December 15, 2023
Australian thin capitalization changes and new subsidiary disclosure rules — December 2023 update
The Australian Parliament still has not passed retrospective changes to Australia's debt (interest) deduction limitation rules. The Senate referred the proposed Government amendments to the June 2023 Bill to the Senate Economics Legislation Committee (SELC) on 5 December 2023 for inquiry and report by 5 February 2024 (in Treasury Laws Amendment (Making Multinationals Pay Their Fair Share — Integrity and Transparency) Bill 2023 (the Bill)).
The proposed Government amendments follow an exposure draft (ED) of proposed amendments that Treasury released for consultation in October 2023 and submissions in response by EY and others.
Changes to the thin capitalization rules are still proposed to apply for income years commencing on or after 1 July 2023.
The government amendments propose to defer the debt deduction creation rules by a year to apply for income years commencing on or after 1 July 2024. Once the rules commence, they may apply to arrangements that occurred on or before and from 1 July 2024.
This EY Global Tax Alert summarizes the expected final rules for the thin capitalization and debt deduction creation rules on the assumption that the proposed Government amendments are made. Note however that there may be further changes to those proposals and the Bill as a result of the additional SELC process.
Notwithstanding the many proposed changes, many issues raised have not been addressed, which could lead to more complexity in complying with the rules and unexpected and unintended outcomes for affected entities.
The Bill also introduces new Corporations Act requirements for Australian public companies (listed/unlisted) to disclose information about their subsidiaries in their annual financial reports, notably including their tax residency. This proposal, effective for financial years commencing on or after 1 July 2023, also requires declarations that the disclosure is "true and correct" and that the company auditor has signed these off.
There are no proposed government changes to the disclosure of subsidiary information measures and they are not the subject of the new SELC inquiry. As such, affected groups should start to collect the information required for their subsidiaries, especially for foreign subsidiaries incorporated overseas. Analysis of Australian and non-resident tax residency rules may be required.
Impacted groups will want to analyze the expected final form of the thin capitalization rules and model what the impacts may be for the current year.
Consideration should be given as to whether one of the alternative calculation methods — the third-party debt test or the group ratio test — may result in a better outcome than the default 30% of tax earnings before interest, taxes, depreciation and amortization (EBITDA) fixed-rate method.
New transfer pricing analysis will be required for cross-border financing arrangements before applying the fixed-ratio or group-ratio tests, to test both the appropriate amount of debt and the applicable interest rate.
The complex debt deduction creation rules are broadly drafted and will require extensive analysis to identify any current or previous transactions and arrangements that are impacted; note, however, that the proposed Government amendments to the Bill do narrow the types of payments and distributions that will fall within the scope of the rules.
Detailed consideration of the revised thin-capitalization and new debt-deduction creation rules must also be factored into all new financing decisions of affected entities. The delay in passing the Bill causes much uncertainty for taxpayers trying to assess the tax implications of many current transactions.
Financial entities and authorized deposit-taking institutions (ADIs) will continue to be subject to the existing thin capitalization rules; however, the third-party debt test replaces the arm's-length debt test for financial entities that are not ADIs.
Debt deduction creation
The Bill reintroduces debt deduction creation rules some 20 years after the former debt creation rules were repealed. The debt deduction creation rules were first included in the 22 June 2023 Bill introduced into Parliament and were not the subject of any previous Government announcement or consultation. Many of the submissions indicated the adverse outcomes that could arise from the draft rules and, while the rules' design has now improved significantly, they continue to cause concerns.
Although the Government's proposed amendments to the Bill include some positive changes to the debt deduction creation rules, a number of issues raised and recommendations made in response to the October ED were not taken up.
The debt-creation rules apply prior to the thin capitalization rules. As such, an entity's debt deductions must first be considered under the debt deduction creation rules and, if applicable, reduced before applying the thin capitalization rules.
