pay Their Fair Share - Integrity and Transparency) Bill 2023 - which contains the proposed reforms to Australia’s thin capitalisation regime - were released in advance of their introduction in the Senate. This is likely to be the final round of changes before the Bill completes its passage through Parliament. As such, the Bill, combined with these amendments, offers the complete picture of how the new thin capitalisation regime will operate.

The amendments to the Bill, following the short consultation process in October 2023, are largely welcome changes addressing critical issues. These amendments include:

a deferral of the start date for the debt deduction creation rules until income years commencing on or after 1 July 2024 for all arrangements
a significant narrowing of the scope of arrangements that may fall within scope of the debt deduction creation rules
the ability to pass up excess tax EBITDA to certain companies, partnerships, and managed investment trusts, in addition to unit trusts (as previously proposed), where the fixed ratio test is used, and
broadening the third party debt test by allowing various exemptions to the prohibition on credit support rights and allowing for situations where the lender has recourse to ‘minor or insignificant’ ineligible assets.

[Addendum (6 December 2023): On 5 December 2023, the Senate referred the Government’s proposed amendments to the Bill to the Senate Economics Legislation Committee for report by 5 February 2024. The Senate will not reconsider the Bill until after this report has been tabled. Accordingly, these measures will not be enacted until at least February 2024]

In Detail

Before we delve into the latest round of changes, let’s recap on the key features of the proposed new regime.

The proposed new thin capitalisation regime for “general class investors” will broadly apply to income years commencing on or after 1 July 2023 (except for the new debt deduction creation rules, see further below, which will now apply one year later).

A general class investor is a new concept that combines the concepts of inward investors and outward investors under the current law. The regime contains three tests – the default fixed ratio test, and two elective tests being the group ratio test and the third party debt test. These are summarised in the table below.

Test	Key features
Fixed ratio test	Limits net debt deductions to 30% of an entity’s tax EBITBA (a defined term that is broadly based on the concept of taxable income before interest, depreciation and other specific adjustments). Denied deductions may be carried forward for up to 15 years subject to an integrity rule, and the entity continuing to use the fixed ratio test.
Group ratio test	A new earnings-based test that allows an entity in a group to claim net debt deductions up to the level of the worldwide group’s net interest expense as a share of earnings. The calculation of the group ratio is broadly based on accounting figures, with this ratio then applied to the entity’s tax EBITDA. No carry forward of denied deductions.
Third party debt test	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. Provides special rules for conduit financing. No carry forward of denied deductions.

The fixed ratio and group ratio tests rely on a new concept of ‘net debt deductions’, which broadly takes into account interest (and similar) income, as well as deductible interest (and similar) expenses. A taxpayer that has nil or negative net debt deductions will not have any amounts denied under these provisions.

The Bill also introduces a new debt deduction creation rule, which is intended to disallow debt deductions to the extent that they are incurred in relation to certain debt creation schemes that typically lack genuine commercial justification.

Debt deduction creation rules

The amendments are welcome changes that ensure the debt deduction creation rule will not apply to many genuine commercial transactions that are not the intended target of these integrity rules.

The first welcome change is a deferral of the start date for the debt deduction creation rule to income years commencing on or after 1 July 2024 for all arrangements. This will provide taxpayers with additional time to understand the scope and implications of these changes and hopefully provide the Australian Taxation Office with time to publish its views on the application of these rules prior to their commencement date. Unfortunately, there is no grandfathering of any pre-existing arrangements and, as such, an exercise will still be required to assess the application of the rules to transactions that may have occurred prior to the commencement of the rules to determine whether the debt deductions will be allowable once the rules commence.

There are broadly two types of arrangements that may fall within scope of the debt deduction creation rules:

related party debt used to fund the acquisition of a capital gains tax (CGT) asset or a legal or equitable obligation from an associate (Type 1) and
related party debt used to fund certain payments and distributions to associates (Type 2).

The draft amendments released for consultation in October 2023 foreshadowed three new exemptions under Type 1 and these have been retained. As such, the acquisition of the following CGT assets will not be within scope of the rules:

New membership interests in an Australian entity or foreign company. This means that the issue of new shares by a company will not trigger the debt deduction creation rule.
New tangible depreciating assets, which the acquirer expects to use within Australia, within 12 months, for a taxable purpose, and has not previously been installed ready for use or used for a taxable purpose by the acquirer or its associates. This is intended to allow an entity to bulk-acquire tangible depreciating assets on behalf of its associates.
New debt interests issued by associates. This is intended to ensure that mere related party lending by an Australian taxpayer is not caught by the debt deduction creation rules.

There is still no exemption for purchases of trading stock under Type 1, meaning that debt deductions will likely be denied where an entity uses related party debt to fund the acquisition of trading stock from an associate. This is likely to capture situations where intercompany payables on stock purchases are left outstanding and begin to accrue interest.

The Supplementary Explanatory Memorandum released with the proposed amendments also clarifies that the acquisition of Australian currency - which is not a CGT asset when used as legal tender - is not expected to be caught by Type 1.

