In Australia, tax rules limit multinational groups' 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 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. This is to follow other countries on earth who have already adopted a similar approach e.g., US, UK, and Japan. The proposed change is significant and is one of the most wide-reaching integrity measures seen for many years, requiring careful consideration by any taxpayer that engages in cross-border activity and investment. Overview of proposed thin capitalisation changes
The proposed changes to Australia’s thin capitalisation rules result in a shift from the current asset-based safe harbour test to an earnings-based safe harbour test. Broadly, the earnings-based test will limit net interest expense to 30% of EBITDA (expected to be tax EBITDA provided legislation aligns with OECD principles). Any denial under the thin capitalisation rules will result in a permanent tax cost to taxpayers, potentially resulting in a significant increase in the cost of funding. The denial also operates irrespective of a taxpayer's compliance with withholding tax obligations and/or transfer pricing requirements.
The proposed changes also impact taxpayers that may currently be relying on the arm's length debt test (ALDT), effectively proposing to limit the ALDT to unrelated / third-party debt only (i.e., ALDT no longer available on intra-group debt).
Timing of proposed changes
The proposed changes are intended to apply to income years commencing on or after 1 July 2023.
Further, it is uncertain whether there will be any transitional rules covering funding agreements already in place on 1 July 2023.
We understand that the draft law is expected to be released for public consultation in March / April 2023, and not expected to pass until the Spring sittings (commencing 31 July 2023).
The potential impact
From our experience, particular industries that are likely to be most negative impacted include property, renewable energy, construction, infrastructure and private equity who uses debt funded structure.
Entities that have high profitability, but low assets may see a positive outcome e.g. technology companies.
Multinational group's new setup subsidiaries that don’t have 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.
How we can assist Given the significance of the impact, we recommend that a review is carried out as soon as practical. This will allow impacted businesses sufficient time to consider the application of alternatively thin capitalisation tests (i.e., world-wide gearing test, ALDT) or consider alternative funding options and/or changes to their current capital management policies. It has become evident that the range of outcomes are varied, and numerous factors are at play - including business cash flows, indebtedness, asset profile (i.e., depreciable intangibles / PP&E) which all contribute to the outcomes (either positive or negative). We generally apply a phased approach to ensure the cost effectiveness of our engagement, which may include:
Phase 1 - Assist you to model the comparison between thin capitalisation positions under the proposed rules vs the current rules.
Phase 2 - consider the application of alternative thin capitalisation tests (where a negative outcome arises under the income-based approach); and/or assessing tax implication of your alternative financing arrangements.
If there are any enquiry about above issue, please contact our business and tax service team. Kind Regards, Wis Australia
Our Business & Tax Service Team
Partner, Corporate Services
Specialist, Business & Tax Services
Manager, Corporate Services