Proposed overhaul of Thin Capitalisation Rules

Anthony Patrk and Leon Ortega

Changes to Australia's thin capitalisation regime gains momentum with the Treasury releasing Exposure Draft legislation for public consultation on 16 March 2023. The draft legislation seeks to align Australia’s thin capitalisation rules with the recommendations in Action Item 4 of the OECD Base Erosion and Profit Shifting (BEPS) with the aim of limiting the use of interest expense to achieve excessive interest deductions.  

The draft legislation represents welcome guidance as to the mechanical operation of the new tests which represent a complete overhaul of the thin capitalisation rules for affected entities and with some surprises as to how these rules will apply in practice. Impacted entities should consider the proposed new rules and the potential impact to their taxable position.  

The proposed thin capitalisation rules would apply for income years commencing on or after 1 July 2023 and will replace the existing tests for ‘general class investors’, a new category of taxpayers. Importantly, the legislation is in draft for consultation purposes until 13 April 2023, and there may be further changes to the draft legislation prior to being submitted for parliamentary approval.  

Summary of the changes

General Class Investor

For a simplified approach to the categorisation of entities for thin capitalisation, the ‘general class investor’ is a consolidation of the existing ‘general’ classes of entities, with entities that currently fall within these categories are now being reclassified into the broader ‘general class investor’ definition.  

Currently, Australia’s thin capitalisation rules operate by limiting an entity’s debt deductions subject to the limit determined by the safe harbour test, arm’s length debt test or the worldwide gearing test. For general class investors, the existing tests may be replaced with the “fixed ratio test” (“FRT”), the group ratio test (“GRT”), and the external third-party debt test (“ETPDT”). FRT applies to all general class investors by default with the GRT or ETPDT available upon the entity making an election. 

Fixed Ratio Test

The FRT is the default test and replaces the existing safe harbour test for general class investors. Under this test, an entity’s net debt deductions that exceed 30% of its tax EBITDA would be disallowed. 

Defining net debt deductions is significant, as this is worked out by taking an entity’s total debt deductions, then subtracting any assessable amounts of interest (or amounts in the nature of interest or calculated by reference to the time value of money).  

The tax EBITDA is calculated by first determining an entity’s taxable income or loss, then adding back all the following amounts:

- net debt deductions; 

- depreciation and capital allowances (excluding amounts such as balancing adjustments, project pool or low value pool); and

- prior year tax losses deducted in the current income year.  

The excess of any net debt deductions over 30% of the tax EBITDA is then disallowed as tax deduction for the year. However, any debt deductions disallowed under the FRT in a prior year shall be able to be carried forward for up to 15 years and utilised as deduction in a year where there is an excess of 30% of tax EBITDA over the net deductions.  

For companies, the debt deduction carry forward is subject to a modified “continuity of ownership” (“COT”) testing requirement. We note the business continuity test is not available for the purposes of satisfying the carry forward requirement for companies under the FRT.

For trusts however, the draft legislation does not require the modified COT or any additional requirement to be satisfied in order to carry forward the excess debt deductions disallowed. It is unclear if this deficiency for trust requirements in the draft law will be addressed in future versions, or if it has been specifically intended that trusts will be excluded from any such additional requirements altogether.

Group Ratio Test

Under the rules, a taxpayer may instead choose to rely upon the GRT (replacing the existing worldwide gearing ratio test), which allows an entity to claim debt deductions up to the “group ratio earnings limit” for the income year. The group earnings limit is worked out by determining the group’s net third party expense as a ratio of the group’s EBITDA (based on the audited consolidated financial statements). The taxpayer’s tax EBITDA is then applied to the ratio and the entity’s ‘net debt deductions’ that exceed this limit are disallowed.

To the extent that the FRT provides adverse outcomes for a taxpayer affected by the thin capitalisation rules, it may be prudent to consider whether the GRT offers more advantageous thin capitalisation outcomes. However, any such consideration must include an assessment of the amount, if any, of “FRT disallowed amounts” carried forward from prior years, as a choice to use either the GRT or the ETPDT (refer below) will effectively forfeit any such balance of carried forward disallowed interest amounts in that year.

