Glossary

Purpose of the Bill

The purpose of the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share—Integrity and Transparency) Bill 2023 (the Bill) is to amend taxation and corporation laws to introduce ‘new rules to protect the integrity of the Australian tax system and improve tax transparency’.[1]

Structure of the Bill

The Bill comprises 2 Schedules:

• Schedule 1 amends the Corporations Act 2001 to require Australian public companies (listed and unlisted) to disclose information about subsidiaries in their annual financial reports for a financial year starting from 1 July 2023.
• Schedule 2 amends the existing thin capitalisation rules under the Income Tax Assessment Act 1936 (ITAA 1936), Income Tax Assessment Act 1997 (ITAA 1997) and the Taxation Administration Act 1953 (TAA) from 1 July 2023, by replacing the current asset-based tests in thin capitalisation rules with the Organisation for Economic Co-operation and Development (OECD) recommended earnings-based tests; and inserting a new anti-avoidance provision to target debt creation schemes.

Structure of this Bills Digest

As the matters covered by each of the Schedules are independent of each other, the relevant background, stakeholder comments (where available) and analysis of the provisions are set out under the relevant Schedule number.

Committee consideration

Selection of Bills Committee

The Bill was referred to the Senate Economics Legislation Committee (the Economics Committee) for inquiry and report by 31 August 2023.[2] The closing date for the Economics Committee receiving submissions is 21 July 2023.

At the time of writing this Digest, no submissions had been published online.

Senate Standing Committee for the Scrutiny of Bills

At the time of writing this Digest, the Senate Standing Committee for the Scrutiny of Bills had not considered the Bill.  

Statement of Compatibility with Human Rights

As required under Part 3 of the Human Rights (Parliamentary Scrutiny) Act 2011 (Cth), the Government has assessed the Bill’s compatibility with the human rights and freedoms recognised or declared in the international instruments listed in section 3 of that Act. The Government considers that the Bill is compatible.[3]

Parliamentary Joint Committee on Human Rights

At the time of writing this Digest, the Parliamentary Joint Committee on Human Rights had not considered the Bill.

Schedule 1: Multinational tax transparency–disclosure of subsidiaries

Background

In 2013, the OECD released its report entitled Addressing Base Erosion and Profit Shifting. Subsequently, OECD and G20 countries adopted the Base Erosion and Profit Shifting Action Plan (BEPS Action Plan), which identified 15 clearly defined (but interrelated) actions for implementation aimed at improving international tax cooperation and tax transparency.[4] The Plan was a response to a ‘perception that the domestic and international rules on the taxation of cross-border profits are now broken and that taxes are only paid by the naive’.[5] As explained by the OECD, Base Erosion and Profit Shifting (BEPS):

refers to tax planning strategies that exploit gaps and mismatches in tax rules to make profits ‘disappear’ for tax purposes or to shift profits to locations where there is little or no real activity but the taxes are low, resulting in little or no overall corporate tax being paid.[6]

Country-by-Country Tax Reporting

Action 13 of the BEPS Action Plan recommended that laws be developed that require multi-national enterprises (MNEs) provide detailed information to the tax authority of each jurisdiction in which they operate on their global allocation of income, taxes paid, and certain economic activities for each jurisdiction in which they operate.[7] These are known as country-by-country reports (CbCRs). The availability of the information in CbCRs enables tax authorities to:

•     assess transfer pricing and other BEPS risks and
• help tax authorities understand how MNEs structure their operations and whether the profits are properly allocated among the countries in which they operate.[8]

Specifically, it was recommended that CbCRs should include a ‘listing of all the Constituent Entities [subsidiaries, parent companies etc] for which financial information is reported, including the tax jurisdiction of incorporation’.[9]

Whilst the BEPS Action Plan did not require public disclosure of CbCRs, there have been calls to make this information, or at least elements of it, publicly available.[10] Some stakeholders argue that public transparency would facilitate accountability and help combat tax avoidance as it enhances transparency and may therefore build confidence in tax administration systems.[11] However:

• concerns exist regarding the potential misuse of sensitive business information[12] and
• media reports state that the OECD Secretary-General Matthias Cormann stated that a proposed public CbCR law ‘could have undermined plans for a global minimum corporate rate’.[13]

Non-public CbCR already exists in Australia, general information about which can be found on the ATO website. In addition, the Bills Digests to the Tax Laws Amendment (Combating Multinational Tax Avoidance) Bill 2015 (pp. 29–30) and Treasury Laws Amendment (2020 Measures No. 1) Bill 2020 (pp. 18–23) provide additional information about the existing non-public CbCR regime.

Beneficial ownership register

Registers of beneficial ownership (BO) contain information about entities and/or individuals who ultimately own or control companies. Recently, the OECD and Inter-American Development Bank have released guidance on implementing BO rules, noting (pp. 6–7) that as BO registers contain information about individuals or entities that ultimately own or control companies, they:

• ensure the availability of, and access to, the identity of the beneficial owners of legal entities as well as financial accounts and other assets to tax and other authorities
• assist in the prevention of the misuse of legal entities, the concealment of funds/assets and anonymity, and
• therefore combat illicit financial flows, including money laundering, corruption, terrorism financing and tax evasion.