The new rules are intended to deny debt deductions in income years commencing on or after 1 July 2024 (deferring the start date by a year) irrespective of when the debt or financial arrangement was entered into if the relevant debt is still in existence and was used as part of a debt creation arrangement.
The debt deduction creation rules apply to two broad scenarios:
There are certain exemptions to the rules, such as borrowings to purchase newly issued shares in an Australian or foreign company (unless this is an indirect way of acquiring prohibited assets via the intermediate company).
Exemptions also apply for the acquisition of depreciating assets, debt interests or Australian currency, but surprisingly, not for the acquisition of trading stock.
The debt creation rules apply to all taxpayers that are subject to the thin capitalization rules and the only taxpayers excluded from the rules are those who satisfy the de minimis test for debt deductions of AUD$2m or less (on an associate inclusive basis), those who choose to use the third-party debt test in a particular year for thin capitalization purposes (since the debt deduction rules essentially apply only to related-party debts) or taxpayers that are insolvency remote special purpose entities, securitization vehicles or ADIs.
Notably, the rules include a specific anti-avoidance provision designed to address schemes seeking to avoid the debt creation rules. The anti-avoidance rule applies a "principal purpose" test rather than the higher threshold "dominant purpose" test and may readily impact any attempts to sidestep the application of the rules, including possibly, the pooling of cash resources to make a related-party acquisition followed by borrowing to fund operating outgoings. This anti-avoidance provision may also be problematic for taxpayers who might seek to reorganize their affairs either before the commencement of the rules or thereafter.
While the Supplementary Explanatory Memorandum to the proposed amendments to the Bill suggests that this specific anti-avoidance rule will not be applied where a taxpayer is "merely restructuring, without any associated artificiality or contrivance, out of an arrangement that would otherwise be caught by the debt creation rules," the actual legislation does not say that.
As a result, it is possible that a third-party loan, which would not normally be within the scope of the debt creation rules, taken out to repay the related-party financing, could fall foul of the rules. It is also possible that the pooling of cash resources from operations or other transactions, which is then used to repay the related-party financing, could also be problematic if it is accompanied by a new related-party loan used for non-prohibited purposes.
The drafting of the rules, including the lack of any tax avoidance purpose test in the main operating provision, means the rules will have application to a broad range of transactions.
Changes to Australia's thin capitalization rules were a 2022 Budget announcement to implement Labor's 2022 election policy.
The Bill replaces the current asset-based rules for "general class investors" (i.e., non financial entity/authorized deposit-taking institution (ADI)), with three alternative new tests, intended to more closely follow the OECD's base erosion and profit shifting (BEPS) project's best practice guidance:
A key feature of the fixed ratio test is the carryforward of denied deductions for up to 15 years, where a modified continuity of ownership test or business continuity test is met for companies or modified trust loss rules for trusts.
Entities/groups must elect to use the group ratio test or third-party debt test for the financial year in the approved form, however, once the choice is made for an income year it can only be revoked in limited circumstances and within four years after a taxpayer lodges, or is required to lodge, their income tax return for the income year. The fixed ratio test is the default if no choice is made.
For transfer pricing purposes, a crucial change means that the Australian Tax Office (ATO) can now challenge whether the amount of debt subject to the earnings based rules is an arm's-length amount of debt, even when it is within the 30% of tax EBITDA under the fixed ratio test (or equivalent under group ratio test).
This debt capacity analysis is a new feature introduced by the new thin capitalization laws, which previously did not require transfer pricing assessments of debt quantum where the debt was within the safe harbor debt amount or the worldwide gearing debt amount.
The debt creation rules are applied first to reduce debt deductions before applying the thin capitalization rules.
General class investor
The new thin capitalization provisions will apply to general class investors, which amalgamates the existing general classes of entities, ensuring the new tests apply to:
Financial entities (as per the amended definition, see below) and ADIs will continue to be subject to the existing thin-capitalization rules however the third-party debt test replaces the arm's-length debt test for financial entities that are not ADIs.
