Budget announcements – changes to thin capitalisation rules

At a glance

Australian multinational groups (inbound or outbound) can lose tax deductions for interest expenditure if they have excessive debt funding for tax purposes. Tax rules limit debt deductions based on three different thresholds – the safe harbour test (debt to asset ratio); an arm’s length debt test; and a worldwide gearing test (debt to equity ratio). Any interest deductions denied are lost.

The existing rules are proposed to be replaced with a new test whereby interest deductions are limited to 30% of profits (based on Earnings Before Interest, Taxes, Depreciation, and Amortisation (EBITDA)). Alternatively, debt related deductions can be claimed up to the level of the worldwide group’s net interest expense as a share of earnings. The arm’s length debt test will be retained only in respect of external debt funding.

Other countries have adopted a similar approach e.g., US, UK, Germany, and Japan. This change will likely have a significant impact on entities affected and requires careful consideration and action.

Current rules

The thin capitalisation rules are designed to limit debt deductions that an entity can claim for tax purposes based on the amount of debt used to finance its operations compared to its level of equity. Generally, debt financing represents a more tax-efficient method of financing, as an entity can claim tax deductions for interest paid on debt and therefore reduce its taxable income.  

Under the current thin capitalisation rules, a non-financial entity's interest deductions in relation to its cross-border investments are limited by the application of a number of statutory tests under which its maximum allowable debt is the greatest of:

• the safe harbour debt amount (60% of the average value of the entity's Australian assets);
• the arm's length debt amount (which looks at whether the debt levels of the Australian business are reasonable and whether an independent lending institution could reasonably be expected to provide that level of debt on such terms); or
• the worldwide gearing debt amount (which allows the entity to gear its Australian operations up to 100% of the actual gearing of its worldwide group).

Proposed changes

The Government has announced it will replace the safe harbour and worldwide gearing tests with earnings-based tests to limit debt deductions in line with an entity's profits. More specifically, the rules will be amended to:

• Limit an entity’s debt-related deductions to 30 per cent of profits (using EBITDA — earnings before interest, taxes, depreciation, and amortisation – as the measure of profit). This new earnings-based test will replace the safe harbour debt test.
• Allow deductions denied under the above EBITDA test (interest expense amounts exceeding the 30 per cent EBITDA ratio) to be carried forward and claimed in a subsequent income year for up to 15 years.
• Replace the worldwide gearing test and allow an entity in a group to claim debt deductions up to the level of the worldwide group's net interest expense as a share of earnings (which may exceed the 30% EBITDA ratio).

The arm's length debt test will be retained as a substitute test which will apply only to an entity's external (third party) debt, disallowing deductions for related party debt under this test.

The changes will apply to multinational entities operating in Australia and any inward or outward investor. Financial entities and authorised deposit-taking Institutions will continue to be subject to the existing thin capitalisation rules.

Some of the changes now proposed are a welcome shift away from the original Consultation Paper (for example, introducing an ability to carry forward denied interest deductions). However, taxpayers are likely to have many questions regarding these changes, the answers to which will not be clear until we see draft legislation. For example, no comment has been made on how the existing $2 million ‘de minimis’ rule may apply to exclude low risk entities from these rules.

Further, it is uncertain whether there will be any transitional rules covering funding agreements already in place on 1 July 2023.

Impact

We expect the impact of the new rules will depend on the sector and industry you are in.  For example;

• highly debt funded structures used by private equity may be adversely impacted
• entities that have high profitability, but low assets may see a positive outcome e.g. technology companies
• start-ups that don’t have a established earnings will need to consider the impact on their funding
• public-private structures that are capital intensive may not have a high EBITDA until the end of the project and will need to remodel cash flow projections where tax deductibility was factored in.

Given the proposed thin capitalisation changes are expected to apply from 1 July 2023, we expect that affected clients need to start modelling the impact and reconsider the level of debt funding.

Over the coming weeks, Grant Thornton will be publishing further alerts on these changes, and specifically, their likely impact on certain industry groups.