The establishment of public BO registers reflects an element of what has been described by Australian tax commentators as ‘a global trend towards mandating public reporting as a means of enhancing public scrutiny of multinational tax arrangements’.[14]

Election and policy commitments

In its 2022 election platform, the ALP committed to ‘Introducing transparency measures including reporting requirements on tax information, beneficial ownership, tax haven exposure and in relation to government tenders’.[15] Subsequently, the October 2022–23 Budget included the ‘Multinational Tax Integrity Package – improved tax transparency’ measure (p. 17). The Explanatory Memorandum to the Bill notes that Schedule 1 ‘partially implements’ that election commitment and the October 2022–23 Budget measure.[16]

Consultation

In August 2022, the Treasury conducted a Multinational Tax Integrity and Tax Transparency consultation process. Part 3 of the relevant Treasury consultation paper examined multinational tax transparency. In March 2023, the Treasury released Exposure Draft legislation dealing with the disclosure of subsidiary information for consultation.

Financial implications

The Explanatory Memorandum states that the estimated financial impact on receipts is ‘unquantifiable’.[17]

Key issues and provisions

The Corporations Act defines a public company as a company other than a proprietary company or a corporate collective investment vehicle.[18] Currently the Corporations Act requires public companies to prepare annual financial statements, which are included in its publicly available annual reports.[19] Where the public company is a parent company, the Australian Accounting Standards (Accounting Standards) generally require the preparation of consolidated financial statements.[20]

Subsection 295(1) of the Corporations Act sets out the constituent parts of a financial report for a financial year. Item 1 in Schedule 1 to the Bill amends subsection 295(1), to require a public company’s financial reports to include a consolidated entity disclosure statement.[21] Item 2 in Schedule 1 sets out the matters which must be included in a consolidated entity disclosure statement. If the Accounting Standards require the public company to prepare financial statements in relation to a consolidated entity, the consolidated entity disclosure statement must include the following information about each entity that was part of the consolidated group at the end of the financial year (that is, the parent and all subsidiary entities) being:

• the names of each entity and whether the entity was a body corporate, partnership or trust at the end of the financial year
•     whether at the end of the financial year, the entity was any of the following:
  • a trustee of a trust within the consolidated entity
  • a partner in a partnership within the consolidated entity, and
  • a participant in a joint venture within the consolidated entity
•     if the entity is a body corporate, where the entity was incorporated or formed
• if the entity is a body corporate with share capital, the public company’s percentage ownership of the entity at the end of the financial year and
•     the tax residency of each of those entities during the financial year.[22] [emphasis added]

However, where the Accounting Standards do not require the public company to prepare financial statements in relation to a consolidated entity, the public company's financial report must include a statement to that effect, which is the consolidated entity disclosure statement for that company.[23]

In addition, the existing declaration of the directors (and for listed companies, the existing declaration of the chief executive officer and chief financial officer) will be expanded to include a declaration that the consolidated entity disclosure statement is in their opinion ‘true and correct’.[24] This is a more onerous requirement than the requirement that financial statements give a ‘true and fair’ view which would otherwise apply.[25]

The new requirements will apply to financial statements prepared by public companies for each financial year commencing on or after 1 July 2023.[26]

Effect of the disclosures

Whist separate concepts, CbCR and BO registers as explained above, both involve an entity listing certain subsidiaries, parent companies and other constituent entities related to it, including the tax jurisdiction of incorporation of those entities, albeit to different levels of detail and in differing circumstances.

The amendments in Schedule 1 to the Bill partly reflect elements of both CbCR and BO disclosure, as they relate to a public company publicly disclosing:

•     subsidiaries, parent companies and other constituent entities related to it and
•     the tax residency and jurisdiction of incorporation of those entities.

The effect of the above disclosures is that there will be more information in the public domain about the structural, operational and tax affairs of MNEs, and therefore potentially greater public scrutiny. As noted in the Explanatory Memorandum:

From a tax perspective, the expectation is that more information in the public domain will help to encourage behavioural change in terms of how companies view their tax obligations, including their approach to tax governance practices, decision making around aggressive tax planning strategies and potential simplification of group structures.[27]

Proprietary companies excluded

As noted earlier, the Corporations Act provides that a public company is not a proprietary company.[28] In turn, the Corporations Act defines a proprietary company as a company whose constitution limits membership to 50 non-employee shareholders, restricts the right to transfer shares and prohibits invitations or offers to the public to subscribe for its shares or debentures.[29]

This means that the measures in Schedule 1 of the Bill will not apply to large proprietary companies that are parent companies, even though such entities are often very large businesses with income and operations comparable to public companies. Whilst no reasons for the exclusion of proprietary companies is given, previous tax transparency reforms that applied to large proprietary companies were opposed on various grounds, including that:

• publication of tax related information of private companies may result in ‘competitors, customers (including large business customers) and other stakeholders’ obtaining ‘information which can be used to exert commercial pricing or other leverage or advantages over private companies’[30] and
• such measures are ‘distinctly discriminatory’ and ‘inappropriately overturn fundamental rights of taxpayer privacy for private Australian companies and their shareholders’.[31]

Policy position of non-government parties / independents

At the time of writing none of the non-government parties or independents appear to have expressed a view on the measure contained in Schedule 1 of the Bill.

