Yesterday, the Federal Government released the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share—Integrity and Transparency) Bill 2023 (the Bill). The Bill, among other things, includes significant reforms to the thin capitalisation regime in Division 820 of the Income Tax Assessment Act 1997 (Cth) (1997 Act). The first version of these reforms was released in the March 2023 Exposure Draft (ED). Our earlier alert on the ED can be found here.
The core concepts in the ED remain the same: the introduction of the “general class investor” category intended to cover entities other than authorised deposit-taking institutions (ADIs) and “financial entities”, the introduction of the default 30% EBITDA limitation on net debt deductions known as the “fixed ratio test”, and the alternative group ratio and third party debt tests. It continues to be the case that there is no grandfathering, no transitional period and no significant exemptions from the changes for particular sectors or entity types other than certain financial entities and ADIs.
However, following a flurry of public submissions within the very short consultation period for the ED, significant refinements have been made to the new rules in response to concerns raised by taxpayers. The explanatory memorandum accompanying the Bill (EM) sets out and responds to some of the main concerns.
The changes will still come into effect from 1 July 2023 (less than 2 weeks from the writing of this alert), though the Bill cannot be passed prior to that date given there are no more Parliamentary sittings in this financial year. The Bill has also been referred to the Senate Economics Legislation Committee with a report due by 31 August 2023. The new provisions will therefore be retrospective in application.
Overview
Many changes, both major and minor, have been made to the draft provisions in the ED and taxpayers should read the new Bill to see what aspects of the new rules may affect their businesses. We note in particular:
- section 25-90 of the 1997 Act (allowing a deduction for interest expenses incurred to derive certain foreign equity distributions) will not be repealed as a part of these amendments, as was previously proposed in the ED. The EM states that any amendments to that section will be “considered via a separate process”. Taxpayers should therefore keep an eye out for any future announcements;
- without warning, the Bill includes new anti-avoidance rules in the form of a “new and improved” version of former Division 16G (Debt creation involving non-residents) of the Income Tax Assessment Act 1936 (Cth) (1936 Act). Unlike Division 16G, the new rules in Subdivision 820-EAA are not limited in their application to dealings with non-residents. The new rules will operate to deny debt deductions incurred “in relation to debt creation schemes that lack genuine commercial justification”;
- the Bill contains changes to the “third party debt test” from the ED in response to concerns about the narrow application of the conduit rules, and the capacity of entities to influence their associates to elect into those rules;
- the section 820-39 exemption for insolvency-remote special purpose entities has been extended to ensure that it applies to exempt such entities from the application of new Subdivision 820-AA (the general class investor subdivision);
- instead of entirely repealing the category of “a registered corporation under the Financial Sector (Collection of Data) Act 2001” as a “financial entity”, such registered corporations will now need to carry on a business of providing finance to non-associates, and derive substantially all of their profits from that business, to qualify as a “financial entity”; and
- changes have been made to the “fixed ratio test”, including to the calculation of tax EBITDA and the circumstances when previously disallowed amounts under that test can be carried forward to future income years.
The EM comments on the non-inclusion of certain matters in the Bill, including public country-by-country reporting and payments for the exploitation of intangibles that are subject to tax in low corporate tax jurisdictions. It is expected that we will see new versions of these proposed rules in due course.
New anti-avoidance provisions – debt deduction creation
The Bill introduces a never-before-seen new Subdivision 820-EAA, which seeks to address the risk of excessive debt deductions for debt created in connection with acquisitions from, or payments to, associate entities.
The Subdivision automatically denies debt deductions in the following situations:
- Asset/obligation acquisition: an entity acquires a CGT asset, or a legal or equitable obligation, directly or indirectly from a disposer which is an “associate pair” of the acquirer, and the debt deduction is in relation to the acquisition or the holding of the asset. An entity is an “associate pair” in relation to another entity where each entity is an associate of the other (regardless of their residence); and
- Associate borrowing to fund associate payment: one associate pair issues a debt interest to another associate pair, and the lending entity uses the proceeds to fund, facilitate the funding of, or increase the ability of any entity to make payments or distributions to other entities (defined broadly), at least one of which is an associate pair of either the lender or the borrower.
These situations are intended to capture the integral parts of schemes where “artificial interest-bearing debt is created within a multinational group”.
Where the Commissioner is satisfied that it is reasonable to conclude that one or more entities entered into a scheme for the principal purpose of (or for more than one principal purpose including the purpose of) ensuring that the above arrangements do not result in denials of debt deductions under Subdivision 820-EAA, the Commissioner may determine that the Act does have such an effect.
Taxpayers should carefully consider whether any of their existing structures might be considered to include such arrangements. This will necessarily include careful analysis of corporate groups to determine which entities are “associate pairs”.
The new Subdivision is intended to be a modernised version of the debt creation rules in former Division 16G of the 1936 Act (Debt creation involving non-residents), which was not replicated in the thin capitalisation rules enacted in the 1997 Act in 2001.
Changes to the third party debt test
The third party debt test replaces the arm’s length debt test for general class investors and financial entities, permitting higher gearing where there is a genuine commercial arrangement. The Treasury has responded to criticism of this aspect of the ED and made some substantial tweaks to the new test.
