Treasury has recently released exposure drafts of proposed amendments to the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share—Integrity and Transparency) Bill 2023 – a bill which seeks to overhaul the existing Australian thin capitalisation regime. The proposed amendments provide welcome guidance on the scope and application of the thin capitalisation and the debt deduction creation rules, as well as some technical amendments necessary for the implementation of the legislation. For further guidance on the proposed changes, of the thin capitalisation rules, please refer to our previous article.
We note these provisions are in draft consultation format only - however given the progress of these bills through the legislative and consultative process we anticipate these provisions are close to finalisation.
Once enacted, changes to the thin capitalisation provisions will apply from 1 July 2023, with a one-year transitional rule being introduced for debt arrangements entered before 22 June 2023 (when the debt deduction creation rules were first announced).
The most significant changes announced in the proposed amendments relate to a debt deduction creation rule, which is intended to apply for income years commencing on or after 1 July 2023 for all new debt arrangements, and with a one year delayed start date (i.e. income years commencing on or after 1 July 2024) for debt arrangements entered into before 22 June 2023.
In broad terms, the debt deduction rule operates to deny debt deductions where the underlying debt is:
As drafted, these rules should apply only to multinationals with total debt deductions of more than AU$2 million on an associate inclusive basis.
When these rules were first announced, there was significant commentary and criticism regarding the overly broad application of the rules compared against the policy intent of the provisions. The Explanatory Memorandum accompanying these rules stated that the provisions were intended to address the risk of excessive debt deductions being claimed by entities “by disallowing debt deductions to the extent that they are incurred in relation to debt creation schemes that lack genuine commercial justification”.
However, it was apparent the operative provisions of the legislation itself did not include any tests for determining whether a scheme in fact lacked genuine commercial justification’ and did not include any purpose test in relation to this matter. Given the significant criticisms provided in the various submissions made to the Senate Committee, amendments have been made to the proposed debt deduction creation rule which alleviate some, but far from all, of the concerns raised in the original draft legislation.
A key change has been made to require the debt deduction creation rule to apply only where the debt deductions are paid to an associate pair of the entity, which effectively excludes third party debt from the scope of these provisions. This change significantly reduces the scope of the provisions and provides some welcome relief for entities with existing third party debt arrangements which may otherwise have had debt deductions disallowed under these provisions.
Further, in respect of the first limb (where debt is used to fund the acquisition of a CGT asset or a legal or equitable obligation from an associate), the following exceptions to the debt deduction creation rule are introduced:
In respect of the second limb (where debt is used to fund payments to associates), the following key changes were made:
In addition, the debt denial is now disallowed on a proportionate basis. In this regard, it is only to the extent the debt deduction relates to the disallowed purpose that any corresponding amount will be disallowed. This should continue to provide some allowability of debt deductions where borrowing is undertaken for multiple purposes and where only one such purpose is disallowed under the debt deduction creation rules.
Moreover, the proposed amendments provide that the debt deduction creation rules should apply prior to the other thin capitalisation provisions in Division 820. As such, any potentially eligible debt expenses should first be reviewed under the debt deduction creation rules to determine whether they are disallowed under those provisions. To the extent any such amounts are disallowed, they are disregarded in the application of the remaining thin capitalisation provisions.
Further, under the proposed amendments ADIs, securitisation vehicles and certain special purpose entities are excluded from the debt deduction creation rules altogether. Other amendments are also proposed to be made in relation to certain definitions, including relevantly modifying the ‘associate pair’ definition to apply to unit trusts and modifying the definition of ‘Australian entity’ to now include trusts and partnerships.
Taken together, these changes provide much needed limitation on the scope of the debt deduction creation rules which would otherwise have significantly reduced the ability to claim debt deductions in respect of ordinary funding arrangements
The Tax EBITDA, which will form the basis of determining the allowable debt deductions for entities subject to the fixed ratio test of thin capitalisation provisions, now includes the addback of two additional deductions relevant to the forestry industry.
Further, the tax EBITDA calculation now includes clarification as to how entities which are capable of applying tax losses are required to factor in these amounts as part of the tax EBITDA calculation. The proposed amendments now require a corporate tax entity that has a choice as to whether to utilise its losses to assume the entity will choose to deduct all tax losses, even if it has not actually claimed the relevant losses in its current year tax return. This change effectively limits the capability of entities to manage their thin capitalisation outcomes through the utilisation of losses and can, in some instances, bring forward testing requirements for entities with untested carry forward tax losses to confirm whether they are required to be deducted in determining the tax EBITDA for thin capitalisation purposes.
Other changes to the calculation of the tax EBITDA for the purposes of the fixed ratio test include:
In addition to the above changes, further amendments have been made to the third party debt test which effectively operates to expand the types of debt which these provisions could apply to. The key changes are broadly summarised below:
Notwithstanding the additional clarification of these rules and the introduction of some exceptions, there remain a number of outstanding issues applicable to the debt deduction creation rules. In particular, while a grace period has been introduced for pre-22 June 2023 arrangements, there continues to be no grandfathering of historical arrangements. Given this, historical transactions which previously provided debt deductions for entities may be subject to disallowance in future years due to the retrospective operation of these rules.
The limitation of the rules to related party debt only is a welcome change in limiting the scope of provisions which were almost universally perceived as significantly broad and overreaching. However, there continues to be no purpose test in determining whether the debt deduction creation rule may apply notwithstanding the specific Explanatory Memorandum comments that the rules should only apply where the relevant scheme lacks genuine commercial justification.
Accordingly, the grace period afforded for pre-22 June 2023 financial arrangements should be used to its full extent by affected taxpayers to consider the implications of any affected arrangements, and any alternatives, prior to the deduction denials commencing in the 1 July 2023 and subsequent income years.
From a transfer pricing perspective, given the proposed changes, taxpayers receiving funds from international related parties will no longer be able to rely on the existing thin capitalisation tests to support the quantum of debt borrowed. Additional transfer pricing analysis will therefore be required to confirm that the quantum of debt is considered arm’s length under the new rules.
As noted, these provisions are in draft consultation format only. However, immediate action should be taken by affected taxpayers to:
Our expert team at Crowe is able to assist you as needed in determining the implications of these proposed changes. Complete our online form today and a member of the team will contact you shortly.
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