Position of major interest groups

At the time of writing, the position of major interest groups in relation to the specific measure in Schedule 1 to the Bill was not clear. However, based on the 5 publicly available submissions to an Exposure Draft consultation process carried out by Treasury in March 2023, in general most stakeholders supported the intent of the proposed measure in Schedule 1 of the Bill.[32]

However, some stakeholders expressed specific concerns including:

• the Bill does not apply the concept of materiality to the proposed consolidated entity disclosure statement, therefore requiring disclosure of a list of all entities included in the consolidated financial statements, potentially including immaterial and dormant entities (rather than being confined to material and active entities)[33]
• the interaction of the proposals with existing Corporations Act requirements for the overall financial report, including that the proposed consolidated entity statement will be subject to audit, may result in duplication of information already included in financial statements and will introduce additional costs and resourcing challenges for public companies[34] and
• in some cases, information contained in the proposed consolidated entity statement may remain unchanged from year to year and therefore the Bill should include ‘standing information’ separately from the financial report, with only any changes in the year being disclosed on an annual basis.[35]

In contrast to some of the above concerns however, the Tax Justice Network Australia, Transparency International Australia and the Centre for International Corporate Tax Accountability and Research argued:

There is minimal compliance burden for companies to publish a list of all subsidiaries with basic information, as proposed, but a significant increase in transparency for investors and other stakeholders.[36]

Schedule 2: Thin capitalisation

What is ‘thin capitalisation’?

The ATO states simply: ‘A thinly capitalised entity is one whose assets are funded by a high level of debt and relatively little equity.’ As Wolters Kluwer explains:

“Thin capitalisation” may be described as the process of financing subsidiaries with greater amounts of debt in comparison with equity than would be normal in an arm’s length funding arrangement. Such a process may be carried out for tax-related reasons. Typically, a company resident in one jurisdiction will fund its subsidiary in another jurisdiction by means of as much debt as possible, so as to reduce the subsidiary’s taxable profits by enabling it to claim excessive deductions for interest paid to the foreign owner. Rules designed to counter this practice usually have the effect of denying tax deductions for interest paid on such debt funding, up to specific limits.[37]

The problem

The lack of coherence in international tax rules creates international tax gaps in a global digital economy where large multinational entities (MNEs) aggressively engage in tax avoidance practices.[38] The OECD’s BEPS Action 4 (the Limiting Base Erosion Involving Interest Deductions and Other Financial Payments, Action 4 - 2016 Update) (p.13) identifies three basic scenarios where large MNEs escape restrictions on the interest debt deductions to avoid income taxes:

• groups placing higher levels of third-party debt in high tax countries
• groups using intragroup loans to generate interest deductions in excess of the group’s actual third-party interest expense
• groups using third party or intragroup financing to fund the generation of tax-exempt income.

In Australia, the ATO has detected mischief involving manipulation of the thin capitalisation rules and has issued Taxpayers Alerts accordingly.[39]

A global solution for a global problem

To address these problems, the OECD’s recommended default approach (p. 13) is based on a fixed ratio rule which limits an entity’s net deductions for interest to a percentage (between 10% and 30%) of its earnings before interest, taxes, depreciation and amortisation (EBITDA). The earnings-based test was recommended by the OECD in 2015,[40] and is accepted as a common approach among the 143 BEPS member countries and jurisdictions within the OECD/G20 Inclusive Framework. According to the OECD, an earnings-based test is a ‘more effective and efficient way of addressing concerns surrounding the use of interest in BEPS’ than other approaches.[41] In addition, the test is ‘straightforward’ to apply and ‘reasonably robust against planning’ as it directly links an entity’s net interest deductions to its level of economic activity and its taxable income.[42]

In contrast, Australia’s thin capitalisation rules originated from the 1999 Review of Business Taxation (the Ralph Review).[43] The current default safe harbour test applies differently to the OECD’s approach and limits interest deductions to 60% of assets. Treasury considers that Australia’s existing tests are ‘generally more favourable to taxpayers than the [OECD] tests’ (p. 8).

In April 2022, the Australian Labor Party (ALP) announced it would broadly align Australia’s thin capitalisation rules with the OECD’s recommended approach as part of its election commitments (pp. 2–3). On 5 August 2022, the Government announced that the public consultation on the ‘Multinational Tax Integrity and Transparency’ package had commenced – the package not only includes the strengthening of interest limitation rules for multinationals, but also complements the Government’s ongoing engagement in the OECD’s Two-Pillar Global Tax Agreement. In October 2022, the Government announced the specific details for the measure in the Budget October 2022-23: Budget paper no.2 (p. 15).

Consultation

The Bill has been the subject of a lengthy four-stage consultation. Submissions have been provided by relevant stakeholders and significant changes made to each iteration of the exposure draft of the legislation. A summary of the consultation process is set out below.

Initial consultation – August 2022

On 2 September 2022, the Treasury completed a broad consultation on a 3-part discussion paper ‘Government election commitments: Multinational tax integrity and enhanced tax transparency’. Part 1 of the paper (pp. 5–10) deals with strengthening the interest limitation rules for MNEs.

