Bill for new thin capitalisation regime introduced
Following consultation to the Exposure Draft legislation earlier this year, the Government has now introduced the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share – Integrity and Transparency) Bill 2023 (the Bill) which details significant reforms to the thin capitalisation regime.
Introduced into Parliament on 22 June 2023, the Bill is in line with the Government’s commitment to address tax avoidance practices of multinational enterprises and streamline with (OECD) best practice guidelines. There are some important distinctions from the Exposure Draft legislation, which SW detailed here in March.
From 1 July 2023, the new proposed thin cap provisions will replace the existing rules and limit the amount of interest deductions for certain entities. The Bill has been referred to the Senate Economics Legislation Committee for review, which will complete on 31 August 2023. This means that final legislation may not be released before September 2023.
Who do the new thin cap rules apply to?
The new regime applies to:
- foreign controlled taxpayers and taxpayers with foreign operations. These remain broadly unchanged from the existing rules
- only applies to general investors and, in part, to financial entities
- certain exemptions will continue to apply – including the $2 million (debt deduction) de minimis exemption.
What are the new tests?
The new regime’s safe harbour will be broadly based on the taxpayer’s current year taxable income – instead of the current safe harbour which is based on a taxpayer’s balance sheet.
The new safe harbour will be known as the Fixed Ratio Test (FRT). The FRT will limit interest deductions to 30% of a taxpayers Tax EBITDA. The Tax EBITDA will broadly be calculated as a taxpayer’s taxable income adjusted for interest deductions, tax depreciation and certain distributions received. Any non-deductible interest can be carried forward for 15 years.
Two other tests will be available:
- The Group Ratio Test (broadly replacing the worldwide gearing test)
- The Third Party Debt Test (broadly replacing the arm’s length debt test).
The Group Ratio Test will apply to disallow interest deductions by applying a group ratio to the taxpayer’s tax EBITDA – instead of the 30% FRT. The group ratio is calculated by applying a complex formula broadly equal to the net third party interest expense of the global group divided by the Group EBITDA.
As the name suggests, the Third Party debt test will only apply to debt issued to external third parties – meaning taxpayers may no longer be able to deduct interest issued to related parties even where third parties would have loaned funds on the same terms. There are exceptions in relation to the use of Australian conduit financing entities.
Notable changes from the Exposure Draft legislation
Some notable changes in the Bill that has been added, or else removed from the Exposure Draft legislation, include:
- Changes to the calculation of tax EBITDA, particularly in relation to:
- excluding dividends and franking credits
- excluding trust distributions and partnership distributions from associate entities
- adding back all amounts under Division 40 and Division 43 except to the extent that the amounts are immediately deductible and
- removing the add back for prior year tax losses that was in the original Exposure Draft.
- Removal from the proposed legislation of changes to section 25-90 of the ITAA 1997 (about deductions for debt deductions incurred to derive foreign non-assessable non-exempt income from non-portfolio investments) At this stage, no announcement has been made as to the future of this controversial proposed change.
- The choice to apply one of the two new alternative tests is revocable, although a taxpayer will need to apply to the Commissioner to have a choice revoked.
- Removal of limitation to apply the third-party debt test where all associate entities had not made the choice. This has been replaced with a deemed choice for members of an obligor group.
- Addition of new Subdivision 820-EAA to disallow debt deductions to the extent they are created under debt creation schemes without commercial justification.
What is the detail of the rules?
A more detailed analysis of the Bill is contained in our Technical Briefing, linked below. We encourage you to talk to the SW team to understand these changes further.
The new legislation is set to apply to income years beginning on or after 1 July 2023.
How should taxpayers prepare?
We recommend that taxpayers subject to the thin capitalisation regime review their existing arrangements having regard to the new Bill as a high priority, noting that the proposed date of effect is 1 July 2023. Whilst we hope that common sense will prevail and technical amendments will be made to ensure that the 3rd party debt test can be used by business, the Bill is predominantly based on the OECD guidance.
How can SW help?
Our SW team can assist with:
- modelling the potential impact of the new rules on your debt deductions
- assessing the feasibility of restructuring any existing financing arrangements for your group
- considering whether one of the alternative tests would be applicable and beneficial to your circumstances.
Reach out to your SW advisor for support from our specialist tax team.