Property funds to be impacted by proposed thin cap changes
The Government has released draft thin capitalisation law changes proposed to commence from 1 July 2023. If enacted, this may have a substantial impact on some property funds.
We recommend that all fund managers review their funds’ existing financing arrangements immediately to understand how the proposed rules impact interest deductions. For further details of the of the proposed changes, please see our previous article: New thin capitalisation regime details released.
These rules will broadly apply to property funds that have:
- a foreign investor that has a controlling interest in the fund or where the fund invests in foreign assets, and
- debt deductions over $2 million.
Potential impact on property funds
We have considered the potential impact on several of our property fund clients. Our key findings are:
- The Fixed Ratio Test (FRT) limits interest deductions to 30% of a taxpayers tax EBITDA (Earnings before Interest, Taxes, Depreciation and Amortisation). The FRT is likely to deny interest deductions for most taxpayers that fall within the regime based modest gearing and market interest rates. Of note, if borrowings are taken out at the head trust level the interest denial will be significant. Importantly, if debt deductions are denied under the FRT the taxpayer can carry forward the excess for up to 15 years.
- It may be difficult for some funds to obtain the relevant information to perform the required calculation under the Group Ratio Test (GRT).
- The External Third-Party Debt Test (ETPDT) should provide an appropriate mechanism to allow interest on Australian bank debt to be claimed. However, the proposed rules only allow this test to be used if:
- debt is borrowed from a third parties, i.e. related party debt not permitted
- all 10% associate entities choose to apply it (it will be practically difficult to get agreement on this from all 10% associate entities), and
- recourse can only be to assets of the borrower. This is practically difficult to achieve and not in accordance with currently lending practices particularly large-scale construction projects where banks typically look for parent support and guarantees
- debt borrowed is used to only fund Australian investments.
- The 15-year carry forward of excess deductions is only available under the FRT. Therefore, property funds will not be able to switch between methods and recover any interest denied under the FRT.
How can SW help?
The proposed changes are likely to have a significant impact on the property funds management industry, which relies heavily on debt financing.
SW Accountants & Advisors has already contributed to submissions that have highlighted these issues to Treasury. Even if most of the issues identified for improvement were to be adopted, there is likely to be some level of interest denial in property funds that fall within the regime.
If you would like to discuss your individual circumstances, please reach out to SW advisor or the team listed here.