In this initial consultation, the Treasury received 70 submissions and published 60 non-confidential submissions. The Explanatory Memorandum (pp. 90–91) contains a summary of the main issues raised at that stage of the consultation process.

Second consultation – November 2022

In November 2022, the Treasury conducted a second consultation with the property sector and tax advisory firms to discuss certain technical parameters of the group trust rule and third-party debt test.[44] The submissions to the Treasury in relation to the second consultation are not available on the Treasury website. Subsequently, the Treasury released the Exposure Draft legislation on 16 March 2023.

The Explanatory Memorandum (pp. 82–83) summarises the industry reactions to the first two rounds of consultation.

Third consultation – March to April 2023

On 13 April 2023, the Treasury completed the third public consultation on the proposed draft legislation on the ‘Multinational Tax Integrity -- strengthening Australia’s interest limitation (thin capitalisation) rules’. Treasury met with a range of stakeholder groups across all sectors including industry representatives, individual firms and tax advisory firms. Treasury received 55 submissions and published 40 non-confidential submissions.

The dominant focus of this consultation was an announced integrity change – a proposed amendment to section 25-90 of the ITAA 1997 which is about the deductibility of interest on money borrowed to acquire shares in offshore subsidiaries. The Explanatory Memorandum (p. 92) indicates that this amendment has been deferred, with the Government to consider this further via a separate process.

Fourth consultation – April 2023

The Explanatory Memorandum (p. 94) states:

Treasury continued to meet with industry representatives after the public consultation period ended, mostly in relation to the third-party debt test and trust grouping rules. These bilateral meetings provided a further opportunity for stakeholders to discuss in specific detail the technical elements of their submissions and to discuss the proposed drafting approach.

Stakeholder feedback in these meetings were considered and, where appropriate, reflected in the final design (as indicated above) to improve the functionality and operability of the legislation, with a view to minimising unintended consequences. This included targeted, in-confidence consultations on revised draft legislation.

Need for ongoing consultation

Speaking in relation to the Bill, Assistant Minister for Competition, Charities and Treasury, Dr Andrew Leigh stressed that ‘Treasury will continue to engage with industry to ensure the changes operate as intended’.[45]

In response Deloitte commented: ‘It therefore appears that the Government acknowledges that amendments may be made to the Bill at least in respect of technical matters.’[46] The Explanatory Memorandum notes (pp. 97–98):

Treasury has worked closely with the Australian Taxation Office and a broad range of industry stakeholders as part of the implementation and legislative design process, to minimise unintended consequences. However, the changes to the interest limitation rules are a very complex undertaking with broad application in the taxpayer community. There are potential risks for unintended consequences which may only come to light as taxpayers seek to apply the new rules. Treasury will continue to engage stakeholders on the operation of this measure to ensure the rules (and the income tax laws more broadly) are operating as intended. [emphasis added]

Financial implications

Schedule 2 to the Bill is estimated to raise $720 million revenue over three years to 2025–26 ($m), as shown in the table below.

Table 2: Financial impact of Schedule 2 ($m)

Source: Explanatory Memorandum, 2.

Compliance cost implications

The Explanatory Memorandum states that ‘there are approximately 2,500 taxpayers with sufficient levels of debt deductions to fall within scope of the new law’ in Schedule 2.[47] An estimated compliance cost impact of $70.1 million is expected in the initial year of effect, followed by nil ongoing costs.[48] 

Position of major interest groups

Stakeholders’ reactions to Schedule 2 appear mixed—in particular because they apply to the financial year commencing 1 July 2023. For instance, law firm Ashurst noted:

The Bill contains material amendments to Australia's thin capitalisation regime that are likely to have significant impacts on a wide range of taxpayers. These changes take effect from 1 July 2023 and in many instances could have a more materially adverse impact on taxpayers than the draft rules contained in the Exposure Draft.[49]

Law firm Gilbert + Tobin expressed a neutral view on the progression of the proposed new tests within the thin capitalisation regime:

These changes are part of the Government’s multinational tax integrity package announced as part of their election campaign, which initially only proposed to replace the safe harbour debt amount to work out a taxpayer’s maximum allowable debt under the thin capitalisation rules (although there has been considerable discussion in relation to amending the Arm’s Length Debt Test (ALDT)), with an earnings-based test. Under this commonly used method, taxpayers are currently permitted to gear up to a debt-to-equity ratio approximating 1.5:1 but, from 1 July 2023, this method will be replaced with a cap on interest deductions for an income year up to 30% of EBITDA, which is based on the concept of “tax EBITDA”(fixed ratio test).

