Financial services and the new interest limitation rules

17 March 2023 

In brief

On 16 March 2023, the Australian Treasury released for comment draft legislation (Exposure Draft) to introduce the previously announced changes to Australia’s interest limitation rules i.e. the thin capitalisation rules. New earnings based tests will replace the existing thin capitalisation asset-based safe-harbour and worldwide gearing tests for more taxpayers, for income years commencing on or after 1 July 2023. The arm’s length debt test will also be replaced with a more restrictive external third-party debt test.

Financial services entities that previously benefited from concessional thin capitalisation outcomes may no longer qualify, with the unexpected removal from the definition of “financial entity” those that are registered under the Financial Sector (Collection of Data) Act 2001. The new tests will require careful examination by financial services entities and we are seeing a range of scenarios, with some benefiting under the new tests but others facing significant headwinds in claiming ongoing debt deductions.

The Exposure Draft also proposes to remove interest deductions for borrowings to invest in an offshore subsidiary. If passed, this would have a material impact on financing across the market and presents particular challenges for outbound multinationals.

Despite specific recommendations being made by the OECD, no specific consideration has been given to the insurance sector, with the new earnings based rules having the potential to limit deductions, particularly in periods of volatility.

There are no changes for thin capitalisation rules that apply to authorised deposit taking institutions (ADI’s) (other than the impact of the repeal of the provision currently allowing deductions for borrowings to fund an offshore subsidiary).

The Exposure Draft legislation is open for consultation until 13 April 2023.

In detail

New interest limitation rules will replace the existing thin capitalisation safe harbour and worldwide gearing tests for most taxpayers for income years commencing on or after 1 July 2023.  A number of unexpected changes may have material impacts for the financial services sector, as a result of key definitional changes and restrictions on deductions that were previously available, in particular for investments in offshore subsidiaries.  

Broadly, under the new interest limitation rules, an entity’s debt-related deductions will be limited to 30% of tax EBITDA (earnings before interest, taxes, depreciation and amortisation). This will replace the existing safe harbour test (asset to debt ratio test). This is in line with the Organisation for Economic Cooperation and Development (OECD)’s recommended approach under Action 4 of the Base Erosion and Profit Shifting (BEPS) Action Plan. Financial entities will continue to be subject to the existing thin capitalisation rules unless they are “carved out” under the new limitations for entities registered under the Financial Sector (Collection of Data) Act (more details below).

Old law New law

Safe Harbour Debt Test (SHDT)

Interest deductions will be limited to 60% ratio of assets to debt

Fixed Ratio Test (FRT)

New “general class” investor’s net debt-related deductions will be limited to 30% of tax EBITDA (earnings before interest, taxes, depreciation and amortisation). Denied deductions may be carried forward for up to 15 years subject to satisfaction of an amended COT test.

Worldwide gearing ratio test

Group Ratio test (GRT)

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. No carry forward is available for denied deductions.

Arm’s length Debt Test (ALDT)

External third-party debt test (ETPDT)

Allows interest expenses to be deducted where those expenses are attributable to genuine third party debt (with some exceptions for financing entities) which is used wholly to fund Australian business operations with recourse only to the assets of the entity. No carry forward is available for denied deductions.

Section 25-90 / Section 230-15 

Deductions removed for debt deductions incurred to derive non-assessable non-exempt (NANE) income.

For a detailed breakdown of the Exposure Draft, please refer to our analysis here.

The example below is a simplified illustration of the proposed changes. 

Simplified example to illustrate the operation of FRT (vs SHDT)

Asset Cost







Interest rate 5%
Interest expense $25
Net debt deductions $25 (assuming nil interest income)
Thin Capitalisation Tests Safe Harbour Debt Test FRT
Thin Capitalisation Limit $600 (i.e. 60% X 1000) debt $18 (i.e. 30% X 60) net debt deductions
Interest denials Nil $7

Practical Implications to the Financial Services Sector

Registered Financial Corporations

A surprise change under the new rules affects entities that previously were classified as financial entities due to being a registered financial corporation under the Financial Sector (Collection of Data) Act 2001. Entities previously relying solely on this limb to the financial entity definition will no longer meet the definition of a financial entity under the new proposals. The Explanatory Memorandum to the exposure draft legislation explains this to be an integrity measure to restrict the application of concessional financial entity thin capitalisation provisions to a limited number of taxpayers. Accordingly, those taxpayers that no longer qualify as financial entities will be “general class investors” and subject to the general rules. 

Taxpayers affected by this proposed change should consider whether the remaining limbs to the financial entity definition are applicable in order to be excluded from the “general class investor” definition. Broadly, the remaining limbs include some limited types of securitisation vehicles and financial services licensees whose licences cover certain financial products, provided that the entity carries on a business of dealing in those products. 

Financial services taxpayers that do transition to the “general class investor” category may still find that their thin capitalisation position is supportable where (broadly) they are in a net interest income position.  For leasing companies it is unlikely that genuine lease income (as opposed to Division 240 and Division 250 deemed loan amounts) would be considered within the net interest concept, so the standard EBITDA ratios are likely to apply.

Alternatively, the third party debt test may be available. However, the rules need to be worked through carefully and generally speaking are more restrictive than the previous arm’s length debt provisions.  

Insurance companies

The amended definition of “financial entity” in the current draft legislation does not automatically include APRA regulated insurers and as such the new general rules will likely apply to insurers. 

