Treasury has recently released draft legislation and explanatory materials for public comment on the implementation of new interest limitation rules, which are intended to replace the existing thin capitalisation safe harbour, worldwide gearing, and arm’s length debt tests.
It is expected the new rules will be effective for income years starting on or after 1 July 2023.
The proposed measures in the draft legislation will replace the safe harbour test with a new earnings-based fixed ratio test that limits an entity’s net debt deductions to 30 per cent of its tax-determined earnings before interest, taxes, depreciation, and amortisation (EBITDA).
The worldwide gearing ratio test will also be replaced with a group ratio test that allows an entity in a group to claim debt-related deductions up to the level of the worldwide group’s net interest expense as a share of earnings.
The arm’s length debt test will be replaced with an external third-party debt test that allows interest expenses to be deducted where those expenses are attributable to genuine third-party debt used entirely to fund Australian business operations, while entirely disallowing third-party debt deductions that do not meet the requisite conditions and all related-party debt deductions.
The draft legislation also includes previously unannounced proposed amendments, including the repeal of interest deductions relating to non-assessable non-exempt distributions from foreign non-portfolio investments. It also includes amendments that require general class investors to demonstrate that their actual debt quantum is arm’s length for the purposes of transfer pricing provisions, as well as amendments to narrow the scope of entities subject to the existing safe harbour and worldwide gearing tests as a financial entity.
It’s important such entities seek professional advice in modelling the potential effects of the new rules on debt deductions, as well as valuating the feasibility of restructuring a group’s financing structure.
This article was authored by Nilan Gandhi, Business Advisory Manager at HLB Mann Judd Brisbane. It was first published in the Winter 2023 Issue of Financial Times.