Understanding the New Thin Capitalisation Rules: An Overview for Taxpayers and Business Owners

Introduction

The Treasury has recently proposed a significant change to Division 820 of the Income Tax Assessment Act 1997 (‘the Act’) with the release of an Exposure Draft and Explanatory Memorandum amending the thin capitalisation rules following the 2022-23 Federal Budget amendments. The amendments are designed to implement the OECD Base Erosion and Profit Shifting Action Item 4. The new rules replace the current asset-based rules with debt deduction limitations based on “tax EBITDA” for all entities except financial entities and authorised deposit-taking institutions. The amendments have the potential to significantly limit the ability of taxpayers subject to the thin capitalisation rules to claim debt deductions in Australia.

General class investors

The amendments introduce the concept of a “general class investor” which replaces separate concepts for entities subject to thin capitalisation rules. General class investors include Australian entities operating in foreign countries, Australian entities controlled by foreign residents, and foreign entities with investments in Australia. The amendments introduce three tests for general class investors:

1. Fixed ratio test: disallows deductions to the extent that net debt deductions exceed 30% of tax EBITDA.
2. Group ratio test: disallows debt deductions to the extent that net debt deductions exceed the entity’s “group ratio earnings limit” for the year.
3. External third party debt test: replaces the arm’s length debt test for both general class investors and financial entities.

Financial Entities

Financial entities and ADIs can still access thin capitalisation rules except for the arm’s length debt test which has been replaced by the external third-party debt test (as stated above). Further, the concept of ‘financial entity’ has been narrowed by deleting paragraph (a) of the definition.

Transfer Pricing

Taxpayer’s associate entity debt is still subject to transfer pricing rules in Division 815. Transfer pricing rules are adjusted to require general class investors to demonstrate non-excessive debt. General class investors will need to ascertain the arm’s length quantum of debt in addition to arm’s length conditions such as price.

Expanding the definition of ‘debt deduction’

The definition of ‘debt deduction’ in section 820-40 of the Act is being updated to align with the OECD best practice guidance. The amendment intends to include interest and amounts equivalent to interest within the definition. The updated definition will include amounts that are economically equivalent to interest, even if not necessarily incurred in relation to a debt interest issued by the entity. This change will ensure that a cost incurred by an entity need not be related to a debt interest for it to be considered a debt deduction.

Exemptions to the thin capitalisation rules

Section 820-37 is amended to ensure it continues to apply to outward investing entities and now applies to general class investors who would be an outward investing financial entity. These amendments maintain the policy intention of providing an exemption from the thin capitalisation rules for outward investing entities in certain circumstances. Section 820-35 is amended to ensure it includes the new thin capitalisation rules set out in new subdivision 820-AA. However, the $2 million or less threshold for exemption from the thin capitalisation rules for an entity and its associate entities remains unchanged.

Complying superannuation fund exemption to an ‘associate entity’

Complying Superannuation Fund Exemption: Superannuation funds are a significant source of capital investment for Australian assets, particularly infrastructure assets. However, the definition of ‘associate entity’ in section 820-905 of the Act is too broad in relation to superannuation funds, hindering their ability to borrow. This issue arises because the current rules may cause superannuation funds to have a relatively large number of associate entities, which would bring their investments into scope of the thin capitalisation rules. Additionally, the definition of ‘associate entity’ does not account for the strong regulatory regime governing superannuation funds, which generally do not exercise any meaningful control over their associate entities. As a result, the definition is amended to exclude a trustee of a complying superannuation entity (other than a self-managed superannuation fund).

Conclusion:

The proposed changes to thin capitalization rules will significantly impact entities subject to these rules, replacing the current asset-based rules with debt deduction limitations based on “tax EBITDA” for most entities. These changes will apply to income years commencing on or after the 1 July 2023 and stakeholders can make submissions until 13 April 2023. The economic effect of denied debt deductions in the current environment of higher interest rates may be punitive. This is especially true since existing debt will not be grandfathered, there will be no transitional period, and there are no significant exemptions for any entity types other than financial entities and authorised deposit-taking institutions. Therefore, given the short consultation period for stakeholders, taxpayers should familiarize themselves with the changes, assess their impact on business and seek professional advice as needed.