Thin capitalisation – changes to be aware of from 1 July 2023

Tim Cheong, Varun Kumar

29 June 2023

Treasury Laws Amendment (Making Multinationals Pay Their Fair Share—Integrity And Transparency) Bill 2023 (the Bill) was introduced into Parliament towards the end of June 2023. The draft Bill proposes to make wholesale changes to the thin capitalisation rules and the methods for claiming allowable interest deductions in Australia.

The Bill has been referred to the Senate Economics Legislation Committee which is required to submit its report to Parliament by 31 August 2023. Unfortunately, as it is currently drafted, the Bill will apply retrospectively and will impact the availability of interest deductions in Australia from 1 July 2023.

Overview
Taxpayers are generally allowed a deduction for interest paid on loans and other debts if they relate to income producing purposes. However, the thin capitalisation rules will limit a taxpayer’s allowable interest deductions where the taxpayer is a foreign entity operating in Australia, an Australian subsidiary of a foreign parent or an Australian resident with foreign investments.

The thin capitalisation rules need to be considered where an entity and its associates have debt deductions of greater than $2 million in a particular income year. The $2 million de minimis threshold will be retained and is unaffected by the Bill.

Debt deductions are not restricted to interest deductions and can include other expenses such as loan establishment fees, borrowing costs etc.

Changes which come into effect from 1 July 2023
Currently, entities impacted by these provisions can calculate the allowable interest deductions based on the asset position of the entity. This position will now be changed to ensure Australian entities claim interest based on the entities’ earnings.

From 1 July 2023, the Bill introduces three tests to ascertain how much can be claimed as debt deductions in Australia.

Fixed ratio test (replaces safe harbour test)
Entities will be able to claim interest deductions capped at the fixed ratio earnings limit. This test replaces the safe harbour test which disallowed deductions in excess of 60% of the average value of an entity’s assets.
Simply put, this limit is 30% of tax EBITDA (earnings before interest, tax, depreciation and amortisation). Certain adjustments may be required for certain types of income e.g., franking credits. This test is meant to be the default test and will apply unless the entity elects to use the group ratio test or the third party debt test.

An example of how this test is meant to apply is below.

EXAMPLE – FIXED RATIO TEST During the 2024 income year, TC Pty Ltd had taxable income of $500,000. Total debt deductions amounted to $2.7 million during the year. TC Pty Ltd claimed $1 million in depreciation and $750,000 in capital works deductions during the year. TC Pty Ltd will need to calculate its allowable deduction based on the method statement below:
Step 1	Taxable income [Disregarding the operation of the thin capitalisation provisions]		$500,000
Step 2	Add: Sum of entity's debt deductions		$2,700,000
Step 3	Add: Decline in value of depreciation assets Add: Capital works deduction	$1,000,000 $750,000 $1,750,000	$1,750,000

	Tax EBITDA		$4,950,000

	Fixed ratio earnings limit - 30% of Tax EBITDA		$1,485,000

	Allowable Debt Deduction (capped at Fixed ratio earnings limit)		$1,485,000
Based on the above, TC Pty Ltd will be allowed debt deductions totalling $1,485,000. Note, the disallowed deduction of $1,215,000 ($2,700,000 less $1,485,000) can be carried forward for 15 years and may be claimed in a future year as a special deduction (explained below).

Where a debt deduction is disallowed by the fixed ratio test, an entity may carry forward these amounts for up to 15 years. A “special deduction” may then be available to claim previously disallowed deductions in a later income year, subject to the application of the fixed ratio test and subject to certain conditions.
These conditions include companies passing a modified version of the continuity of ownership test (COT) or business continuity test (BCT).

Pleasingly, the option for entities to avail themselves of the special deduction by passing the BCT, is a welcome change. Previously, the exposure draft restricted entities to satisfying the COT only. This would have presented a major disadvantage for entities subject to ownership changes and capital injections.

Note, this special deduction only applies where an entity has used the fixed ratio test.

Group ratio test (replaces worldwide gearing test)
Under this test, debt deductions will be disallowed where the debt deductions exceed the group ratio earnings limit for the income year. The group ratio test requires an entity to determine the ratio of its group’s net third party interest expense to the group’s EBITDA for an income year.

The group ratio test allows an entity in a sufficiently leveraged group to deduct debt deductions in excess of the amount permitted under the fixed ratio rule, based on a ratio of the group’s profits after adding back certain expenses – the group ratio earnings limit. An entity’s ‘group ratio earnings limit’ for an income year is its ‘group ratio’ for the income year multiplied by its tax EBITDA for the income year. The ratio needs to be calculated based on audited financial statements for the group parent entity (subject to certain adjustments).

This test replaces the worldwide gearing test and is available to members of a GR Group i.e., a worldwide parent entity or a global parent entity and each other entity that is fully consolidated in the relevant financial statements.

Third party debt test
The third party debt test effectively disallows an entity’s debt deductions to the extent that they exceed the entity’s debt deductions attributable to third party debt and which satisfy certain other conditions. This test replaces the arm’s length debt test for general class investors and financial entities - ADIs will continue to have access to the arm’s length capital test.

Under this test, the amount of an entity’s debt deductions for the income year that is disallowed is the amount by which the entity’s debt deductions exceed the entity’s third party earnings limit for the income year. This limit is the sum of each debt deduction of the entity for the income year that is attributable to a debt interest issued by the entity that satisfies the third party debt conditions which broadly capture genuine commercial arrangements relating to Australian business operations. The application of this test is fairly restrictive.

Other changes – debt deduction creation rules
The Bill also introduces anti avoidance provisions which target schemes entered into which lack commercial justification. Debt deductions will be denied if incurred in relation to debt creation schemes. This will target two types of schemes:

Entities acquiring assets (e.g., shares in foreign subsidiaries or business assets), from foreign and/or domestic associates which give rise to debt deductions in Australia.
An entity borrowing from its associate to fund a payment to that, or another, associate which give rise to debt deductions in Australia.

In the exposure draft legislation, it was proposed to disallow deductions for interest expenses incurred in deriving non-assessable non-exempt income from foreign equity distributions (e.g., interest deductions incurred by Australian entities funding foreign subsidiaries). This has now been deferred following consultation but the Government may consider this via a separate process. The debt creation rules provisions have been put in place to replace this.

This will only apply to entities subject to the thin capitalisation rules i.e., debt deductions in excess of $2 million.

In summary
The changes to the thin capitalisation rules present a major shift and will be highly relevant for operators in industries with high leverage positions, such as property and construction. Given that there are no transitional provisions or grandfathering of existing financial arrangements pre commencement of these new rules, we highly recommend that a review of the impact of these provisions are considered in the immediate future.
Should you wish to consider these changes in more detail, please contact your Moore Australia advisor for further information.