Major changes to Australia’s Thin Capitalisation rules are expected to be enacted soon

Since publishing our previous alert, the Senate Economics Legislation Committee have released their report, recommending that the new thin capitalisation rules be passed subject to a few technical amendments that were already foreshadowed by the Treasury.

In response to this, Treasury has issued an updated Exposure Draft that includes their proposed amendments to the Bill, which is again open to consultation. We will discuss these amendments in an upcoming alert. With the legislation progressing, it seems certain that the new thin capitalisation rules will be enacted soon. The proposed new rules reflect a significant change and may result in reduced tax deductions for interest (and more broadly, ‘debt deductions’) for a wide range of taxpayers, but especially those that are highly capitalised with low EBITDA, typically found in the Real Estate and Construction industry.

Once enacted, the new rules will apply to income year commencing on or after 1 July 2023, with no grandfathering or transitional rules. The current exemption from these rules for taxpayers with less than $2m of debt deductions in a year is expected to continue.

The new law will significantly align Australia’s thin capitalisation rules with OECD recommendations. The proposed rules will be particularly familiar to taxpayers in the UK and US, where similar regimes already operate.

The key changes include:

• The safe-harbour test (an asset-based test that is currently the most-commonly used in assessing a taxpayer’s debt capacity) will be replaced with the ‘fixed-ratio test’. This test limits an entity’s debt deductions to 30% of its EBITDA. Any denied debt deductions may be able to be carried forward for up to 15 years.
• The worldwide-gearing ratio will be replaced with the new earnings-based ‘group-ratio test’, which allows an entity in a group to claim debt-related deductions in proportion to the worldwide group’s debt divided by its earnings. Taxpayers would need to elect to use this test, and debt deductions denied in the year cannot be carried forward.
• The ‘arm’s-length debt test’ (ALDT) will be replaced with the ‘external third-party debt test’ (ETPDT), which only allows for costs related to genuine third-party debt to be deducted. Again, the taxpayer will need to elect to use this method, and there is no carry forward of debt denied.

The legislation is still in draft and subject to possible changes, though significant changes seem unlikely given there has now been a lengthy and robust consultation process. From a practical perspective, there are still uncertainties amongst the detailed provisions that taxpayers and their advisers will need to work through in the coming months, as they start to apply the new legislation to real-life circumstances.

Some key takeaways are:

• The new rules are likely to significantly impact capital-intensive (and low EBITDA) businesses, such as those in real estate and construction, the most.    
• The ETPDT is drafted more narrowly than the existing ALDT, so don’t assume you can access the ETPDT if you are currently relying on the ALDT.
• Unlike under the safe-harbour test, you cannot share excess debt capacity with associate entities under the fixed-ratio test, which may penalise non-consolidated structures. Taxpayers should consider reviewing their existing structures to see whether there may be unnecessary tax inefficiencies as a consequence.
• If you have carried forward debt deductions under the fixed-ratio test, and you subsequently elect to use the group-ratio test or ETPDT, then you will lose those carried forward amounts completely. Note that once the election to use the group-ratio test or ETPDT has been made, it cannot be revoked for that year. A careful cost-benefit analysis should be undertaken before electing to use these tests.

Taxpayers who have more than $2m of total debt deductions should be considering now how the draft rules are going to impact them. In many instances, it will be appropriate to model which test will provide the maximum debt deductions, assess whether all the conditions to use that test are likely to be met, and consider whether there are restructuring opportunities that could offer a preferable outcome.

Taxpayers in the real estate, property investment and construction industries might find that projects that are now profitable, might not be when the new rules apply, which might instigate broader commercial discussions regarding retaining/selling projects and future investments in Australia.

If you have any questions in relation to the above, please feel free to contact us.