Thin Capitalisation Measures: Amendments Introduced into Australian Senate
01 December 2023
01 December 2023
Important Update: The below summarises the Government's amendments to the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share – Integrity and Transparency) Bill 2023 that were introduced into the Australian Senate on 28 November 2023. On 5 December 2023, the Senate agreed to amend the motion that the Bill be read a second time, and instead moved that the Government's amendments be referred to the Senate Economics Legislation Committee for inquiry and report by 5 February 2024, and that further consideration of the Bill be made an order of the day for the first sitting day after the Committee has reported. Accordingly, the amendments referred to below will now be the subject of further scrutiny by the Senate Economics Legislation Committee.
On 28 November 2023, amendments to the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share – Integrity and Transparency) Bill 2023 were introduced into the Australian Senate. The Bill is currently at second reading stage.
The amendments are based on Exposure Draft Legislation that was released for public consultation on 18 October 2023, although there have been some substantial changes to the Exposure Draft Legislation. A summary of the Exposure Draft Legislation, and some of the critical tax issues, is available here. Earlier commentary on the thin capitalisation measures is available here and here.
Detailed analysis of the amendments is provided below, but a key summary of the main changes are as follows:
One of the issues identified with the Bill was that the thin capitalisation measures contained no ordering rule, with the consequence that both the debt deduction creation rules, and the other elements of the thin capitalisation measures, could apply to debt deductions. One consequence of this was that a greater quantum of debt deductions could be denied than was expected (and, it seems, intended).
The amendments contain an ordering rule, which requires a taxpayer to first work out whether debt deductions are disallowed under the debt deduction creation rules. Once such a determination has been made, any disallowed debt deductions under those rules are disregarded in applying the thin capitalisation provisions applicable to general class investors and financial entities.
The principal change to the fixed ratio test is to permit upstream entities to include excess thin capitalisation capacity from downstream entities in determining the upstream entity's fixed ratio earnings limit, in certain circumstances.
In particular, excess thin capitalisation capacity is determined by taking the downstream entity's fixed ratio earnings limit, and subtracting from it the downstream entity's net debt deductions, as well as the unused FRT disallowed amounts for the preceding 15 years (i.e., effectively, the carried forward denied deductions that have not been utilised). To determine the upstream entity's share of that excess thin capitalisation capacity, the formula requires that you add up the percentage interests held in that vehicle for each day (where it was 50% or more), and divide it by the total number of days in the income year. This amount is applied to the excess thin capitalisation capacity, and then divided by 0.3 (i.e., to gross up for the fact that the amount is included in Tax EBITDA).
The Exposure Draft Legislation included this change with respect to certain unit trusts that held controlling interests in certain downstream unit trusts. The amendments have expanded this rule beyond unit trusts, so that the rule now applies to certain unit trusts, and companies and partnerships that are Australian entities. However, there remain a number of restrictions to these rules that result in adverse implications in certain common scenarios:
Some other less material changes have also been made to the fixed ratio test, as follows:
Substantial changes have been made to the "base test", the "conduit financing test", and the way in which the third party debt test applies to certain swap arrangements.
One of the critical concerns with the base test (as introduced in the Bill) is that it limited permissible recourse of the lender to Australian assets that were held by the issuer of the debt interest (i.e., the borrower). This requirement to satisfy the base third party debt test was entirely inconsistent with prevailing market practice associated with third party debt arrangements, where the lender would ordinarily take security over (at least) the assets of the borrower, the equity interests in the borrower, and potentially assets held by upstream and downstream entities from those entities.
The amendments expand the forms of permissible recourse in the following ways:
The Bill (as introduced) also contained a prohibition on rights under or in relation to a guarantee, security, or other form of credit support. It was not clear how this operated in the context of permissible recourse beyond the assets of the borrower (or if the borrower's assets included, for example, a guarantee). While the amendments retain a prohibition on certain forms of guarantees, security, or credit support, this prohibition does not apply to:
Finally on the base test, the development asset concession has also been expanded to cover not only the development of land assets (per the Bill) and certain incidental movable property (per the Exposure Draft), but also to cover certain offshore renewable energy infrastructure and offshore electricity transmission infrastructure. While this is positive, the development asset concession does not apply to certain onshore infrastructure development projects where the underlying assets are not land. For example, certain renewable energy projects do not qualify as interests in land, such that the development assets concession will not be available for the development of these projects. Given the size of investment needed to assist in Australia's energy transition, and the importance of this to the Government's agenda, this is counter intuitive. The development assets concession could have been expanded straightforwardly to permit this, by referring to economic infrastructure assets as defined in the Taxation Administration Act 1953 (Cth). Unfortunately for the Government's commitment (both internationally and domestically) to a Net Zero economy by 2050, this change has not been included in the amendments.
In addition, and for completeness, no changes have been made to the rule that prohibits guarantees, security, or other forms of credit support being provided by non-resident associate entities (by reference to a 50% threshold). Accordingly, foreign investors are likely to face a greater quantum of debt deduction denial where they hold controlling interests in development assets. If the rationale of the development asset concession is not to adversely impact the willingness to invest in development assets (in light of lender requirements), it is not clear why the rules produce more favourable outcomes for residents or, indeed, for foreign investors with non-controlling interests.