Definition of financial entity
Paragraph (a) of the definition of financial entity in subsection 995-1(1) is amended to include two additional conditions for entities that are a registered corporation under the Financial Sector (Collection of Data) Act 2001 (Cth). These conditions require that the entity be carrying on a business of providing finance (but not predominantly to associates) and that it derives all or substantially all of its profits from that business.
Entities that satisfy the requirements of the amended definition will remain subject to the existing thin capitalization rules.
Exemptions from thin capitalization
Debt deduction definition
The section 820-40 definition of debt deduction is amended so that a cost incurred by an entity does not need to be incurred in relation to a debt interest issued by the entity for that cost to be a debt deduction. The change will bring more deductions into the thin capitalization net for potential disallowance including amounts economically equivalent to interest, in line with OECD best practice guidance. This expanded definition of "debt deduction" may therefore include costs such as guarantee fees, arranger fees and other costs related to financing arrangements that were not previously treated as a debt deduction. Subsection 820-40(3)(a) will also be repealed to ensure that interest rate swaps are included within the definition of "debt deduction."
For both the fixed ratio test and group ratio test, a "net debt deductions" definition applies, which involves:
This change will bring more deductions into the thin capitalization net for potential disallowance including amounts economically equivalent to interest.
Transfer pricing and thin capitalization interaction
The Bill amends the Division 815 transfer pricing rules to remove the exclusion from applying the arm's-length conditions in relation to the quantum of the debt interest, which applies in the current thin capitalization rules applicable in determining the maximum allowable debt, for "general class investors."
Before applying the new earnings-based thin capitalization tests, the arm's-length conditions will need to be assessed from a transfer pricing perspective, including both the appropriate amount of debt and the applicable interest rate. Consequently, the fixed ratio test/group ratio test do not automatically allow net debt deductions up to the calculated threshold (i.e. the ratio tests represent an ultimate ceiling or cap and not a safe harbor). This is a significant deviation from the historical thin capitalization provisions, which did not require a separate transfer pricing analysis to assess the quantum of debt, where this was within the asset-based safe harbor limit.
The analysis that will be required to support the debt quantum will be analogous in many ways to the economic assessment of an arm's-length capital structure, which was required under the former arm's-length debt test in Division 820. This would typically involve an analysis of borrowing capacity with reference to relevant financial ratios that an independent lender would consider, as well as debt/equity and risk profile that would be acceptable in the market. In this context, taxpayers need to be mindful that this analysis will be expected to consider a range of financial ratios relative to comparable industry peers, such as: interest cover, debt service cover, Debt to EBITDA and Debt to Equity. The analysis may also extend to the overall structure of debt finance (e.g., subordination) as part of the arm's-length conditions.
This analysis is potentially complex and may be onerous for taxpayers seeking to document their self-assessment position for transfer pricing purposes in relatively conservative gearing scenarios. It is unclear at this stage whether the Commissioner of Taxation will subsequently release any Practical Compliance Guidelines, which would assist taxpayers in documenting low-risk scenarios, where a comprehensive analysis would be overly burdensome relative to the risk profile of the debt.
Fixed ratio test
The fixed ratio test will be the default test for general class investors who have not made a choice to apply either the group-ratio test or the third-party debt test. Under the fixed ratio test, an entity's net debt deductions will be capped at 30% of its "tax EBITDA" (fixed-ratio earnings limit).
A number of proposed amendments to the tax EBITDA calculation are included in the summary below.
An entity's tax EBITDA will be calculated as follows:
There are specific taxable income/tax loss rules to account for trusts, attribution managed investment trusts and partnerships.
