INSIGHT

Thin cap: debt deduction creation regime

By Ellen Thomas, Joseph Power, Martin Fry, Anuki Suraweera
Private Capital Private Equity Tax

Rules likely to proceed (with amendments) 6 min read

A new debt deduction creation regime (or DDCR) was included in the latest iteration of the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share-Integrity and Transparency) Bill 2023 (Bill).

The DDCR contains a sweeping suite of measures that would disallow debt deductions incurred in relation to debt creation schemes that 'lack genuine commercial justification'. If the rules are enacted in thier current form, the DDCR may increase tax and compliance costs for many taxpayers, particularly large corporate groups that:

  • have borrowed from a related party; or
  • have debt funding in place and enter into related party transactions.

On 22 June 2023, the Bill was referred to the Senate Economics Legislation Committee (Committee) for inquiry and report. During the Committee's process of reviewing the Bill, Treasury recognised that there would be some benefit in including certain exclusions that would clarify the operation of the DDCR. Further, Treasury reassured the Committee that technical amendments could be modelled on the former 16G Income Tax Assessment Act 1936 (ITAA 1936) exclusions, and that other further technical amendments to the Bill were being explored.

On 22 September 2023, the Committee issued a report recommending that the thin capitalisation (thin cap) rules (ie including the DDCR) be passed subject to the technical amendments foreshadowed by Treasury. The Committee did not suggest the removal of the DDCR from the Bill.

Who in your organisation needs to know about this?

Tax managers, CFOs and commercial managers seeking to evaluate the cost/benefits of undertaking a transaction, particularly with a non-resident.

Key takeaways

  • The proposed DDCR is very broad and (if enacted in its current form) may increase tax and compliance costs for many taxpayers.
  • The Committee has recommended that further technical amendments to the Bill (ie including the DDCR) be made. It is anticipated that the amendments would include exclusions modelled on former Division 16G of the ITAA 1936 (discussed below), and other technical amendments. It is uncertain whether Treasury will publicly consult on the amendments to the DDCR. 
  • The Committee's report will be formally tabled in Parliament in mid-October 2023. The Federal Government may choose to ignore or accept the Committee's recommendations (in full or part).

Operation of the rules

The DDCR would disallow debt deductions to the extent that they are incurred in relation to 'debt creation' schemes that are seen to lack genuine commercial justification. The DDCR only applies to entities that are subject to the thin cap rules and apply in addition to the normal operation of those rules.

The DDCR may apply to:

1. An acquisition of a CGT asset or obligation from an 'associate pair': where an entity acquires a relevant asset (or obligation) from an 'associate pair' and incurs debt deductions in relation to the acquisition or holding of that asset.

2. A borrowing from an 'associate pair' to indirectly or directly fund a payment or distribution made to a relevant associate: where an entity borrows from an 'associate pair' predominantly to fund, facilitate the funding of, or increase the ability of an entity to make, a payment or distribution to a relevant associate of the entity. This may require taxpayers to trace their use of funds, which is very difficult given that money is fungible.

Importantly, there are currently no carve outs for transactions on arm's length terms (eg transfers of trading stock, cash pooling, securitisation transactions). It is also unclear how this rule can be read and applied alongside the conduit finance rules (discussed in our Insight article on the overall changes to the thin cap rules) which permit certain related-party borrowings.

The DDCR includes a specific anti-avoidance rule. If the Commissioner is satisfied that it is reasonable to conclude that one or more entities entered into or carried out a relevant scheme for the principal purpose of, or for more than one principal purpose that included the purpose of, ensuring there are no denials of debt deductions under the DDCR, the Commissioner may determine the provisions apply.

Concerns raised before the Committee

More than 50 submissions were made to the Committee in respect of the thin cap reforms in Schedule 2 of the Bill, with the majority complaining about the breadth of the DDCR and lack of consultation. Concerns raised included:

  • There was no grandfathering of the DDCR; the rules are to apply retrospectively.
  • There were no carve outs for commercial transactions, such as the purchase of trading stock from an associate, securitisation transactions and cash management pools.
  • Transactions with an Australian group would be captured, even though there would be no tax leakage out of Australia.
  • The DDCR does not have a purpose test.
  • The DDCR applies in addition to the general thin cap rules.
  • Deduction denials could apply to third-party debt, as well as related-party debt.
  • The rules were particularly complex for trusts, where the associate provisions apply broadly.
  • Deduction denials could apply where there was a refinancing and no increase in the level of debt.
  • Complex tracing of funds would be required to determine whether the rules would apply, which was impractical and uncertain.

Treasury views the DDCR as necessary so that the Australian Taxation Office does not have to rely on the anti-avoidance rules in Part IVA to deny deductions on certain transactions. However, the DDCR extends well beyond the type of transactions that would ordinarily raise an anti-avoidance concern. Treasury acknowledged that technical amendments could be modelled on the exclusions in former 16G of the ITAA 1936, and that other further technical amendments to the Bill were being explored.

Report and recommendations

The Committee's report acknowledges stakeholders' concerns in relation to the broad scope of the DDCR and the lack of carveouts. The Committee ultimately recommended that Schedule 2 of the Bill, which deals with thin cap, should be passed 'subject to technical amendments proposed by Treasury'.

As noted above, Treasury accepted that there would be benefit to amendments, such as introducing exclusions to the current proposed DDCRs based on former Division 16G of the 1936 Act. Relevantly, former Division 16G only applied to the acquisition of assets, whereas the DDCR also covers borrowing to fund a payment (or distribution) to an associate. In addition, former Division 16G generally only captured transactions with a 50% or greater foreign controller and did not apply:

  • to the acquisition of cash or trading stock, other than where acquired with a business;
  • to the acquisition of a share in a company upon its issuance;
  • to the acquisition from a non-resident of an asset that was not previously used to produce assessable income; or
  • where the Commissioner was satisfied that the overall indebtedness of the group was not increased.

During the Committee's inquiry, Treasury indicated it may consult on any changes to the Bill. However the scope of any consultation is not clear.

It is likely that, based on the Committee's report, the DDCR will remain in the Bill, albeit in a modified form.

Actions you can take now

  • Monitor the Government's response to the tabling of the Committee's Report.
  • If there is further consultation, work constructively with the Treasury to ensure the DDCR works appropriately.
  • Review how any acquisitions of assets from a foreign associate have been funded. These transactions may be within the scope of the amended DDCR, subject to the exclusions previously contained in former Division 16G (discussed above).
  • Review the amended Bill when released to determine its application to your business.