However, the proposed changes to the thin capitalisation rules have progressively morphed throughout the consultation process which commenced in August last year, culminating in the Bill which, in addition to the new fixed ratio test, introduces a new third party debt test to replace the current arm’s length debt test, and a new group ratio test which will replace the worldwide gearing debt test for most taxpayers.[50]

Key issues and provisions

How the thin capitalisation rules currently work

Division 820 of the ITAA 1997 contains the thin capitalisation regime. The rules apply to limit the amount of debt deductions that an entity can otherwise deduct from their assessable income where the debt-to-equity ratios exceed prescribed limits.[51]

As explained by the ATO, the thin capitalisation rules apply to:

• Australian entities that control foreign entities or operate a business at or through overseas permanent establishments and associated entities– these entities are called outward investing entities
• Australian entities that are foreign controlled and foreign entities that either invest directly into Australia or operate a business at or through an Australian permanent establishment – these entities are called inward investing entities.[52]

The thin capitalisation rules can apply to all types of entities, including companies, trusts, partnerships and even, to a small extent, individuals.[53]

A de minimis rule prevents the Division from denying deductions for entities that, together with associate entities, claim no more than $2 million in debt deductions in a year of income for income years starting on or after 1 July 2014.[54]

In addition, the rules take different approaches depending on whether or not the entity affected is an authorised deposit-taking institution (ADI) (for the purposes of the Banking Act 1959). For entities that are not ADIs, the tests set a maximum debt level. For ADIs, the tests are based on a minimum requirement for equity capital. The requirement for ADIs is based on existing Australian prudential regulatory requirements. There is provision for entities which are not ADIs to choose to be treated as ADIs for thin capitalisation purposes, provided they meet certain requirements. [55]

The legislation separates entities into categories because the rules for calculating the maximum debt levels or minimum capital levels are different depending on the type of entity involved. The eight categories are:

• non-ADI general outward investor
• non-ADI financial outward investor
• non-ADI general inward investment vehicle
• non-ADI financial inward investment vehicle
• non-ADI general inward investor
• non-ADI financial inward investor
• ADI outward investing entity
• ADI inward investing entity. [56]

Tests that determine the debt funding limits

The asset-based tests that determine the maximum amount of debt funding limits are dependent on whether the entity concerned is a financial entity, and whether the entity is an inward or outward investing entity.  

As an example, for an outward investing entity that is neither an ADI nor a financial entity, called a non-ADI general entity, the maximum allowable debt currently is the greatest of the:

• safe harbour debt amount, which is 3/5 of the average value of the entity's Australian assets, with some adjustments. This is based on the safe harbour ratio of 1.5:1[57]
• arm's length debt amount, which is the amount of debt that could have been borrowed by an independent party carrying on the entity's Australian operations[58]
• worldwide gearing debt amount, which in certain circumstances can allow the Australian operations to be geared at up to 100% of the gearing of the Australian entity's worldwide group.[59]

For detailed explanations on how to apply the asset-based tests, see information from the ATO webpages.

Consolidated groups and multiple entry consolidated groups

The head company of a consolidated group or multiple entry consolidated group (MEC group) can be classified as any of the following:

• a non-ADI outward investing entity
• a non-ADI inward investing entity
• an ADI outward investing entity
• an ADI inward investing entity. [60]

However, the thin capitalisation rules will not apply where the consolidated group or MEC group passes either the:

• debt deduction test: section 820-35 of the ITAA 1997
• assets threshold test: section 820-37 of the ITAA 1997.

There is a further exemption relating to a head company that is either a foreign controlled ADI or a foreign controlled Australian company that wholly owns a foreign controlled Australian ADI. This is discussed in more detail in ATO information about Exemptions for foreign controlled consolidated groups (p. 35).

How the head company is classified is determined by the nature of the entities making up the consolidated group or MEC group. Entity categories explains how individual entities are classified (p. 23). If the consolidated group or MEC group contains a special purpose entity that is exempt from thin capitalisation under section 820-39 of the ITAA 1997, it is treated as not being part of that group for thin capitalisation purposes only.[61]

Entities that are both outward and inward investing entities

If an entity is both an outward investing entity and an inward investing entity, the rules for outward investing entities apply. For example, if an Australian resident entity is foreign controlled and also carries on business through an overseas permanent establishment, the rules for outward investing entities apply subject to two qualifications:

• The entity is not able to apply the assets threshold test in section 820-37 of the ITAA 1997.
• The entity may choose to apply a worldwide gearing debt test, provided that certain requirements are met including a requirement that the entity’s Australian assets represent no more than 50% of the entity’s statement worldwide assets. [62]

What the Bill does

Commencement date of 1 July 2023

The proposed changes in Schedule 2 are intended to take effect from 1 July 2023. Stakeholders highlighted that there is no grandfathering and no transitional period.[63] One stakeholder commented:

This means the changes may apply to existing debt, not just borrowings entered into on or after 1 July 2023. This is clearly potentially adverse to taxpayers who have borrowed on the basis of the existing safe harbour debt amount and may, for example, have modelled the viability of investments or projects based on interest deductions which may cease to be available in just over 90 days’ time.[64]

New class of investors

As stated above, Division 820 of the ITAA 1997 provides for 8 separate categories of investor. Item 29 in Schedule 2 to the Bill inserts proposed Subdivision 820-AA into the ITAA 1997 to create a new general class investor. It does so by consolidating 3 existing general classes of investors.

An entity is a general class investor for a financial year if it is not a financial entity or an ADI: proposed subsection 820-46(2). The Bill amends the existing definition of financial entity in the ITAA 1997 so that the distinction between a financial entity and any other investor is clear.[65]

The new general class investor category comprises:

• an Australian entity that carries on a business in a foreign country at, or through, a permanent establishment or through an entity (an ‘associate entity’) that it controls
• an Australian company, trust or partnership that is controlled by foreign residents
• a foreign entity having investments in Australia.[66]

ADIs are subject to the existing thin capitalisation asset-based tests. Financial entities are subject to the existing safe harbour debt and worldwide gearing tests, however, they will be subject to the new third party debt test and not the existing arm’s length debt test.