In practice, insurers are subject to stringent regulatory capital requirements which limit the ability of insurers to have debt. Additionally, insurers typically have significant net interest income derived from investments in fixed interest securities and liquid assets rather than net interest expenses.  Where there is no net debt deduction (calculated under the proposed new statutory tests) then the new provisions are not expected to result in any denials of debt deductions.

However, some insurers (e.g. life insurers) are subject to significant swings in profitability, and hence EBITDA, due to the nature of their business. As such it will be important to appropriately monitor the impacts and consider the additional compliance costs to address the new provisions.

It is disappointing that the draft legislation has not specifically considered an exclusion for insurance companies more broadly in line with the OECD’s comments on BEPS Action 4.

Treasury companies and cash pooling

Structures that utilise a financing special purpose entity or treasury company with simple financing arrangements are not intended to be adversely impacted by the changes, subject to the comments below. 

For domestic finance entities and treasury functions, where there is no net debt deduction then the new provisions should not result in any denial of debt deductions.

For Australian entities that borrow from related offshore treasury or related parties, the Explanatory Memorandum to the Exposure Draft acknowledges that “conduit financier” arrangements are generally implemented to streamline the borrowing process of a group by allowing one entity in a group to raise funds on behalf of other entities in the group. As such, where the debt can be clearly traced to an external third party (i.e. there are simple back-to-back terms), the ETPDT can still be utilised for these arrangements. However, a treasury function in a structure with multiple on-lending is unlikely to pass the additional conditions to apply the ETPDT as the on-lending terms will not be identical. Below are 2 examples where the terms may differ:

  1. Treasury will be providing security over all of its assets and its subsidiaries whereas each subsidiary borrower is only giving security over its own individual assets, and

  2. There may be differences in the currency of funds in the context of multinational groups.

The conditions of the ETPDT seem to have been drafted under the assumption of a simple arrangement (one loan from the bank which is lent to a treasury function). Practically, financial services groups are more likely to have multiple financing arrangements and direct tracing would be difficult to achieve in order to satisfy the ETPDT conditions.

Australian entities which participate in group cash pool facilities are also unlikely to satisfy the ETPDT conditions in relation to amounts borrowed from the cash pool, even where the cash pool is administered by a third party financial institution.

Amounts economically equivalent to interest

Under the current thin capitalisation rules, the definition of a ‘debt deduction’ requires a cost to be incurred in relation to a debt interest issued by the entity. 

Under the proposed rules, an expanded concept of what a debt-like return is has been used to determine what is both income and a debt deduction for both the ‘net debt deduction’ and debt deduction rules.

The draft legislation proposes that the ‘debt deduction’ definition will be amended so that a cost does not need to be incurred in relation to a debt interest (as defined by Division 974)  issued by the entity in order to be treated as a debt deduction. The Explanatory Memorandum to the exposure draft legislation explains that, in effect, the concept of ‘debt deduction’ will be broadened to include both interest and amounts economically equivalent to interest in line with OECD best practice guidance.

No examples are given in the Explanatory Memorandum of what is intended to be captured in this expanded definition.

Although it is not expected that genuine lease income and net swap gains or losses (and associated fees) should be included in this expanded definition, detailed work will be needed to consider the application of the broader definition.  In relation to swaps in particular, the ATO has previously raised concerns in Taxpayer Alert TA 2016/3 on the use of cross currency swaps in a way that may give rise to thin capitalisation and withholding tax benefits - as such it will be important to appropriately consider whether the new provisions are intending to capture arrangements of this kind.

Repeal of sections 25-90 and 230-15

Sections 25-90 and 230-15 of the Income Tax Assessment Act 1997 are proposed to be amended so that they do not allow a deduction for interest expenses incurred to derive the NANE dividend income.  

The logic of this change is not entirely clear, particularly in the case of ADIs that remain subject to the current thin capitalisation rules, where they have their thin capitalisation capacity reduced by the investment in overseas subsidiaries (i.e. they are currently entitled to the debt deductions but take a reduction in their thin capitalisation capacity).

This change will also be particularly challenging for financial institutions with broad funding sources and a lack of direct allocations for investments to identify what portion of debt deductions, if any, are attributable to foreign investments.  

The Takeaway

With only a little over three months before the earliest start date (1 July 2023), there is not much time for taxpayers to assess the impact that the new measures will have on their capital structure - particularly given the unexpected changes that will impact those entities that will no longer benefit from the financial entity classification.  Our comments above reflect our early views and additional issues or considerations may arise as more is understood about the changes.

The loss of concessional treatment for some taxpayers, restrictions on deductions on foreign investments and real challenges in accessing the External Third Party Debt Test where group treasury companies are involved means that a number of financial services entities will need to quickly review their capital structures to ensure compliance with these new rules.

Sarah Hickey

Financial Services Tax Leader, Melbourne, PwC Australia

+61 2 8266 1050


Grant Harrison

Partner, Financial Services, PwC Australia

+61 402 897 597


Julian Pinson

Partner, Financial Services - Tax, Sydney, PwC Australia


Andrew Hirst

Partner, Financial Services, Sydney, PwC Australia


Samuel Lee

Partner, Financial Services, PwC Australia


Matt Osmond

Partner, Tax, Melbourne, PwC Australia

613 8603 5883


Liam Collins

Partner, Financial Services Leader - Financial Advisory, Melbourne, PwC Australia

+61 3 8603 3119


Grahame Roach

Partner, Financial Services, Sydney, PwC Australia

+61 2 8266 7327


Marco Feltrin

Partner, Tax, Melbourne, PwC Australia

+61 (3) 8603 6796


Raffaella Malkoun

Partner, Tax, Sydney, PwC Australia

+61 0408 100724