External Third-Party Debt Test  

The ETPDT would replace the existing arm’s length debt test for both general class investors and financial entities.  

The test operates by disallowing debt deductions to the extent they exceed the entity’s “external third-party earnings limit”. This third-party earnings limit is the sum of all debt deductions attributable to debt interest which meets the following conditions:

- is not issued to an associate entity;

- is not held at any time in the income year by an associate entity;  

- the holder has recourse for payment of the debt only to the assets of the entity; and  

- the entity uses the proceeds of issuing the debt interest to wholly fund investments that relate only to assets that are attributable to the entity’s Australian permanent establishments or holds for the purposes of producing assessable income, and its Australian operations.  

The purpose of this test is to effectively deny all debt deductions which are attributable to related party debt, while allowing debt deductions which are used wholly to fund Australian business operations. This test may prove to be unfavourable for entities that are largely funded by related parties. Certain concessions are available for conduit financier arrangements to be treated as third party debt, but subject to strict conditions in order to meet these concessions.  

Similar to the GRT, no carry forward is available for previously disallowed interest expenses, and an entity must choose to apply this test in the relevant income year. However, the choice to apply this test will not be available if a taxpayer’s associates choose a different test (i.e. the taxpayer and all associate entities must mutually choose the ETPDT together). 

Removal of Deduction for NANE income

Currently, certain non-portfolio foreign equity distributions received from an entity can be non-assessable, non-exempt (“NANE”) income of an Australian recipient. While expenses incurred to derive NANE income would typically be non-deductible, the Australian tax law has previously allowed for interest expenses incurred to derive this type of NANE income as deductible (e.g. borrowings used to fund foreign acquisitions for the purpose of deriving NANE dividend income). However, the proposed amendments seek to remove the eligibly to claim this interest expense. 

This may have material implications for Australian taxpayers holding foreign companies which are currently claiming interest expenses on loans used to fund or acquire those operations.  

Our recommendation

To prepare for the upcoming income year, we recommend that affected taxpayers undertake an assessment based on projected forecasts to determine the implications of these new rules.  

If you’re feeling less certain about your tax outcomes due to the proposed changes in FRT and GRT, please contact your adviser. The thin capitalisation results could be subject to less controllable factors like profitability, volatility of variable interest rates, and the overall economic outlook compared to an entity’s discretion in planning to set up its debt and equity structure which previously formed the basis of the safe harbour test. 

In addition, it appears there is currently no consideration of indexation of the 15-year carry forward benefit, with its value decreasing against inflationary pressures over the relevant period. This effectively makes accurate financial modelling a critical requirement to take into account any assessment which considers the choice to use the GRT or the ETPDT being made with a long-term forecast of expected earnings over a 15 period on a present value basis to determine the likely outcomes under the relevant tests. This is particularly important as the carry forward of disallowed amounts is not available under the GRT or the ETPDT, and prior year disallowed amounts under the FRT are forfeited where an entity chooses to switch from using FRT within the 15-year period. 

ETPDT may not be an attractive option for an entity that is highly leveraged on related party loans as all interest expenses will be permanently disallowed as a deduction under this test. 

The disallowing of interest expense deductions relating to investment returns on non-portfolio foreign equity will have material implications for Australian taxpayers holding foreign companies which are currently claiming interest expenses on loans used to fund or acquire those operations.  

Finally, it is important to note that there are however no changes to the existing exemptions such as the de minimis threshold for taxpayers with debt deductions of $2m or less (on an associate inclusive basis) as well as the 90% average Australian asset threshold test.  

Next steps

Entities subject to the thin capitalisation rules should: 

- Prepare projected financial statements for the year ended 30 June 2024, and

- Contact their tax adviser immediately to determine:  

1. the impact of the three new tests regarding the deductibility of debt deductions;  

2. options or alternatives available to limit the effect of the proposed changes prior to the start date of 1 July 2023; and  

3. the implications of the deductibility of borrowings used to fund existing controlled foreign companies, or for future foreign acquisitions. 

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.