General class investors will be subject to the stricter OECD earnings-based tests as shown in the table below.

Table 1: Comparison of changes to thin capitalisation rules

Source: Ryan Leslie, Toby Eggleston and Professor Graeme Cooper (Herbert Smith Freehills), ‘Changes to Thin Capitalisation Rules – Part 1’, Thomson Reuters Westlaw, 14 April 2023.

Fixed ratio test—a default test

The fixed ratio test (FRT) is the default earnings-based test for general class investors.[67] It replaces the existing safe harbour test.

The FRT disallows net debt deductions in excess of an entity’s fixed ratio earnings limit [68] which is 30% of its tax EBITDA for the income year.[69]

Key issue: tax EBITDA for trusts and partnerships

Generally speaking, tax EBITDA (earnings before interest, taxes, depreciation and amortisation) is calculated as follows: [70]

According to the Explanatory Memorandum to the Bill:

These steps allow for an entity’s net interest expense to be calculated according to concepts from Australia’s income tax system and consistent with the OECD best practice guidance. This includes interest on all forms of debt, payments economically equivalent to interest, and expenses incurred in connection with the raising of finance.[71]

The key issue for stakeholders is how the definition of tax EBITDA applies to trusts[72] and partnerships.[73] According to Deloitte:

Special provisions have been included to address investments in partnerships and trusts. The broad objective is to ensure that amounts included in the net income of partnerships and trusts, and hence included in the Tax EBITDA of a partnership or a trust, are not counted again in the Tax EBITDA of a partner or a beneficiary, who is a relevant associate of the partnership or trust…

… in most non-tax consolidated cases, whether joint venture companies, partnerships or trusts, any relevant debt needs to be issued by the entity conducting the relevant business and income earning activities, and not at the level of the shareholder, partner or beneficiary, in order for the interest to be deductible.

For existing structures where the debt is at the investor level, seeking to restructure the debt into the underlying joint-venture company, partnership or trust risks the operation of the new debt creation rules (with the result that interest on the restructured loan could be fully non-deductible).[74]

Ashurst also commented on this aspect of the Bill stating:

… the introduced legislation goes further than the Exposure Draft in its impact on upstream gearing. New sections now exclude franking credits, dividends, and assessable income amounts arising from holding interests in associate entity trusts and partnerships in determining tax EBITDA. This will, in effect, deny upstream holding entities from having a positive tax EBITDA completely, rendering their debt deduction capacity under the fixed ratio test nil. Given that the rules take effect from 1 July 2023, these taxpayers will find themselves with insufficient time to restructure debt arrangements to sit at the asset entity level prior to these rules taking effect (and, even if there were time to restructure to shift debt to the asset entity level, they could face potential issues under the debt creation provisions, among other integrity provisions (such as Part IVA)).[75]

However, the Explanatory Memorandum to the Bill states:

Partnerships and trusts calculate tax EBITDA in effectively the same manner as other entity types…

In calculating tax EBITDA for partners of a partnership and beneficiaries (and trustees) of a trust, certain adjustments are made to ensure that amounts included in the net income of partnerships and trusts are only counted towards tax EBITDA once. These adjustments aim to ensure that such amounts only count towards the tax EBITDA of partnerships and trusts, and not the tax EBITDA of the entities (partners, beneficiaries and trustees) to which such amounts may ultimately be assessed. These adjustments only apply where the partner or beneficiary are an associate entity of the relevant partnership or trust.[76]

Key issue: using net debt deductions

In order to work out an entity’s tax EBITDA it is necessary to take into account net debt deductions, which are worked out in according with the formula in proposed subsection 820-50(3).

According to Ashurst:

The concept of "debt deductions" is being amended, so that it captures amounts that are not in relation to a debt interest. The changes to the relevant components of the definition of debt deductions make it clear that it is now intended to capture deductions arising in respect of swap arrangements (such as interest rate swaps, but potentially not foreign exchange swaps), but it is not clear whether it is intended to capture other arrangements where payment flows are economically equivalent to interest.

The definition of "debt deductions" and the amounts that reduce debt deductions in calculating net debt deductions remain non-symmetrical. That is, certain items of expenditure are included in debt deductions, but then income amounts of an equivalent nature are not necessarily applied as a reduction in calculating net debt deductions. This is likely to increase taxpayers' net debt deductions in certain circumstances.[77]

Key issue: availability of special deduction for previously FRT disallowed amounts

A special deduction for debt deductions disallowed under the fixed ratio test over the previous 15 years is available to general class investors in certain circumstances. The special deduction allows entities to claim debt deductions that have been previously disallowed within the past 15 years under the fixed ratio test in a later income year when they are sufficiently profitable and where their fixed ratio earnings limit exceeds their net debt deductions. There is no equivalent to this in the current rules. This special rule is not available for the group ratio test or third party debt test. [78]

According to Gilbert and Tobin:

… taxpayers will be permitted to carry forward denied deductions for up to 15 years which can be used where there is an excess capacity available under the fixed ratio test in a subsequent year of income. This measure will address volatility concerns and will also ensure that entities engaging in projects which are initially loss making, e.g. start-ups, tech firms, construction projects or greenfield investments, will not permanently lose deductions for interest incurred during the initial capital-intensive stages…

If a taxpayer entity chooses [a test other than the fixed ratio test] in a subsequent income year, the entity loses the ability to carry forward denied deductions.

