Proposed changes to Australia’s thin capitalisation rules
17/08/2022
The Government proposes to amend Australia’s existing thin capitalisation rules to limit interest deductions for multinational enterprises. Our modelling indicates one in four multinational enterprises (MNE’s) could be negatively affected by the changes.
The Australian Treasury has released Exposure Draft legislation aimed at strengthening Australia’s thin capitalisation (thin cap) rules on 16 March 2023. Click here to read the article about this latest update.
These amendments are part of a consultation paper released by the Treasury in line with the Government’s commitment to address tax avoidance practices of multinational enterprises. The thin capitalisation test will be changed to an earnings stripping approach. Under the proposed approach, net interest deductions will be limited based on a defined measure of profit (see below). This will impact taxpayers differently based on their profit profile, regardless of whether or not they are currently excessively geared based on the current safe harbour gearing level.
Who is impacted?
Affected groups will include:
- foreign controlled Australian entities and branches
- Australian entities with foreign subsidiary entities and branches
- certain associates of the above.
Background of thin capitalisation rules
The thin capitalisation rules seek to restrict interest deductions of affected entities. Historically, the rules were intended to prevent the shifting of profits offshore via interest payments to related parties or on loans guaranteed by related parties. However, the rules have since been expanded to apply to interest payments to all lenders including third party financiers whether or not guaranteed by the parent entity or another group entity.
The current thin capitalisation provisions provide for a safe harbour debt amount. This is broadly the maximum debt amount calculated based on the entity’s gearing level. Once exceeded, an entity interest expense is proportionately denied1. It is noteworthy that the 60/40 debt to equity safe harbour debt amount is the measure most widely used by multinational groups.
When will the proposed rules apply?
The rules may apply from as early as 1 July 2023. However, the consultation paper is not law and does not specify an intended commencement date.
Discussion on proposed change
The Government recently released a consultation paper regarding the proposed multinational tax integrity package. One of the proposed measures is the amendment of Australia’s existing thin capitalisation rules to limit interest deductions of affected entities in line with OECD’s recommended approach.
The OECD’s recommended approach limits net interest deductions to 30% of Earnings Before Interest, Taxes, Depreciation, and Amortisation (EBITDA). The use of accounting EBITDA can be problematic as the measure does not account for items such as such as revaluations and impairments.
The Government has flagged the use of tax EBITDA. This means that the taxpayer will firstly need to calculate/model its taxable income to determine the safe harbour debt amount. Note that the use of tax EBITDA may mean that non-assessable non-exempt foreign income e.g. foreign non-portfolio dividends, foreign branch profits and participation exemption capital gains may have to be excluded. Adjustments could be required depending on the definition of “tax EBITDA”.
Regardless, it is hoped that the $2m de minimis exemption continues to apply or increased. As examples and broadly speaking, the “de minimis” interest level in Germany, France, Greece and some other EU countries is €3 million.
The Government has also indicated that the arm’s length debt measure will be retained. This is positive as particular industries (e.g. property funds) may be negatively impacted by the change.
Looking at thin capitalisation rules in comparable international jurisdictions
In the paper it was highlighted that approaches adopted by comparable international jurisdictions (for instance, the UK, Canada, France, Germany and the US) may be drawn upon. The deduction for net interest expense in the UK is restricted to the greater of:
- 30% of taxable earnings before interest, taxes, depreciation and amortization (EBITDA) in the UK (the Fixed Ratio Rule)
- a proportionate share of the worldwide group’s net interest expense, equal to UK taxable EBITDA multiplied by the ratio of worldwide net interest expense to worldwide EBITDA (the Group Ratio Rule).
Similar to Germany, the consultation paper also considers the Group ratio rule. This will provide greater flexibility of highly leveraged groups, which is defined in the Paper as those with a net third party interest/ EBITDA ratio above the 30% benchmark fixed ratio.
Additionally in Germany, any unused EBITDA potential may be carried forward for a certain number of years to cover future excess interest cost.
Meanwhile in Canada, the changes are phased in i.e. starting with a 40% ratio before reducing to 30%. Any net interest expense for a particular year that is denied in that year, could be carried backwards and forwards for a certain number of years. The incorporation of carry forward and carry back rules will provide a fairer outcome for taxpayers and allows for profit fluctuations arising from economic conditions and other disruptions.
In France, taxpayers will need to assess whether they are thinly capitalised (where related party debt-to-equity ratio exceeds 1:5). If so, then different ratios are applied depending on whether the debt is from a related or external party.
Examples
Example 1
In year 20XX, Ausco has EBITDA of $100m. Assume that AusCo has no interest, depreciation or amortisation. Included in EBITDA is a non-deductible impairment loss of $50m. Therefore tax EBITDA is $150m. Applying a fixed ratio of 30%, the maximum net interest expense (i.e. all borrowing & interest expenses minus interest income) allowed based on EBITDA and Tax EBITDA are $30m (30% x $100m) and 45 (30% x $150m) respectively.
Example 2
In year 20XX, AusCo derived a profit before tax (PBT) of $100m. Included in the EBITDA calculation are:
- accounting depreciation of $50m
- interest expense of 20m
- tax depreciation is $80m.
Subject to how tax EBITA is eventually defined, we calculate the maximum allowable net interest under EBITDA and tax EBITDA as follows:
| EBITDA ($) | Tax EBITDA ($) | |
|---|---|---|
| Profit before Tax/ Taxable Income | 100m | 70m |
| Add accounting depreciation | 50m | |
| Add tax depreciation | 80m | |
| Add interest | 20m | 20m |
| EBITDA/Tax EBITDA | 170m | 170m |
| Maximum net interest expense under model | 51m | 51m |
| Interest denied? | No | No |
How should taxpayers prepare?
Whilst legislation is yet to be released, taxpayers are advised to model the impact of the use of the earning stripping approach on their interest deductions.
SW modelled the earnings stripping approach using the Tax EBITDA of 40 taxpayers. While we had to make certain assumptions in the absence of legislation, the results show that 25% of the entities modelled will be negatively impacted by the change. The results show a positive impact for 1 of the taxpayers modelled.
Taxpayers holding investment type assets (e.g. equity or property) which generate a low annual return/yield on the investments (but may derive future capital gains on their eventual disposal) are particularly impacted. A carry forward rule such as that in Canada would therefore be helpful so as to not discourage the growth of funds management in Australia. Also impacted are entities which are not yet generating income for example companies in the process or research or commercialising a new product/innovation or mining companies in the exploration stage.
Note that businesses are invited to be a part of the consultation process to ensure that the legislation is fair (i.e. advocating for: carry forward and carry back rules for excess interest deductions and for a world-wide group ratio similar to the UK). Information about how to respond can be found here.
How can SW help?
Our SW team can assist with:
- Modelling the impact of the use of the earing stripping approach on your interest deductions
- assessing the feasibility of restructuring the financing structure of the group
- consider whether one of the alternative tests would be applicable (i.e. arm’s length debt test).
Reach out to your SW advisor for support from our specialist tax team.
1 Entities with debts exceeding the safe harbour debt amount can also consider alternative debt measures being the arm’s-length debt amount and the worldwide gearing debt amount.
