On 16 March 2023 the Federal Government released its Exposure Draft (ED) legislation giving effect to its October 2022 Federal Budget thin capitalisation measures, which will apply mainly to multinationals with high interest deductions for income years commencing on or after 1 July 2023.
These measures were forecast to raise an additional $370m in 2024/25 and $350m in 2025/26 in tax revenue for the Government.
Grant Thornton previously discussed these measures here.
The ED broadly gives effect to the measures as announced, with welcome detail and clarification as follows:
- It introduces a new Fixed Ratio Test (FRT) that caps net interest deductions above 30% of tax EBITDA compared to the previous safe harbour asset ratios.
- It introduces a simple definition of “tax EBITDA” which is taxable income or tax loss (per a taxpayer’s Australian tax return), with add backs for net interest deductions, Division 40-B and Division 43 depreciation and capital allowance and prior year tax losses deducted in the current year. However, entities applying the FRT may now have to forecast tax EBITDA as well as “normal” accounting EBITDA.
- Where a debt deduction is denied under this FRT, it permits the debt deduction to be carried forward for up to 15 years (subject to modified Continuity of Ownership Test and tax consolidation rules), to be used in a future year where there is excess limit available under the FRT. This carry forward is not available for the alternative tests described below.
- It permits worldwide groups to choose to apply an alternative Group Ratio Test (GRT) based on audited consolidated financial statements rather than applying a fixed 30 per cent cap to tax EBITDA under the FRT.
- It also permits an entity to choose to claim debt deductions based on an earnings limit set by satisfying external third-party debt conditions. The logic of this choice is that entities which borrow money from arm’s length third parties should prima facie be accepted as not engaging in profit shifting by artificially increasing interest deductions. It is expected that this alternative will be simpler to apply than the existing “arm’s length debt test”. However, entities will need to identify how debt funding is used for Australian operations and assessable income earning activities.
- It preserves the existing de minimis threshold for taxpayers with associate inclusive debt deductions of $2m or less.
- Financial entities and Authorised Deposit-taking Institutions (ADIs) will not be subject to the FRT or GRT and will continue to apply the existing Division 820 Thin Capitalisation rules. Financial entities which are not ADIs will be permitted to apply the external third-party debt test.
- The ED will also legislate to remove debt deductions for section 768-5 non-portfolio dividend non-assessable non-exempt income.
Now that the detailed rules are here, we expect that affected clients should start modelling the impact of these rules and reconsider (where appropriate) their level of debt funding.
The ED is open to consultation until 13 April 2023. However, given the Government is set on these measures and has already consulted heavily on this matter, it is unlikely that further consultation would result in material amendments prior to enactment.
Please contact us if you wish to discuss these measures further.