The Federal Government has released draft legislation to follow through on an announcement in last year’s Budget to significantly reform Australia’s thin capitalisation rules.

As a general guide, from a tax planning perspective, when an overseas parent company / investor, funds capital into new subsidiaries / investments in Australia, it is generally optimal to explore whether interest bearing shareholder / investor loan funding can be provided for the following reasons:

  1. An offshore loan if provided within certain limits will assist create interest deductions in Australia (thereby reducing taxable Australian profits);
  2. Interest paid to an overseas lender is subject to a 10% final interest withholding tax rate (this is lower than the corporate tax rate of 25% / 30%);
  3. It is typically commercially easier to repatriate funds provided as loans rather than equity.

The draft legislation is currently open for public comment until 13 April 2023 and the proposed changes are expected to apply from 1 July 2023.

Key insights

The key insights that can be taken away are as follows:

  • There are 3 new tests being the Fixed Ratio Test (default test), Group Ratio Test and the External Third-Party Debt Test;
  • The existing Safe Harbour Test, Arm’s Length Debt Test and Worldwide Gearing Ratio Test will all be removed;
  • The Fixed Ratio test broadly limits debt deductions to 30% of EBITDA (earnings before interest, taxes, depreciation and amortisation). Practically this means interest deductions itself will never be able to offset all of the taxable income. Any unused debt / interest expense amounts under the Fixed Rate Test can be carried forward for up to 15 years subject to meeting certain tests such as continuing majority ownership;
  • The Group Ratio Test allows an entity in a worldwide group that has audited financial accounts, to claim debt related deductions up to the worldwide group’s net interest expense as a share of earnings;
  • The External Third-Party Debt Test allows debt deductions for genuine third party debt used to fund Australian operations with the lender having recourse to the assets of the entity;
  • Each of the 3 tests will need to be considered to determine which may be the most optimal for each taxpayer. For example, the Group Ratio Test and External Third Party-Debt Test will result in unused debt deductions being lost versus the Fixed Ratio Test which allows these to be carried forward for up to 15 years;
  • The choice of preferred test needs to be made before lodgement of the tax return otherwise the default Fixed Ratio Test will apply;
  • The existing $2 million (de minimis) threshold such that debt deductions below this amount will not be subject to the thin capitalisation rules remains unchanged;
  • The new rules look at each entity’s thin capitalisation position at the per entity level (unless within a tax consolidated group). Therefore, to the extent there are multi tiered structures such that existing financing may reside in a “head trust” but the asset may be held in a “sub / asset trust” a review of the flow of funds will likely be required to ensure that the new rules do not unnecessarily limit the quantum of deductions at the head trust level which is not commercially aligned with group structure outcomes.

Final comments

Whilst the new changes are significant, inbound shareholder / investor loan funding is still a key commercial and tax planning consideration that can yield efficient after tax outcomes.

However, the new changes require necessary modelling of the different tests to determine the choice that best optimises the after-tax outcomes over time for the entity.

In addition, thin capitalisation is only one aspect of tax planning when dealing with inbound loans. Transfer pricing (required to make sure the terms of any related party loans are on arm’s length terms) and the relatively new hybrid mismatch rules (which can also apply to deny interest deductions for loans from low taxed jurisdictions and / or unique hybrid features) need to be considered holistically as part of commercial and tax planning.

Given we are approaching Australian end of financial year (30 June) shortly, this should be placed as a key agenda item as part of broader tax planning discussions.