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The ED introduces new earnings-based tests for general class investors, specifically:
Financial entities and ADIs will otherwise continue to be subject to the existing asset-based Thin Capitalisation safe harbour and worldwide gearing tests, subject to an altered definition of ‘financial entity’.
1. Simplicity of the FRT
The introduction of the Fixed Ratio Test (FRT), which caps net interest deductions at 30 per cent of tax EBITDA, can be considered straightforward to apply compared to the previous safe harbour asset ratios, which were difficult to apply correctly in practice.
The earnings-based FRT will be the default test, with tax EBITDA calculated as taxable income before interest, depreciation and amortisation deductions, and deductions for carried forward tax losses (but not capital losses – which are not a deduction against income per se, but net off in determining net capital gains).
2. Entities eligible for R&D and franking offsets may benefit
Entities which rely on debt deductions and which are eligible for the Australian Research & Development incentives and/or franked dividend offsets should benefit from using tax EBITDA in either the FRT or GRT because the offset rules work to 'add back' grossed up franking credit amounts or deny deductions for eligible R&D expenditure, thus increasing tax EBITDA, whereas the franking and R&D offsets (whether refundable or otherwise) do not reduce tax EBITDA. Even where they are non-refundable and may generate carry forward tax losses in future years, deductions for prior year tax losses are added back to determine future tax EBITDA, thus not detrimentally impacting the ability to claim debt deductions under either FRT or GRT.
3. FRT disallowed deductions carried forward for up to 15 years
Where a debt deduction is denied under the FRT, the denied debt deduction can now be carried forward for up to 15 years to be used in a future year where there is excess limit available under the FRT. Under the current rules, denied deductions are permanently lost. The entity will be subject to passing a modified version of the Continuity of Ownership Test (COT) before they can utilise the denied deductions, and the ability to use FRT disallowed amounts will cease upon election of one of the alternative tests (GRT or ETPDT).
There are also special rules to allow FRT disallowed amounts to be brought into a tax consolidated group when an entity joins the group, which will reduce the entry Allocable Cost Amount (ACA) for the joining entity.
There is potential to improve this carry forward rule, for example, to clarify that entities with excess FRT disallowed deductions may apply these carry forward deductions in future where they have excess ‘cap’ even if they are no longer subject to the Thin Capitalisation Rules in that future year (e.g. if they fall under the $2m de minimis rule, or if they cease becoming a ’general class investor’ and still pass the modified COT).
Additionally, there should be an option for a tax consolidated group head company to ‘cancel’ transferred FRT disallowed amounts. This would be consistent with existing choices for transferred tax losses.
Finally, the Government could reconsider allowing carry forward of excess FRT disallowed deductions if a taxpayer were to revert to FRT in income years subsequent to choosing GRT or ETPDT.
4. Continuation of de minimis threshold and financial entity exemptions
The ED preserves the existing de minimis threshold for taxpayers with associate inclusive (gross) debt deductions of $2m or less. The definition of associate entity for this de minimis test is the current definition (ie not the expanded 10 per cent or more test described elsewhere in this Client Alert). Further, financial entities will continue to be able to access the existing safe harbour and worldwide gearing tests. However, as explained below, the definition of financial entities has been narrowed with these changes. As such, ADIs, which are subject to a different Thin Capitalisation Regime to non-ADI financial entities, will generally not be impacted by the changes in the ED.
1. Pre revenue and asset rich/income poor entities to miss out on debt deductions
The shift of focus for Thin Capitalisation purposes from assets to tax EBITDA by definition will likely work to deny or limit debt deductions more severely under the FRT or GRT for entities which are asset rich but income poor and reliant on debt capital (including hybrid instruments) to operate, because these entities will likely have a nil or negative tax EBITDA albeit they may have adequate valuable assets to support their borrowings. Such entities may, by necessity have to rely on the ETPDT to support their debt deductions unless they rely on related party debt funding and are not eligible for the ETPDT.
2. Narrow scope of the External Third-Party Debt Test (ETPDT)
The ETPDT replaces the current Arm’s Length Debt Test, operating only for genuine third-party debt, which is used wholly to fund Australian business operations with recourse only to the assets of the entity. However, this restriction requires an entity and all its associate entities to make a consistent choice to use the ETPDT, which is particularly problematic given the broadening of the definition of ‘associate’.
The modified definition of ‘associate’ applying here is based on a Thin Capitalisation control interest of 10 per cent or more. Being a low-percentage control interest will create issues around the identification of all relevant associate entities, and not all those entities may wish to adopt the ETPDT.
This new test is markedly narrower in its application than its predecessor and is particularly biased against internally funded entities (e.g., where external debt is raised with a guarantee from a global parent), or entities whose borrowings are asset backed, such as property, and typically held in trust structures with associated finance companies. This will result in increased interest deduction denials.
This could be particularly problematic for private equity structures where different earning profiles exist in different groups within a PE’s portfolio. An election to use the ETPDT by one group will have an impact on another group which may be completely unrelated other than being caught as an associate under the tax definitions.
It is our view that it is unrealistic that all associates should have to apply this test, as this could result in entities not being able to apply it if an associate they do not influence chooses not to apply this method. This rule should be revisited and refined.