Ashurst noted the effect of the amendments on companies and trusts[79] stating:

The carry forward of denied deductions by companies is subject to either a modified continuity of ownership test and … a modified business continuity test (which is positive).

However … trusts will now have to satisfy the 50% stake test (or alternatives) in order to access carry forward amounts. As most trusts are not able to apply the same or similar business test, most trusts will not have this as a fall back option where the 50% stake test is failed. Those trusts that are eligible to apply the same or similar business test to tax losses will be entitled to apply those tests to carried forward denied deductions.

Group ratio test

The group ratio test (GRT) requires an entity to determine the ratio of its group’s net third-party interest expense to the group’s EBITDA for an income year: proposed subparagraph 820-50(1)(b).[80] The amount of debt deductions of an entity that are disallowed for an income year is the amount by which the entity’s net debt deductions exceed the entity’s group ratio earnings limit for the income year. The test replaces the worldwide gearing test.

A general class investor can only choose to use the GRT if it is a member of a GR group and the GR group EBITDA for the period is at least zero: proposed subsection 820-46(3).

The Explanatory Memorandum states:

The worldwide parent or global parent entity is referred to as the ‘GR group parent’ and must have financial statements that are audited consolidated financial statements for the period. Where a GR group has a global parent entity, the equivalent global financial statements must be prepared for the period. Each entity that is fully consolidated on a line-by-line basis in the GR group parent’s financial statements is referred to as a ‘GR group member’.[81]

According to Herbert Smith Freehills the GRT operates using a mixture of financial accounting concepts and Australian tax law concepts:

• the group is defined to consist of all entities which are consolidated on a line-by-line basis in accounts of a worldwide parent entity
• the group ratio (the ratio of interest to EBITDA of the group) is calculated using the data from the audited consolidated financial accounts and
• that ratio is then applied to the tax EBITDA of the Australian entity for the income year; that is, to amounts defined under the Australian tax law.[82]

The group ratio earnings limit is calculated using information from the consolidated financial accounts of the group. It is the ratio of the group net third party interest expense to group EBITDA for an income year multiplied by the entity’s tax EBITDA for the income year.[83]

The group net third party interest expense is worked out in accordance with the formula in proposed section 820-54. It is the total amount appearing in financial statements which reflects:

• amounts in the nature of interest plus
• any other amount that is economically equivalent to interest minus
• payments made by the entity to an (ungrouped) associate of the entity (that is, the amount is not third party interest expense) minus
• payments made by an (ungrouped) associate of the entity to the entity (that is, it is not third party interest income and so does not diminish the net interest expense).[84]

The group EBITDA for a period is:

• the group's net profit plus
• the group's adjusted net third party interest expense plus
• the group's depreciation and amortisation expenses minus
• tax expenses.[85]

Stakeholder comments

Law firm Ashurst expressed concern about adverse and unexpected outcomes that may arise from the use of these tests. By way of example ‘trusts and partnerships are ineligible to apply the third party debt test, meaning they will have to rely on the fixed ratio test or the group ratio test’.[86]

Third-party debt test

General class investors and financial entities may choose to apply the third party debt test for an income year: proposed subsections 820-46(4), 820-85(2) and 820-185(2). General class investors can be deemed to have made a choice to use the third party debt test (TPDT) if certain conditions are satisfied. If the entity that issues a debt interest chooses to use the TPDT, then their associate entities in the obligor group in relation to the debt interest are all deemed to have chosen that test: proposed section 820-48. The TPDT replaces the arm’s length debt test.

Proposed section 820-49 provides that an entity is a member of an obligor group in relation to a debt interest if the creditor of that debt interest has recourse for payment of the debt to the assets of the entity. The borrower in relation to the debt interest is also a member of the obligor group.

According to PWC ‘the third party debt test seeks to limit debt deductions of the taxpayer by reference to genuine third party debt’.

The holder of the debt must only have recourse to the Australian assets of the relevant entity … The Bill does not provide for any adjustment where recourse may be available to non-Australian assets of the entity. Therefore, the third party debt test will operate to deny all debt deductions attributable to a third party debt interest that is secured over both Australian and non-Australian assets of the borrower.[87]

The amount of debt deductions of an entity for an income year that is disallowed is the amount by which the entity’s debt deductions exceed the entity’s third party earnings limit for the income year.[88]

The meaning of the term third party earnings limit is set out in proposed section 820-427A (at item 76 of Schedule 2). An entity’s third party earnings limit for an income year is the sum of each debt deduction of the entity for the income year that is attributable to a debt interest issued by the entity that satisfies the third party debt conditions in relation to the income year. Debt deductions of an entity that are:

