The proposed changes to the thin capitalisation rules in Treasury Laws Amendment (Making Multinationals Pay Their Fair Share - Integrity and Transparency) Bill 2023 (the Bill) were introduced into Parliament almost 4 months ago on 22 June 2023 and were intended to take effect from 1 July 2023. Notwithstanding the extensive consultation process preceding the introduction of the Bill, the enactment of the Bill was delayed as it was referred to the Senate Economics Legislation Committee upon its introduction into Parliament. The committee issued its report on 22 September 2023 with a recommendation the Bill be passed subject to technical amendments. Details of the proposed technical amendments were finally released for consultation in exposure draft legislation issued on 18 October 2023.
Although the changes proposed by the exposure draft are framed as ‘technical amendments’, they address several of the issues raised in previous submissions and, in some cases, represent significant (and positive) changes to the Bill as drafted. In this alert, we summarise the key changes contained in the exposure draft legislation.
Please refer to our previous commentary on the Bill, 'Targeting multinational tax integrity: changes to the thin capitalisation rules' .
When will the changes to the thin capitalisation rules apply from?
Once enacted, the changes will apply to income years starting on or after 1 July 2023 whether or not the relevant borrowings were entered into before, or on or after, that date. However, the exposure draft proposes that the ‘debt deduction creation rules’ (discussed below) will, in some cases, only apply to debt deductions for income years beginning on or after 1 July 2024.
Third party debt test - lender recourse
The ‘third party debt test’ denies a borrower’s debt deductions to the extent to which they exceed the borrower’s ‘third party earnings limit’. The third party earnings limit is calculated by reference to third party debt which satisfies certain conditions.
Concerns have been raised with one of the conditions specified in the Bill as drafted which requires that a lender must only have recourse to Australian assets held by the borrower and which are not rights under a guarantee, security or other form of credit support. Where the borrower is part of a group, it is not uncommon for a lender to take security over assets of other entities in the group, which would make the third party debt test practically unavailable in many cases.
The exposure draft partially addresses this concern by allowing a lender to have recourse not only to Australian assets held by the borrower but also to Australian assets held by an Australian entity that is a member of the ‘obligor group’ in relation to financing. The obligor group is defined as the borrower and any other entity whose assets the lender has recourse to.
In conduit financing cases, recourse can be had to assets of the conduit financier and borrowers.
The proposed changes, however, do not remove the requirement that a lender can only have recourse to Australian assets. If a lender has recourse to foreign assets of the borrower or another member of the borrower’s group, the third party debt test cannot be used. This will require appropriate structuring of security arrangements where the borrower is a member of a multinational group or holds foreign assets. Alternatively, a borrower could seek to rely on the fixed ratio test or the group ratio test to determine its maximum debt deductions.
The exposure draft also proposes that a lender will be permitted to have recourse to membership interests (e.g. shares or units) in a borrower with the exception where the borrower has a direct or indirect interest in foreign assets.
A lender will still not be permitted to have recourse to guarantees, security or other forms of credit support unless those rights wholly relate to the creation or development of land or other real property situated in Australia and, as proposed by the exposure draft, the creation and development of certain moveable property situated on the land. Moveable property is property that is incidental to and relevant to the ownership and use of the land, and situated on the land for the majority of its useful life.
Debt deduction creation rules
The debt creation rules were a surprise inclusion in the Bill when it was introduced in June. Under the proposed debt deduction creation rules, there are two scenarios in which debt deductions can be denied, this being where:
an entity borrows to acquire an asset (or an obligation) from an associate (first scenario ); and
an entity borrows from an associate to fund a payment it will make to that entity or another associate (second scenario ).
Under the Bill as drafted, these rules will not apply to taxpayers who are not subject to the thin capitalisation rules because their debt deductions are $2 million or less. The exposure draft proposes that special purpose vehicles (i.e. insolvency-remote vehicles), authorised deposit taking institutions and securitisation vehicles will also fall outside the scope of these rules.