The proposed amendments to narrow the scope of ‘payments or distributions’ captured by Type 2 appear to reflect the concerns of many stakeholders regarding the breadth of this measure in the previous iterations. Type 2 has now been limited to related party debt which funds, or facilitates the funding of, the following types of payments only:

a dividend, distribution or non-share distribution
a distribution by a trustee or partnership
a return of capital, including a return of capital made by a distribution or payment made by a trustee or partnership
a payment or distribution in respect of the cancellation or redemption of a membership interest in an entity
a royalty, or a similar payment or distribution for the use of, or right to use, an asset
a payment or distribution that is referable to the repayment of principal under a debt interest if, broadly, the original debt was used to make a payment or distribution that would have attracted the operation of the Type 2 debt deduction creation rules
a payment or distribution of a kind similar to a payment or distribution mentioned in the preceding paragraphs, and
a payment or distribution prescribed by Regulations (no doubt to enable additional arrangements found to be of concern to be readily captured).

Under these proposed amendments, the scope of Type 2 is narrowed to only cover situations where the payer uses the proceeds to ‘fund’ or ‘facilitate the funding of’ one of the types of payments or distributions listed above, i.e. it is no longer necessary to determine whether the financial arrangement could “increase the ability of any entity (including the payer) to make” a payment or distribution to an associate. This is a welcome narrowing of the measure that should make the provisions easier to apply in practice. There will still be, however, a need for a complex tracing exercise to determine the original use of any existing and new related party debts, including where these debts have been refinanced multiple times.

Another welcome change will see entities that apply the third party debt test for any income year exempt from the operation of the debt deduction creation rules for that year. This is a logical change that recognises that such entities are subject to the third party debt conditions, and therefore, their debt deductions are only allowed where they are attributable to genuine third party debt that is borrowed against Australian assets and is used to fund Australian operations. However, the debt deduction creation rules will still need to be considered where an entity has conduit financing arrangements that satisfy the conditions of the third party debt test but the entity has not chosen the third party debt test (e.g. because the entity also has related party debt or if it does not want to forfeit its ability to carry forward disallowed amounts under the fixed ratio test).

The Supplementary Explanatory Memorandum released with the proposed amendments also features a welcome clarification that the targeted anti-avoidance rule for schemes that have a principal purpose of avoiding application of the debt deduction creation rules “is not intended to apply where a taxpayer is merely restructuring, without any associated artificiality or contrivance, out of an arrangement that would otherwise be caught by the debt deduction creation rules”. It is hoped that a similar approach will be taken to the application of the general anti-avoidance rule in Part IVA of the Income Tax Assessment Act 1936.

The amendments also ensure that the debt deduction creation rules are to be applied prior to the fixed ratio test or group ratio test. This means that any deductions that are denied under the debt deduction creation rules are excluded from any calculations under the fixed ratio test or group ratio test.

Third party debt test

The amendments proposed with regards to the third party debt test will generally expand its application to a wider range of third party debt arrangements. Many of these amendments were foreshadowed in the draft that was released for consultation in October 2023 and have been retained.

The requirement to be an ‘Australian resident’ to access the third party debt test has been replaced with a requirement to be an ‘Australian entity’. An ‘Australian entity’ will include Australian residents, Australian trusts as well as Australian partnerships where at least 50% of the partnership interests are directly held by Australian residents or Australian trusts. This is a critical change that will appropriately expand access to the third party debt test, and was likely an oversight in the original Bill.

The amendments also clarify that interest rate swap costs that relate to multiple debt interests or are incurred by a borrower in a conduit financer arrangement will be generally deductible under the third party debt test to the extent that the costs are directly associated with hedging or managing the interest rate risk of the debt interest and not referable to an amount paid to an associate entity.

The third party debt conditions include a requirement that the lender only has recourse to certain permissible assets of the borrower. This requirement has been expanded to permit lender recourse to Australian assets that are either:

held by the issuer (in conduit financer cases this is modified to also refer to the Australian assets of the conduit financer and borrowers)
membership interests in the issuer (in conduit financer cases this is modified to include membership interests in the conduit financer and borrowers); however, membership interests in an entity will not be a permissible recourse asset if the entity has a legal or equitable interest, directly or indirectly, in an asset that is not an Australian asset, or
held by an Australian entity that is a member of the obligor group in relation to the tested debt interest.

A welcome change that was not included in the previous draft amendments is the ability to disregard lender recourse to ‘minor or insignificant’ ineligible assets. The Supplementary Explanatory Memorandum explains that this modification is intended to prevent the permissible recourse requirement being contravened for inadvertent and superficial reasons. From a practical perspective, this will ensure that small amounts of foreign assets, such as a foreign bank account with a small balance, will not prevent an entity from using the third party debt test where the lender has recourse to all of the entity’s assets, although difficulties will remain in determining what is considered to be a minor or insignificant amount of ineligible assets.

Although the general prohibition on recourse to assets that are credit support rights is maintained, there is a broadening of the so-called ‘greenfield exception’ (which will broadly allow rights in relation to a guarantee, security or credit support in certain circumstances) to include the creation of and development of certain moveable property situated on Australian land (in addition to development of Australian land as per the original Bill). The Supplementary Explanatory Memorandum notes that moveable property that is renewable energy producing moveable property could be covered by the exemption.