• directly associated with hedging or managing the interest rate risk in respect of the debt interest and
• not referrable to an amount paid, directly or indirectly, to an associate entity of the entity

are taken to be attributable to the debt interest.[89]

The third party debt conditions in relation to an income year are:

• the entity issued the debt interest to an entity that is not an associate entity of the entity
• the debt interest is not held at any time in the income year by an entity that is an associate entity of the entity
• the holder of the debt interest has recourse for payment of the debt only to Australian assets held by the entity
• the entity uses all, or substantially all, of the proceeds of issuing the debt interest to fund its commercial activities in connection with Australia
• the entity is an Australian resident.[90]

One commentator had this to say about the TPDT:

The third party earnings limit has been expanded to include debt deductions directly associated with hedging or managing the interest rate risk in respect of the debt interest, unless paid, directly or indirectly, to an associate entity. …

The third party debt test now contains a limited carve out for certain credit support arrangements that provide direct or indirect recourse to the assets of an Australian entity or non-associated foreign entity. It appears that the carve out only applies where the credit support is considered an Australian asset held by the borrower and the debt financing wholly relates to the creation or development of a CGT assets that are real property situated in Australia.

The third party debt conditions require that the borrower is an Australian resident, which does not technically include a trust or partnership.[91]

Key issue: conduit financing rules

Proposed section 820-427C provides addition rules about the manner in which conduit financer arrangements can satisfy the third party debt conditions in certain circumstances.[92]

According to the Explanatory Memorandum to the Bill:

Such arrangements are generally implemented to allow one entity in a group to raise funds on behalf of other entities in the group. This can streamline and simplify borrowing processes for the group.

In the context of the third party debt test, conduit financer arrangements exist where an entity (a ‘conduit financer’) issues a debt interest to another entity (an ‘ultimate lender’) and that debt interest satisfies the third party debt conditions. The conduit financier then on-lends the proceeds of that debt interest to one or more associate entities on substantially the same terms as the debt interest issued to the ultimate lender.[93]

Deloitte opines that under the conduit financing rules:

• the security under the ultimate external loan can extend to assets of the borrower and other Australian resident members of the "obligor group" …
• certain terms of each on-lending are still required to be the same as the ultimate debt interest, however, in a positive development, only terms relating to a cost under the ultimate debt must be the same, and certain terms of the on-lending can be disregarded (including the on-charging of reasonable administrative costs of the conduit financier in relation to the ultimate debt interest)
• the conduit financing rules now cater for successive on-lending scenarios. The conduit financier and borrowers must be "Australian residents", which does not technically include trusts or partnerships.

The various conditions mean that the conduit financing conditions will be challenging to meet at best, and in many cases, cannot be satisfied.[94]

Debt deduction creation rules (anti-avoidance provisions)

Item 76 of Schedule 2 to the Bill inserts proposed Subdivision 820-EAA—Debt deduction limitation rules for debt deduction creation (all relevant entities) into the ITAA 1997. The purpose of the new Subdivision is to disallow debt deductions to the extent that they are incurred in relation to debt creation schemes that lack genuine commercial justification.[95]

The debt deduction creation rules operate in two circumstances. First, where an entity acquires an asset (or an obligation) from its associate. The entity, or one of its associates, will then incur debt deductions in relation to the acquisition of that asset. The debt deductions are disallowed to the extent that they are incurred in relation to the acquisition, or subsequent holding, of the asset.[96]

Second where an entity borrows from its associate to fund a payment to that, or another, associate. The entity will then incur debt deductions in relation to the borrowing. The debt deductions are disallowed to the extent that they are incurred in relation to the borrowing.[97]

Entities may have limited objection rights against private ruling or determination if the Commissioner of Taxation determines that tax avoidance debt deduction schemes exist under proposed section 820-423D. [98]

Making a choice

A general class investor may make a choice for an income year to use either the GRT or the third party debt test: proposed subsections 820-46(3) and (4). In that case, the choice must be made in an approved form and by a specified due date: proposed subsections 820-47(1) and (2).[99] (The current law does not require an explicit election: the taxpayer automatically gets the best out come under the existing 3 asset-based tests). If the general class investor wishes to revoke the choice it has made, it must apply to the Commissioner in the approved form; and the Commissioner can make a decision to that effect in writing: proposed subsections 820-47(4). The Commissioner must be satisfied that, amongst other things, it is fair and reasonable, having regard to the matters the Commissioner considers relevant, to allow the entity to revoke its choice: proposed subsection 820-47(6).

Stakeholder comments

According to Herbert Smith Freehills the new law ‘will work rather differently for general investors’ than the current law:

First, the taxpayer must apply the fixed ratio method for the income year unless it is eligible and elects to use either the group ratio test or the external third-party debt test for the year.

Second, if it makes an election to use the group ratio test or the external third-party debt test:

• the debt deduction is dictated by that election even if another method would produce a more favourable result;
• the entity must notify the ATO in the approved form that it is making this election;
• that election applies for the relevant year and is irrevocable for that year;
• while a different election (or no election) can be made for subsequent years, changing methods across years can produce an unfavourable outcome if the taxpayer wants to carry forward denied deductions under the fixed ratio test to use in later years.

The existing automatic system will continue to apply to financial investors and ADIs.[100]