Furthermore, to ensure the debt deduction creation rules are appropriately targeted, a new related party debt condition must now also be satisfied for the debt deduction creation rules to apply in either scenario. In order for the rules to apply, the relevant entity’s debt deduction must now be paid or payable, to an associate of the entity. This is a key change from the Bill as the first scenario potentially applied to deny debt deductions in respect of any borrowings whether from an associate or an unrelated lender.
The exposure draft also proposes three exceptions to the first scenario:
The acquisition of a new membership interest in an Australian entity or foreign company. For example, if an entity borrows to subscribe for shares in an Australian company, the first scenario will not apply;
The acquisition of certain new tangible depreciating assets;
The acquisition of certain debt interests which are issued by an ‘associate pair’ of the acquirer. This is to ensure that mere related party lending is not caught by the rules.
There are also two exceptions proposed in relation to the second scenario:
A payment that is entirely referable to mere on-lending to an Australian associate on the same terms; and
A payment that is entirely referable to the repayment of principal under a debt interest.
As noted earlier, a transitional rule is proposed whereby the debt deduction creation rule will not apply to debt deductions that relate to financial arrangements entered into before 22 June 2023 until the income year commencing on or after 1 July 2024. This proposed change is welcome given there was no grandfathering previously provided for in the Bill.
Fixed ratio test - calculating tax EBITDA
The fixed ratio test is the default test to determine maximum debt deductions under the thin capitalisation rules. Under this method, debt deductions for an income year will be capped at 30% of ‘tax EBITDA’. The main changes proposed by the exposure draft are:
Under the Bill as drafted, dividends and franking credits are not included in calculating tax EBITDA. The exposure draft now clarifies that dividends are disregarded from tax EBITDA only where, broadly, the entity receiving the dividend is an ‘associate entity’ of the company paying the dividend;
Deductions relating to forestry and establishment costs and in relation to the capital costs of acquiring trees will be added back in working out tax EBITDA. This is to allow for a more appropriate application of the fixed ratio test to plantation forestry entities whose earnings are subject to longer lead times;
Notional deductions for R&D expenditure will be subtracted from tax EBITDA to ensure there is no double benefit where taxpayers are already entitled to the R&D tax offset;
New provisions will be introduced to ensure that tax EBITDA can be appropriately calculated for attribution managed investment trusts and their members;
Certain unit trusts and managed investment trusts will now be permitted to transfer excess tax EBITDA amounts to other eligible unit trusts. The transferee trust will be required to have a direct interest of at least 50% in the transferor trust. This change will be of relevance to the funds management sector where structures involving multiple tiers of trusts are utilised to invest in certain asset classes (e.g. property).
Other changes to thin capitalisation rules
Some other proposed changes in the exposure draft include the following:
Under the Bill, where a borrower makes a choice to apply the third party debt test, ‘associate entities’ of the borrower who are members of the ‘obligor group’ will also be deemed to have made the choice to apply the test.
As noted earlier, a member of an obligor group is an entity whose assets a lender has recourse to. However, it is proposed that if a lender only has recourse to assets of an entity which are membership interests in the borrower, that entity will not be a member of the obligor group.
A further proposed amendment will also clarify that a creditor does not need to have recourse to all assets of an entity for that entity to be an obligor entity (i.e. it will be sufficient for recourse to be had to one or more assets of the entity).
Interest rate swap costs may be deductible under the third party debt test.
Amendments are proposed which will confirm that trusts and partnerships can rely on the third party debt test.
Key takeaways
Consultation on the exposure draft closes on 30 October 2023. However, we note that the proposed changes are generally positive, in particular those which broaden the scope of the third party debt test and narrow the scope of the debt deduction creation rules.
We remain cautiously optimistic that this will be the final round of proposed changes which will hopefully provide taxpayers with the certainty they need to appropriately structure (or restructure) their financing arrangements in light of the changes to the thin capitalisation rules.
Please contact one of our tax experts if you would like to discuss how the proposed changes to the thin capitalisation rules, and more broadly, the multinational tax integrity changes, may impact you.