Rights relating to the following will also be specifically exempt from the prohibition on credit support, provided the rights do not allow recourse to a foreign entity that is an associate:

rights providing recourse only to otherwise permissible Australian assets
rights that do not give the lender recourse to an associate entity of the issuer (we expect that this can include third party financial or performance guarantees, insurance and bonding lines), and
rights relating wholly to the creation or development of eligible offshore renewable energy infrastructure and offshore transmission infrastructure that is directly related to the offshore renewable energy infrastructure.

The third party debt test contains modifications to ensure that conduit financing is permitted. The proposed amendments include changes to the conduit financing conditions to allow for the recovery of:

reasonable administrative costs relating to the ultimate debt interest
reasonable administrative costs of the conduit financer in relation to relevant debt interests
costs of the conduit financer associated with hedging or managing the interest rate risk in respect of the ultimate debt interest
reasonable administrative and hedging costs “indirectly through one or more interposed entities”, and
hedging costs of a borrower in a conduit financing arrangement (the conduit rules previously only allowed for the recovery of hedging costs if incurred by the conduit financer in respect of the ultimate debt interest).

Fixed ratio test and excess tax EBITDA

The draft amendments released for consultation in October 2023 proposed a new concept of ’trust excess tax EBITDA’ which, broadly, would have allowed certain units trust to flow excess tax EBITDA of lower tier entities up a chain of trusts that used the fixed ratio test. In a welcome expansion, the amendments will see this concept expanded to other entity types including companies and partnerships, which will provide greater flexibility in choice of investment vehicles.

Broadly, the excess tax EBITDA for an income year of lower tier entities will be able to be included in the calculation of another entity’s (the controlling entity) tax EBITDA for that year if the following conditions are satisfied:

the controlling entity is an Australian company, resident unit trust, managed investment trust or partnership (where broadly half or more of its partners are resident)
the controlling entity is a is a general class investor (for all or part of the income year) and is using the fixed ratio test for the income year, and
the controlling entity has a direct control interest of 50% or more in the ‘controlled entity’ (i.e. the entity that transfers its excess tax EBITDA) at any time in the income year.

The controlled entity must also be an Australian company, unit trust, managed investment trust or partnership, a general class investor and using the fixed ratio test for its excess tax EBITDA to flow up to the controlling entity.

An excess amount transferred to a controlling entity will be taken into account when considering whether that controlling entity itself has an excess amount, which it can in turn transfer to another eligible controlling entity further up the chain. This amendment will ensure that most existing tiered structures, which are commonly used with trusts, will not be significantly disadvantaged if the debt is held in a different entity to that carrying on the operations generating tax EBITDA.

Entities that hold less than 10% in a lower tier entity will generally be permitted to include returns from that entity in tax EBITDA (either dividends, trust distributions or a share of partnership net income), and now entities that hold at least a 50% interest will be able to benefit from the excess tax EBITDA amount. However, entities that hold between 10% and just below 50% in an investment entity will not be able to benefit from either. This could have wide ranging implications for consortium investments.

Other amendments

The amendments also contain additional changes to the Bill, most of which were included in the draft amendments released for consultation in October 2023, including:

Changes to the calculation of tax EBITDA to:
- include new ‘add-backs’ for certain deductions relating to the forestry industry
- limit the adjustments for dividends to circumstances where the entity receiving the dividend is an associate entity of the company paying the dividend (with an interest of at least 10% in the company, in line with the treatment of partnership and trust distributions)
- require a corporate tax entity to assume it will utilise all of its available tax losses when calculating tax EBITDA, even where it does not ultimately choose to do so
- accommodate the calculation of tax EBITDA for Attribution Managed Investment Trusts (AMITs), and
- a new adjustment to subtract notional research and development (R&D) deductions of R&D entities.
Amendments to ensure that amounts disallowed under the fixed ratio test and carried forward are appropriately dealt with under the allocable cost amount (ACA) provisions for tax consolidated groups, specifically to reduce the entry ACA for both ‘owned’ and ‘acquired’ carry forward amounts.
Minor clarifications and amendments in relation to choices to use the various new tests.

Key takeaways

Now that we have what would appear to be the final elements of the law to implement the Government’s new interest limitation rules, all affected taxpayers should be working through the implications on their existing debt funding arrangements. Once the Bill and its amendments have completed their passage through both Houses of Parliament, the next stage will be enactment, which we expect will be forthcoming well before the end of this calendar year.

[Addendum (6 December 2023): On 5 December 2023, the Senate referred the Government’s proposed amendments to the Bill to the Senate Economics Legislation Committee for report by 5 February 2024. The Senate will not reconsider the Bill until after this report has been tabled. Accordingly, these measures will not be enacted until at least February 2024]

Contact us

If you would like to further discuss the amendments, reach out to our team or your PwC adviser.

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Final amendments to new thin capitalisation regime

Debt deduction creation rules

Third party debt test

Fixed ratio test and excess tax EBITDA

Other amendments

Key takeaways

Contact us

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