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ATO's New Regulations: A Guide to Australia's Reinforced Thin Capitalisation Rules

Thin Capitalisation
 

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The Australian government recently announced the strengthening of thin capitalisation rules, aiming to ensure tax fairness for multinational enterprises operating in Australia. This significant measure holds particular importance for most businesses. In this article, we will delve into the changes brought about by this regulation and its implications for enterprises.


On 25 October 2022, as part of the 2022-2023 Budget, the government announced the reinforcement of Australia's thin capitalisation rules. These changes aim to align with the Organisation for Economic Co-operation and Development (OECD) best practices.


On 27 March 2024, the Treasury Law Amendment (Making Multinationals Pay Their Fair Share – Integrity and Transparency) Act 2024 passed through both houses of Parliament and received royal assent on 8 April 2024.

 

New Testing Methods

The amendments established 3 new tests that apply to 'general class entities' (this includes most multinational businesses):


  1. Fixed Ratio Test: This test limits an entity’s net debt deductions to 30 per cent of its tax earnings before interest, taxes, depreciation, and amortization (EBITDA). Under this new test, debt deductions exceeding the 30% EBITDA limit will be denied. Denied deductions can be carried forward and claimed in subsequent income years (subject to the 30% EBITDA limit each year), for a maximum of 15 years. This method is the default method unless a taxpayer makes a choice to use the other 2 methods.

  2. Group Ratio Test: This test limits net debt deductions using a ratio of the worldwide group’s net interest expense and EBITDA based on the worldwide group's financial statements. There is no carry forward of denied deductions under this method.

  3. Third-Party Debt Test: This test limits an entity's debt deductions to those attributable to an entity’s external (or third party) debt except for non-qualifying external debt. Debt deductions attributable to related party debt are denied under this test. There is no carry forward of denied deductions under this method.


Other Key Changes
  • The new rules narrow the scope of the third-party debt test, making it challenging for debt with personal guarantees from overseas parent companies/directors or related party guarantees to meet the requirements.

  • Introduces debt deduction creation rules to prevent non-commercially motivated related-party debt deductions.

  • Transfer pricing rules take precedence over thin capitalisation rules. Taxpayers need to prioritize transfer pricing analysis for cross-border related party financing to ensure compliance with transfer pricing requirements.


Who will be affected?

These revisions apply to most multinational enterprises and Australian businesses, excluding financial entities and certain special entities. Specifically, the scope of impact includes but is not limited to:


  • Multinational Enterprises: These revisions directly affect the capital structure and financing strategies of multinational enterprises operating in Australia. Enterprises need to review their existing debt structures to ensure compliance with the revised testing requirements. Enterprises may need to reassess their debt deduction amounts to avoid exceeding the new limits.

  • Australian Businesses: Australian businesses involved in cross-border transactions or with overseas subsidiaries will also be affected by these revisions. These enterprises need to review the capital structure and financing arrangements of their overseas subsidiaries to ensure compliance with the new rules. Additionally, Australian businesses may need to reassess whether their overseas financing arrangements comply with transfer pricing requirements to avoid unnecessary tax risks.

  • Financial Entities and Special Entities: These revisions do not apply to financial entities and certain special entities, such as authorized deposit-taking institutions. Therefore, these entities are not subject to the new rules and can continue to operate under existing regulations.


 

These revisions aim to ensure compliance with capital structures in Australia and align with global best practices. Taxpayers should promptly understand and adjust their financing structures to avoid potential adverse effects.

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