Carryforward tax losses
One of the major proposed changes to the Bill is that in calculating the tax EBITDA for a corporate tax entity, it is to be assumed that the entity made a choice to use all of its prior year tax losses (irrespective of whether the entity actually made such a choice). It would seem that this adjustment disregards any limitations that may otherwise apply to the amount of prior year losses that can be utilized by the entity in an income year (e.g., an available fraction limitation for transferred tax losses of a tax consolidated group).
This adjustment may mean that a prior-year tax loss (unless fully utilized in the immediately following income year) may be applied in more than one income year to reduce an entity's tax EBITDA — in the income year(s) in which the entity is deemed to have used its loss and in the income year in which it actually chooses to use the loss.
Notional R&D deductions
The Bill also proposes that entities that have made research and development (R&D) offset claims under Division 355 of the ITAA 1997 will be required to subtract an amount from their taxable income/tax loss equal to the notional R&D deduction that was otherwise treated as a nondeductible expense. The reason for this change is that an entity applying the fixed ratio test would receive a double benefit of the R&D tax offset and disregarding the notional R&D deductions in calculating its tax EBITDA.
Distributions from companies, trusts and partnerships
A key element of the tax EBITDA calculation for non-consolidated groups requires certain adjustments to an entity's taxable income/loss to exclude distributions from investee entities as follows:
The "associate entity" test for these adjustments only requires a thin capitalization (TC) control interest of 10% or more. The requirement that the entity be an "associate" (per section 318 of the ITAA 1936) of the investee entity is disregarded unless the investee entity is only an associate entity by virtue of paragraph 820-905(1)(b) (sufficient influence test). This is a very low threshold for the application of these adjustments.
Excess tax EBITDA amount
A positive proposed change from the original Bill is the ability to transfer "excess tax EBITDA" between "eligible entities." This (in part) alleviates the reduction in an entity's tax EBITDA due to disregarding distributions from investee entities (as noted above). However, the ability to transfer excess tax EBITDA only applies where an entity holds a direct interest of 50% or more in the investee entity (which will be more restrictive than the current "associate entity excess amount" calculation for certain entities).
The eligible entities (both the "controlling entity" and the "test entity") are:
In addition, the eligible entities must be general class investors for all or part of the income year and must apply the fixed ratio test. Further, the controlling entity must hold a TC direct control interest of at least 50% in the test entity at any time during the income year.
Where these requirements are met, the test entity's excess tax EBITDA is transferred to the controlling entity based on the controlling entity's average TC direct control interest in the test entity for the income year. If the controlling entity has an interest of less than 50% in the test entity on a particular day, that day is excluded in calculating the average TC direct control interest for the income year.
The excess tax EBITDA amount can be transferred through a tier of entities provided the above conditions are satisfied. This will be of benefit to structures where the debt is issued at a different level to where the operational activities occur.
The final fixed ratio test may create issues, in particular for entities which have debt funded investments in companies, tax partnership joint ventures and in unit trusts (including managed investment trusts (MITs) and attribution managed investment trusts (AMITs)) with ownership between 10% and 50% (or where the direct TC control interest requirement for allowable transfer of excess tax EBITDA is not met).
Fixed ratio test disallowed amount
Debt deductions previously disallowed under the fixed ratio test (FRT disallowed amount) may be carried forward for 15 years (subject to satisfying certain conditions) and will be deductible in a subsequent year if the entity's net debt deductions are less than the fixed-ratio earnings limit in that year.
The entity will need to apply the fixed ratio test in all relevant income years to be able to deduct any FRT disallowed amount in a later income year. If a choice is made to use either the group-ratio test or the third-party debt test in an intervening income year, the FRT disallowed amount is deemed to be zero and therefore will not be carried forward.
The FRT disallowed amount will be treated in much the same way as a tax loss. Companies will have to satisfy either a modified continuity of ownership test (COT) or modified business continuity test (BCT) to be able to utilize the FRT disallowed amount in a later year.
Trusts will need to satisfy a modified version of the trust loss rules.
