Thin Capitalisation reforms and their impact on corporate tax management

As of 8 April 2024, the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share - Integrity and Transparency) Act 2024 has officially been enacted. This landmark legislation introduces major reforms to Australia’s Thin Capitalisation regime, which will apply to income years commencing on or after 1 July 2023. In this article, we provide an overview of the new rules, including potential impacts to your financing arrangements.

Background: Global tax environment and reform of thin capitalisation rules

In broad terms, the Thin Capitalisation provisions were introduced to prevent enterprises from deducting interest in high-tax countries through borrowing, thereby reducing their tax liabilities. These rules were considered a significant measure to prevent eroding national tax bases through debt financing strategies. The traditional Thin Capitalisation rules mainly relied on the "Safe Harbour Debt Test," which limited the deductible interest on debt based on the value of corporate assets. However, given the complexity of multinational corporate capital structures, this asset-based debt limitation method could no longer effectively meet new challenges.

Australia being a member of the OECD has actively responded to the BEPS Action Plan, reforming the Thin Capitalisation provisions in an approach to which follows the OECD’s earning-based interest limitation rule. These rules not only aim to limit profit shifting through debt arrangements but also attempt to match corporate tax burdens more closely with actual business conditions by introducing earnings-based limitation tests.

1. Core changes and detailed analysis of the news rules

The new Thin Capitalisation rules introduced several significant changes, especially strict restrictions on debt deductions, as these changes may affect multinational group’s financial and tax planning activities.

The Bill introduces the concept of general class investors, consolidating the existing general classes of entities including Outward investor (general), Inward investment vehicle (general) and Inward investor (general). This simplified classification allows taxpayers to focus on the compliance with earnings-based test applied to the broad general class investors. By unifying these previously distinct categories, the new rules reduces the complexity of navigating multiple entity classes.

2. Scope of application and exceptions

The new Thin Capitalisation rules apply to various entities including:

• Foreign-controlled Australian entities, such as foreign-owned Australian subsidiaries or branches.
• Australian entities investing overseas, such as Australian businesses with subsidiaries or investment projects abroad.
• Foreign entities' operations in Australia, such as foreign companies with branches or permanent establishments in Australia.
• Financial entities, including banks and other financial institutions, which typically have higher leverage ratios.

Additionally, certain types of businesses and industries enjoy specific exemptions. For example, non-ADI financial entities (such as non-bank lending institutions) will operate under the new third party debt test, no longer restricted by the fair debt test. Plantation forestry enterprises are also exempt from the new rules, continuing to apply the old Thin Capitalisation rules. These industry-specific exemptions reflect the government's consideration of specific industry needs when formulating the new rules but also indicate that most multinational enterprises must engage in stricter tax planning under the new regulations.

Note the A$2 million de minimis threshold still applies and taxpayers with an associate inclusive debt deduction of less than $2million in an income year is not subject to the debt deduction limitation under the Thin Capitalisation provisions.

3. New debt deduction creation rules

The new debt deduction creation rules apply to income years starting on or after 1 July 2024 and aims to prevent entities from creating debt deductions through internal transactions to exploit additional debt deduction capacity.

The debt deduction creation rules focuses on the use of related-party loans. Specifically, if an enterprise utilises a related-party loan to acquire capital gains tax (CGT) assets, pay dividends or undertake capital returns, the debt deduction attributable to the related party borrowing will be restricted. Additionally, the rules also apply to enterprises borrowing from related parties to pay specific types of expenses, such as royalties for the use of a right.

The debt deduction creation rules are designed to prevent entities from artificially creating debt deductions through internal complex related party dealings and ensuring genuine and commercially justified debt deductions remain deductible.

4. Interaction with transfer pricing rules

The interaction between Thin Capitalisation rules and transfer pricing rules is a key factor that enterprises must consider in the compliance process. Taxpayers are required to assess their debt arrangements from a transfer pricing perspective before applying the Thin Capitalisation rules. This means that enterprises not only need to prove that their interest rates meet arm’s length pricing but to also evaluate whether the quantum of the loan is at arm’s length.

For example, when enterprises borrow from related parties, they need to ensure that the terms of their loans match those of independent third-party loans. During an ATO audit or review, it is likely that related party financing arrangement would be subject to increased scrutiny, and it would be critical for the Taxpayer to be provide relevant documentation substantiating arm’s length dealings between international related parties. Loan interest rates, repayment schedules, and collateral arrangements will likely be reviewed as part of an audit, and enterprises need to ensure their records are complete and meet the standards of arm’s length transactions.

5. Our key observations

These new rules may impact how your businesses account for and report debt deductions. Here are our key observations for consideration:

Expanded definition of debt deduction: The new rules broaden the scope of what qualifies as a ‘debt deduction.’ This could mean that a wider range of costs now fall under the thin capitalisation regime compared to the previous rules.

Economic equivalence to interest: Payments or receipts that are economically equivalent to interest must be examined closely. The substance of each arrangement should be reviewed to determine if amounts qualify as debt deductions.

Accounting records: Instances where a debt deduction is not reflected as an expense in the accounts—such as interest capitalised to an asset—should be carefully monitored.

6. Enterprise response strategies: adjusting capital structures and tax planning

In light of the new Thin Capitalisation rules, enterprises will need to undertake adjustments to their capital structure and tax planning strategies. The following are some approaches businesses may consider:

Optimising capital structure: The implementation of the new regulations necessitates that enterprises reassess their capital structures and strategically adjust the balance between equity and debt financing. This is essential to maintain financial flexibility and improve internal cash flows. Particularly for capital-intensive industries, businesses may need to refine their project financing strategies to ensure that their overall leverage levels are in compliance with the new tax requirements.

Adjusting global group structures: The group ratio test may provide a more flexible to some multinational groups. A careful analysis of the group’s debt levels is required, and appropriate documentation will need to be retained to support the higher deductions claimed.

Strengthening documentation and tax compliance: Enterprises will need to ensure that contemporaneous documentation is retained to support the relevant debt levels, debt deductions claimed and compliance with the fixed or group ratio tests. Loan agreements, cash flow records, collateral terms, and other documentation are critical as part of a taxpayer’s audit defence file. Accurate records will assist with mitigating tax risks and provide Taxpayers with a reasonably arguable position.

Summary

The updates to the Thin Capitalisation rules and the addition of new debt deduction creation rules mark a change in Australia's tax system and an alignment with OECD’s model. These rules aim to limit multinational enterprises from engaging in tax planning through complex capital structures while encouraging enterprises to enhance operating profits and capital efficiency.

Disclaimer: This article is seeks to provide an overview of the new Thin Capitalisation provisions. It is not intended as professional advice and should not be relied upon as such. Tax laws and regulations are complex and subject to change. Readers are encouraged to seek tailored advice from a qualified tax professional or legal advisor to ensure compliance with applicable laws and to address specific circumstances related to their business or corporate structure.  If you have any questions or require further advice, please contact the PKF’s tax team.