Australia has introduced significant changes to its thin capitalisation rules this year. These changes aim to prevent multinational corporations from excessively leveraging debt to reduce taxable income through interest and other debt deduction claims.
These rules, which will apply to income years beginning on or after 1 July 2023, mean that if an entity has aggregated debt deductions exceeding AU$2 million, it can choose to apply one of the threshold tests highlighted in this article to determine the amount, if any, of the denied debt deduction. The former thin capitalisation tests, including the 60% debt to assets ratio ‘safeharbour’ test, no longer apply.
However, the AU$2 million aggregated debt deduction threshold still applies. Broadly, the thin capitalisation rules do not apply to disallow any debt deduction if the total debt deductions of that entity and all its associate entities for that year are below AU$2 million.
The changes also include the addition of a new integrity rule, which will not apply until income years on or after 1 July 2024 when the financial arrangement was in place before 22 June 2023.
These changes represent a shift in Australia’s thin capitalisation rules, incorporating internationally recognised best practices endorsed by the Organisation for Economic Co-operation and Development (OECD).
So, what are these tests?
Fixed Ratio Test
The fixed ratio test represents one of the major changes to the Australian thin capitalisation rules.
Under this test, an entity’s net debt deductions are capped at 30% of its tax earnings before interest, taxes, depreciation, and amortisation (EBITDA). Any debt deductions exceeding this limit are disallowed, with the option to carry forward denied debt deductions for up to 15 years.
This provides a clear and straightforward mechanism to prevent excessive leveraging by multinational corporations, ensuring that taxable income is not artificially reduced.
Group Ratio Test
The group ratio test considers a multinational corporation’s worldwide financial position. This test limits net debt deductions by calculating a ratio of the worldwide group’s net third party interest expense and EBITDA, which can be found in the group’s financial statements.
Compared to the fixed ratio test, denied debt deductions are unable to be carried forward as part of this test.
Third-Party Debt Test
This final test distinguishes between third-party and related-party debt. Under this test, only debt deductions attributable to external debt are allowed, while deductions associated with related-party debt are denied.
Like the group ratio test, there is no provision for carrying forward denied debt deductions in this test. By targeting related party transactions, this test addresses concerns regarding the manipulation of intra-group financing arrangements to artificially inflate debt levels and reduce taxable income.
What is the new integrity rule?
A significant change introduced this year was the debt deduction creation rule which governs the eligibility of debt deductions claimed by entities for tax purposes. Broadly, debt deductions must be directly linked to income-producing assets or activities, preventing the deduction of interest on the non-income producing debt.
A key integrity rule introduced deems certain types of debt non-deductible in full where the debt has arisen through related party restructures or transactions. This is notwithstanding that the debt deduction may be below the AU$2 million de minimus.
In our view, the rules appear to emphasise adherence to arm’s length dealings in intra-group financing or asset transfer arrangements, ensuring transactions reflect market terms.
How do these changes impact businesses?
Decreased Compliance Burden
For groups that operate in jurisdictions that already adopt thin capitalisation, many of the amendments appear to align with established provisions overseas.
Increased Emphasis on Planning
Ensuring accurate reporting, gaining a better understanding of current and proposed debt and equity funding and identifying the global business structure are becoming more important to ensure that the tax outcomes are appropriately quantified ahead of time.
Potential Restructuring of Financing
Entities with high debt levels may need to consider restructuring their financing arrangements to comply with the amendments. This could involve reducing debt, injecting equity or renegotiating terms with lenders.
These amendments underscore the Australian government’s longstanding focus on multinational businesses and structures by minimising potential loopholes and enhancing transparency. Careful planning is required to understand the impact of the amended rules ahead of the end of the financial year, including assessing any additional compliance or disclosures in income tax returns.
If you are interested in understanding how thin capitalisation applies to your business, contact William Buck’s tax advisory team.