There have also been substantial changes to the conduit financing test. The material changes are as follows:
There have been a number of important changes to permitted interest rate swap arrangements under the third party debt test.
First, the amendments have sought to permit hedging on a pooled basis. However, the way in which this change has been made is to permit the debt deduction "to the extent that" the debt deduction is directly associated with hedging or managing interest rate risk in respect of the debt interest. If a borrower has issued two debt interests, one for $60 million, and one for $40 million, and has also entered into an interest rate swap with a notional principal of $80 million, it remains unclear how this rule applies. For example, it is not clear how taxpayers are to show the swap is "directly associated" with hedging or managing interest rate risk in respect of a particular debt interest. Although it is clear the changes are intended to permit this (per the Supplementary Explanatory Memorandum), it would be clearer if the legislation referred to the debt interest or debt interests.
Second, both the Bill and the Exposure Draft permitted an extremely unusual form of embedded swap arrangement under the terms of conduit financing on-lending. In particular, they permitted the conduit financer to on-lend and recover (from the borrower) swap-related costs it had incurred, but did not allow the conduit financer to pass on receipts it received under the external swap. As the receipts under a swap may be higher than the payments (e.g., if the swap is in the money), this would have resulted in the conduit entity no longer being a genuine conduit – it would have taxable income. The change contained in the amendments referred to above, which only requires testing the same terms requirements with respect to costs incurred by the borrower (and not costs incurred by the conduit financer), should now permit the conduit financer to pass on swap-related benefits under the terms of the on-lending agreement.
While this is positive, the most common form of swap arrangements in a conduit financing scenario remains prohibited by the rules. The most common form of swap arrangement would be for the conduit financer to enter into a swap, and then to enter into back-to-back swap arrangements with the entities to which it is on-lending. These very common arrangements are not permissible under the third party debt test, because the back-to-back swap arrangements will result in debt deductions that are referable to amounts paid or payable to an associate entity. Accordingly, taxpayers will be required to enter into economically equivalent (but structurally different) arrangements by embedding swap-elements into the on-lending arrangements. This will likely result in income tax implications on closing out the back-to-back swap, and also has the potential to result in the conduit financer ceasing to be a pure conduit for income tax purposes (i.e., where it does not close out, at the same time, the third party swap arrangements). Given the substance of these arrangements are materially the same, it is unclear why the amendments have not facilitated the ordinary type of arrangements entered into in a conduit financing scenario.
Finally, cross-currency interest rate swaps remain problematic. Cross-currency interest rate swaps hedge interest rate fluctuations in a foreign currency. It remains unclear if these debt deductions are available, as the arrangement goes beyond hedging or managing interest rate risk. This is likely to impact taxpayers who have borrowed in a foreign currency, as cross-currency interest rate swaps are very common in this scenario.
As noted above, the debt deduction creation rules were included in the Bill as introduced without consultation, and with extremely limited time for taxpayers to consider their impact. This was particularly problematic, as the rules were drafted in an extraordinarily broad manner, and also applied (in effect) retrospectively, in that they applied to arrangements entered into before the Bill was introduced. Accordingly, the debt deduction creation rules, as included in the Bill, caused significant issues for a large number of taxpayers, even where their arrangements were relatively straightforward and common.
In a temporary reprieve for taxpayers, the amendments defer the application of the debt deduction creation rules to income years commencing on or after 1 July 2024. However, the rules will apply retrospectively from that point. The Supplementary Explanatory Memorandum indicates that schemes involving a "mere restructuring" of an arrangement that would otherwise be caught by the debt deduction rules is permitted, provided there is no associated artificiality or contrivance. Accordingly, taxpayers who are undertaking restructures should consider not only the technical application of the debt deduction creation rules, but also the potential application of both specific and general anti-avoidance rules.
Some of the critical changes to the debt deduction creation rules are as follows:
Although it is positive that the concept of a payment or distribution has now been constrained, the list remains very broad. To take a very simple example, if an entity borrows from a conduit financer (i.e., ultimately sourced from a third party), and makes a lease payment to an associate entity, that would arguably be similar to a payment of a royalty and is for the use of an asset. Accordingly, the debt deduction creation rules may apply. In many instances, the logic of the application of these rules is not clear – in the example given, the payment would be treated as assessable income and subject to tax, and the ultimate source of the funding is from a third party. It would have been straightforward to exclude related party debt where it is a relevant debt interest that satisfied the conduit financing rules. Instead, taxpayers will now have to consider all of their related party arrangements, and may be denied debt deductions in circumstances where there is no identifiable tax-related mischief.
The above summary is a snapshot of some of the key changes arising from the amendments; there are others. The thin capitalisation measures, once enacted, represent a highly complex set of rules which have the potential to have significantly adverse impacts on taxpayers. In addition, elements of the rules do not appear to have a clear policy rationale. While the measures represent an improvement on the Bill as introduced, it is likely that the measures will decrease Australia's attractiveness as a destination for capital.
Authors: Steve Whittington, Partner; Vivian Chang, Partner; Sanjay Wavde, Partner; and Ian Kellock, Partner.
The information provided is not intended to be a comprehensive review of all developments in the law and practice, or to cover all aspects of those referred to.
Readers should take legal advice before applying it to specific issues or transactions.