FRT disallowed amounts may be transferred to the head company of a tax consolidated group on joining or formation, applying either a modified COT or modified BCT as a transfer test (similar to the transfer of a tax loss). The FRT disallowed amount is transferred to the head company at the joining time if the joining entity could have deducted the FRT disallowed amounts in respect of the "trial year." As with the loss transfer tests in the tax consolidation provisions, the trial year is generally the period starting 12 months before the joining time and ending just after the joining time.
The 15-year period for using the FRT disallowed amounts is not refreshed when transferred to the tax consolidated group. However, for the purposes of applying the modified COT or modified BCT going forward, the head company is deemed to have acquired the FRT disallowed amounts at the joining time.
The head company may irrevocably choose to cancel the transfer of an FRT disallowed amount.
The joining entity's allocable cost amount (ACA) for tax cost setting purposes will be reduced as follows:
The FRT disallowed amount stays with the consolidated group if that entity leaves the group.
Group ratio test
Entities are able to elect to use a worldwide group ratio test for a year, although there are extensive eligibility conditions to consider. There is no carry-forward of denied deductions under this test. No changes are proposed to the Bill for this test.
The group ratio test allows an entity in a highly leveraged group to deduct net debt deductions in excess of the amount permitted under the fixed ratio rule, based on a relevant financial ratio of the worldwide group.
If the group ratio test applies, the amount of debt deductions of an entity for an income year that are disallowed is the amount by which the entity's net debt deductions exceed the entity's group ratio earnings limit for the income year, where the limit is equal to its group ratio multiplied by its tax EBITDA.
The entity's group ratio is its GR group net third-party interest expense divided by the GR group EBITDA of the GR group (if zero or less then the ratio is zero).
The calculation relies on information in audited consolidated financial statements for a worldwide parent entity or global financial statements for a global parent entity. This creates the potential for volatility in calculations and the rules may be very difficult to apply in practice.
Some particular definitional features of the group ratio calculation include:
The definition of associate entity for this test is modified to be determined based on a 20% or more TC control interest, reduced from the current 50% associate interest threshold. The modified "associate entity" definition will mean more entities will have interest payments made to an associate entity disregarded and this could also be difficult to track.
Third-party debt test
As with the group ratio test, entities are able to elect to utilize the third-party debt test for a year, but any disallowed interest cannot be carried forward for use in later years. Amendments to the Bill extend eligibility to use the rules to partnerships and trusts.
The third-party debt test allows all debt deductions attributable to third-party debt that satisfies certain conditions.
The conditions include:
Proposed changes to the Bill extend the recourse of assets' conditions to include more Australian assets, such as:
Changes were also made to disregard recourse to minor or insignificant assets.
Conduit financer arrangement rules may allow associate entity debt to qualify in some circumstances where the conduit financier's debt interest (to an "ultimate lender") satisfies all the third-party debt conditions and the on-lending to the associate is on the "same terms" that relate to costs as the debt interest issued to the ultimate lender. Amendments to the Bill now focus on the terms of a relevant debt interest that relate to costs incurred by the borrower, rather than costs incurred by any entity, and the associated ultimate debt interest that relate to costs incurred by the conduit financer, rather than costs incurred by any entity.
Further amendments to refine the conduit financing measures are proposed, to clarify their operation, ensure intended outcomes and provide some flexibility in how the provisions operate.
Deferral of section 25-90 changes
Following its (unexpected) inclusion in the original Exposure Draft law, the Explanatory Memorandum to the Bill announced the "deferral" of the proposed amendment of section 25-90 ITAA 97 (and section 230-15), to remove the reference to section 768-5 which operates to treat interest expenses incurred to derive non-assessible non-exempt (NANE) income as deductible (e.g., dividends from foreign subsidiaries), following government consideration of stakeholder concerns regarding its potential application. The EM states that the proposed amendment is instead to be considered via a separate process, hopefully involving broad and meaningful consultation with industry and impacted taxpayers, albeit with no current guidance as to timing, scope, etc.