The requirement that the proceeds of the third party debt be exclusively used to fund the taxpayer’s commercial activities in Australia has been loosened to “substantially all” of the proceeds. Concerns remain about how this might be demonstrated in practice.
The conduit financing conditions (which allow certain intergroup back-to-back debt arrangements to be effectively looked-though for the purposes of the third party debt test) have been modified so that amounts borrowed and lent by conduit entities need not be identical in every respect, but only to the extent that the terms of the debts relate to a cost incurred in relation to the relevant debt interest. There are further carve-outs from this requirement which have been included in response to various submissions and which acknowledge that only part of a conduit debt may comply with the conduit rules and that differences in costs may be necessary to cover outgoings such as administrative costs of the conduit entity. These are listed in a series of precise categories which may be difficult to apply to in practice.
Previously where an entity wished to elect into the third party debt test, the ED required all general class investor associates to also make the election. This potentially required a wide range of only very loosely related entities to also elect into the third party debt test, which may be impossible for a taxpayer to achieve. Acknowledging that this was an unintended consequence of the proposed rules, the Bill introduces the concept of an “obligor group”. Entities are in an “obligor group” where a creditor of one entity has recourse for payment to the assets of those other entities. Every entity in the obligor group is now deemed to have elected into the third party debt test.
Amendments to section 820-39 and the definition of “financial entity”
The exemption from the thin capitalisation rules available to special purpose insolvency remote vehicles in section 820-39 is now extended to entities classed as “general class investors”.
This allays concerns expressed by the securitisation industry that many special purpose vehicles could inadvertently be subject to denials of debt deductions under Division 820 despite a previous policy decision to exempt them from the regime.
Concerns were also expressed about the impact of the proposed changes to the definition of “financial entity” to non-bank securitisation industry participants. The ED had wholesale deleted the category of “a registered corporation under the Financial Sector (Collection of Data) Act 2001”, which would have resulted in many entities that were previously financial entities being classified as general class investors.
The Bill restores the category, while limiting it to entities that carry on a business of providing finance not predominantly to or on behalf of their associates, where all or substantially all of their profits are derived from that business. While not helpful for entities which carry on hybrid financial businesses which also derive other types of profits, this is a middle ground which covers off on the Treasury’s concerns about too many non-financial entities being registered under the Financial Sector (Collection of Data) Act 2001 (Cth).
Changes to the fixed ratio test
The Bill makes adjustments to the calculation of tax EBITDA for the purposes of the fixed ratio test. In particular, changes have been made to:
- add back to an entity’s taxable income or tax loss the sum of the entity’s deductions under Divisions 40 and 43 for the income year (other than deductions for the entire amount of an expense incurred by the entity, such as a deduction under Subdivision 40-H of the 1997 Act);
- account for the fact that partnerships and trusts have “net income” rather than “taxable income”. The EM notes that Treasury considered whether to include an ability to share excess interest capacity within trust groups but decided against it.
Further, in assessing whether the special deduction for previously disallowed debt deductions is available to general class investors, a company must pass the company loss rules in relation to their fixed ratio debt test disallowed amounts. Companies can now rely on a modified business continuity test, in addition to the modified continuity of ownership test, for this purpose.
What’s not included in the Bill?
As noted above, the proposed repeal of section 25-90 of the 1997 Act has been deferred. The EM states that the section will be “considered via a separate process”, noting that Treasury received a large number of submissions opposing the change.
In addition to the thin capitalisation amendments, there are a number of other tax integrity and transparency measures previously released in exposure draft form that were due to commence from 1 July 2023. In attachments to the EM, some comments are made about the non-inclusion of measures relating to:
- public country by country reporting. There is recognition that further consultation with industry may be beneficial on this measure, and thus the application of this measure has been deferred by 12 months to income years commencing on or after 1 July 2024; and
- payments for the exploitation of intangibles that are subject to tax in low corporate tax jurisdictions (our previous Alert on this measure can be found here). We note that:
(a) Treasury will further consider stakeholder feedback received during consultation on the exposure draft legislation for this measure;
(b) the interactions between the intangibles legislation and Pillar Two global and domestic minimum taxes will be considered during Australia’s implementation of its global and domestic minimum taxes; and
(c) to provide stakeholders with further guidance, the Australian Taxation Office intends to issue guidance materials to assist taxpayers after the legislation has passed Parliament.
Despite this, it appears that it is proposed that the measure will still apply to payments made from 1 July 2023. This puts taxpayers in a difficult position. Do they follow the measure as set out in the exposure draft legislation, or do they hazard a guess as to what the measure might look like when a Bill is introduced into Parliament? Taxpayers must also consider the prospect of a shortfall penalty provision being introduced to complement the intangibles measure (as was flagged in the explanatory materials to the exposure draft legislation).
Conclusion
Taxpayers will welcome a number of changes from the ED contained in the new Bill, which addresses a number of concerns raised during the very short period of public consultation. Nonetheless, the amendments still result in substantial changes to the current Australian thin capitalisation regime – and taxpayers will have little time to consider the impacts of the changes given the changes will commence applying in little over a week.
As we previously noted, taxpayers may wish to consider replacing existing related party debt with third party debt or equity, or otherwise consider restructuring their internal financial arrangements.
Please contact us if you wish to discuss the potential impact of these new rules on your business.
