Navigating the new thin capitalisation rules for renewables

Key aspects:

• The FRT replaces the Safe Harbour Test as the default test.
• It’s an earnings-based test that limits net debt deductions to 30 per cent of ‘tax EBITDA’.
• Tax EBITDA broadly includes taxable income adjusted for net debt deductions, tax depreciation, and recouped tax losses.
• Denied debt deductions can be carried forward for up to 15 years, subject to satisfaction of the relevant criteria (including continuing to use this test). This rule is designed for entities such as those in the renewable energy space with high up-front capital investment relative to their initial income.

Industry insights:

• Greenfield Investment Projects: Entities involved in greenfield investments under the development and / or construction phase will, in most cases, be in a tax loss position. In these circumstances, interest deductions could be denied under the FRT (but may be carried forward).
• Review Existing Financial Arrangements: Businesses should assess their current financial arrangements to identify potential financing costs that might be disallowed under the FRT.
• Modelling Impact: Given the 15-year carry-forward rule, businesses should update their financial models to evaluate the FRT’s impact on existing and new funding arrangement and assess whether it is likely that they would meet the conditions to carry forward.
• Transfer pricing: new transfer pricing analysis is required for cross-border financing arrangements before applying the FRT (along with the GRT), to test both the appropriate amount of debt and the applicable interest rate. This is a significant deviation from the previous rules, which did not require a separate transfer pricing analysis to assess the quantum of debt, where this was within the asset-based safe harbour limit.

Key aspects:

• This is also an earnings-based test that broadly requires an entity to determine the ratio of its worldwide group’s net third party interest expense to the group’s accounting EBITDA for an income year. This ratio is then multiplied by the entity’s tax EBITDA to calculate the ‘group ratio earnings limit’. Net debt deductions above this limit are effectively disallowed.
• This test may be relevant if the worldwide group is more highly leveraged than the Australian group allowing for potentially higher debt deductions.
• Denied debt deductions cannot be carried forward.

Industry insights:

• Large global groups: This calculation relies on information in audited consolidated financial statements for a worldwide parent entity. Further, the calculation must exclude any entities in the group that have a negative EBITDA amount. For large global groups, it may be very difficult to apply this test in practice.  

Key aspects:

• The TPDT allows a deduction for financing costs related to genuine third-party debt, provided relevant conditions are met.
• The test effectively disallows all debt deductions which are not attributable to third party debt (or otherwise meet the requisite criteria).
• A group of related entities must all choose to apply this test to qualify.
• Any interest deductions denied under the test cannot be carried forward unlike the FRT.

Industry insights:

• Conduit Financing Arrangements: Many renewable energy businesses utilise conduit financing structures involving FinCos (i.e. where a FinCo is set up to raise funds on behalf of another entity of the same group). Before setting up such arrangements, consider whether your entity can adhere to additional prescriptive conditions designed for such arrangements under the TPDT rules. Key questions include determining which entity should hold the FinCo.
• Associate entities and ‘obligor groups’: If there are other related entities in Australia and / or multiple entry points of investment, you will need to evaluate whether any of these entities are ‘associate entities’ that are also members of the same ‘obligor group’ in relation to the debt interest. This is because all associate entities that are also a member of the same obligor group must choose to apply this test for the same income year in order to qualify.
• Related party credit support: a debt interest must satisfy numerous ‘third party debt conditions’ in order to access this test. One of which being the holder of the debt interest has recourse for payment of the debt only against the Australian assets of the borrowing entity (which may include assets of a member of the obligor group). However, recourse to assets of the entity that are rights under or in relation to a guarantee, security or other form of credit support are prohibited, unless specified circumstances apply. Whilst recent amendments were introduced to exempt certain rights relating to moveable property (such as renewable energy assets) and offshore energy infrastructure, these exemptions do not apply where the right is provided by a foreign entity that is an associate.

In our experience, it is common for global parent companies to provide such credit support to Australian subsidiaries (often as a condition imposed by the financier for project financing). Therefore, further review should be undertaken to understand whether this test can in fact apply to third party debt.

If the TPDT cannot be applied, the borrowing entities should revert to the FRT. From the perspective of a FinCo set up to borrow and on-lend its funds, the FRT should not have any adverse material impact on the FinCo. For a project entity, on the expectation it will be in tax losses in the early years of a project, the 15-year rule should be considered to ensure the entity can eventually recoup all of its tax losses. This may have implications for secondary market transactions.

Key aspects:

• Intended to be effective for income years commencing on or after 1 July 2024 for all arrangements, these new rules are designed to completely disallow debt deductions ‘to the extent that they are incurred in relation to debt creation schemes that lack genuine commercial justification.’
• Effectively, these rules disallow deductions in two cases where related party debt is used to fund:
  • The acquisition of a capital gains tax (CGT) asset or obligation from an associate (Type 1); and
  • Certain payments and distributions to associates (Type 2).
• However, there are various exemptions from these rules.  In particular, of note is that entities that apply the TPDT for any income year will be exempt from the operation of the debt deduction creation rules for that year.

Industry insights:

• Review arrangements: With the delayed start date being 1 July 2024, entities should now be considering if any of their existing arrangements, as well as proposed new arrangements, might be caught by these rules such that interest might be denied.
• Trading stock: Debt deductions may likely be denied where an entity uses related party debt to fund the acquisition of trading stock (such as solar panels) from an associate. This may capture common situations where intercompany payables on stock purchases are left outstanding and begin to accrue interest. 

Key aspects:

• The definition of debt deduction is amended so that a cost incurred by an entity does not need to be incurred in relation to a 'debt interest' for that cost to be a debt deduction.
• Further, the new rules include amounts ‘economically equivalent to interest’.
• Interest rate swaps are now included within the definition of ‘debt deduction’ (including the assessable income component of the definition of net debt deductions). 

Industry insights:

• Broadening of definition: The significantly expanded definition may include costs such as guarantee fees, arranger fees and other costs related to financing arrangements, along with interest rate swaps that were not previously treated as a debt deduction. It will be necessary to carefully consider what income and expenses are included in calculating debt deductions and net debt deductions.
• De minimus threshold: A common exemption applied for thin capitalisation is the $2 million de minimus threshold on an associate inclusive basis. Whilst this exemption is retained, given the broadening of the definition of debt deduction, entities may no longer be exempt.