In the meantime, however, taxpayers will need to consider the impact of the targeted debt creation rules (see above) which have been (per the Government) progressed in its place and presumably designed to address some of the concerns regarding section 25-90.
There appears to be significant overlap between the two proposals, which could mitigate the impact of the deferral, as well as uncertainty as to whether the proposal has been replaced or merely deferred. This overlap might occur, for example, where an Australian MNE acquires a foreign subsidiary from a foreign related party with the purchase funded by way of interest-bearing related party debt.
New disclosure of subsidiary information including tax domicile in June 2024 and later financial reports
New Corporations Act requirements for Australian public companies (listed and unlisted) to disclose information about their subsidiaries in their annual financial reports will apply for financial years commencing on or after 1 July 2023.
Hence, these new disclosures will therefore first apply to 30 June 2024 year-end reports.
Covered groups should commence work well in advance of year-end to prepare these disclosures, which could require detailed technical analysis and documentation of the tax residency of multiple foreign incorporated group companies as well as documentation sufficient to enable both their officers and auditors to sign off on the disclosure.
New financial report disclosures
If the accounting standards require the public company to prepare financial statements in relation to a consolidated entity, the "consolidated entity disclosure statement" in the company's annual financial reports must provide the following information in relation to entities within the consolidated entity:
A public company is defined in the Corporations Act and is generally a company other than a proprietary company or a corporate collective investment vehicle.
Public companies that are not subject to the rule (i.e., no consolidated statements) must state this in their annual financial report.
Importantly the new disclosure requirements are not subject to any de minimis type threshold and groups will need to provide details for all group entities including dormant companies or entities with minimal trading activities.
New declarations required
In addition, the director's declaration and the declaration in relation to listed entity's financial statements by the chief executive officer and chief financial officer must each include a new statement whether, in the opinion of the directors/chief executive and chief financial officers, the consolidated entity disclosure statement is "true and correct." This is a higher standard than the "true and fair" standard which generally applies to financial position or performance under the current law.
Determination of tax residency
Covered Australian public companies with foreign incorporated companies and other entities in their group will therefore need to first consider the Australian Income Tax Act residency tests to determine whether those entities are Australian residents. Entities that do not qualify as Australian residents will then need to perform additional work to determine where the entities' tax residency is, whether, for example, it is in the country of incorporation or another jurisdiction under the laws of that foreign country.
For foreign incorporated companies, the ATO's views on central management and control in its public rulings will be relevant to this analysis. While the ATO's practical compliance guides (including risk framework) should also usually be considered, these administrative approaches will not be determinative for these purposes.
Consider if additional information should be provided
Covered groups should consider whether it might be appropriate to provide additional information in their financial reports to give readers appropriate context for how entities with a tax residence other than Australia are used in the group, so that this new information is not misinterpreted.
Affected groups will want to address a variety of issues raised by these complex new provisions, including analyzing them, modeling impacts, considering alternatives going forward, and conducting a transfer pricing analysis to support an arm's-length capital structure/debt capacity for companies seeking to apply the fixed ratio test or group ratio test.
Groups will also want to consider analyzing current related-party debts that are within the scope of the new debt deduction creation rules, as these measures have a retrospective element. Analyzing the tax residency of subsidiaries as part of workstreams to comply with the new financial report subsidiary disclosure requirements and alternatives going forward may also be necessary.
For additional information with respect to this Alert, please contact the following:
Ernst & Young (Australia), Sydney
Ernst & Young (Australia), Brisbane
Ernst & Young (Australia), Adelaide
Ernst & Young (Australia), Melbourne
Ernst & Young (Australia), Perth
Ernst & Young LLP (United States), Australian Tax Desk, New York
Ernst & Young LLP (United Kingdom), Australian Tax Desk, London
Published by NTD’s Tax Technical Knowledge Services group; Carolyn Wright, legal editor