3. Alteration to the definition of ‘financial entity’
The ED alters the definition of ‘financial entity’ in subsection 995-1(1) of the ITAA 1997, limiting the range of entities that can access the provision applicable to financial entities. This alteration is understood to be an integrity measure to ensure that the amendments to introduce the new earnings-based rules remain ‘fit for purpose’ and prevent misuse, whilst also limiting the application of the existing rules to a smaller group of taxpayers. This change will cause Thin Capitalisation difficulties for entities with financing businesses that do not fall into one of the limited categories of ‘financial entities’.
4. Inability to share associate entity excess under FRT
A major departure from the predecessor safe harbour methods is that the FRT test does not allow associate entities to share excess interest deduction capacity under the FRT. This penalises non-consolidated associated entity structures with debt deductions in one entity related to earnings in another entity, and will be particularly detrimental to unit trusts, which are unable to consolidate for tax purposes.
5. Removal of interest deductions for NANE income
An unexpected inclusion in the ED is the proposed removal of deductions for interest incurred in respect of foreign equity distributions that are non-assessable non-exempt income (NANE) under section 768-5, which has been a longstanding feature of the Australian tax law to encourage Australian businesses to expand offshore. We see that this is going to increase compliance costs and result in further denials of interest deductions, whilst increasing the cost of Australian businesses expanding overseas. It will be applied to pre-existing arrangements to treat interest as non-deductible that was previously deductible. Whilst submissions may be made to retain the deduction, it is expected that Government has decided on the policy and will not likely reverse its decision on this matter.
6. GRT and ETPDT choice irrevocable for each income year
Where a choice is made for an income year to use either the GRT or ETPDT, this choice cannot be revoked for that income year, significantly reducing flexibility to switch to an alternative method. For example, should a taxpayer choose to apply the ETPDT, but subsequently determine post tax return lodgement that the relevant debt does not satisfy the third-party conditions, the taxpayer will be denied debt deductions without being able to amend its tax return to access the FRT. A fairer outcome would be for a taxpayer to be allowed to amend its choice within the permissible tax return amendment periods and with appropriate notice being given to the ATO.
Furthermore, a choice to apply either GRT or ETPDT will cause any carried forward FRT excess to be lost permanently, thus further increasing the negative consequences of making and not being able to amend that choice. Government should, but is unlikely to, consider changing this position to allow the carried forward FRT disallowed amounts to be deducted in subsequent years where a taxpayer reverts back to applying the FRT.
7. Group Ratio Test – more complexity
The GRT, replacing the Worldwide Gearing Test, operates to limit Australian net debt deductions up to the level of the worldwide group’s net third party interest expense as a share of accounting EBITDA instead of applying the 30 per cent in the FRT.
When using this method, denied deductions cannot be carried forward, and in calculating the EBITDA for the group, entities with negative EBITDA must be excluded due to the stated reason of allowing ‘exploitation’ to claim excessive debt deductions. It would be impractical for an Australian subsidiary of a large multinational group to determine the stand-alone EBITDA of each entity within the multinational group if it wishes to choose to apply the GRT.
In the absence of clearer explanation as to how this adjustment would prevent exploitation, it would be ideal if the Government were to consider removing this adjustment.
A further peculiar feature of the GRT is it requires application of a group’s accounting EBITDA to work out the Group Ratio, which is then applied against tax EBITDA, instead of applying the 30 per cent cap in the FRT. So a taxpayer would from a GRT perspective ideally want high global net third party interest expenses as a proportion of GR group EBITDA.
The relevance of both accounting and tax EBITDA in the GRT adds a layer of complexity when a taxpayer is seeking to model its GRT outcomes. Additionally, using accounting EBITDA adds a layer of volatility for groups which reflect mark to market pricing in its accounts.
For example, for taxpayers in the Real Estate and Construction industry, revaluations of assets held can result in substantial year on year EBITDA variations in circumstances of volatile mark to market asset prices.
Finally, an entity will only be a member of a GR group if it is fully consolidated on a ‘line-by-line’ basis with the group for accounting purposes, which may further limit the practical benefits of choosing the GRT.
8. Amended definition of ‘debt deduction’
The definition of ‘debt deduction’ in s 820-40 of ITAA97 is amended to capture interest and amounts economically equivalent to interest in line with the OECD best practice guidance. This broadens the types of expenses that will be caught by the Thin Capitalisation rules as compared to the existing debt interest tax rules.
9. Interaction with transfer pricing rules
The existing Thin Capitalisation rules operate to limit debt deductions based on the amount of maximum allowable debt. So, taxpayers are not currently required to apply the transfer pricing rules in Division 815 to their quantum of debt (albeit they need to do so to the level of interest applied).
However, the transfer pricing rules will be amended to require taxpayers subject to the new Thin Capitalisation rules to further ensure that their quantum of borrowings is consistent with arm’s length conditions under the transfer pricing rules, in addition to also ensuring they pay an arm’s length rate of interest and that their total debt deductions are less than the threshold under their choice of either the FRT or GRT rules. Taxpayers who choose and satisfy the ETPDT should also satisfy these transfer pricing requirements.
Now that the detailed rules are here, and with just over three months until the anticipated commencement date for most taxpayers, affected clients should start modelling the impact of these rules and reconsider (where appropriate) their level of debt funding. Affected entities are urged to engage early to test the impact of the new rules under their current debt position, if necessary, prior to the start of the rules.
The ED is open to consultation until 13 April 2023. It is anticipated that Grant Thornton will make a submission to improve some of the aspects of the rules that may ease the compliance burden. However, given the Government is set on these measures and has already consulted heavily on this matter, it is unlikely that submissions would result in material amendments prior to enactment.
Please contact us if you wish to discuss these measures further.
