Clarifying aspects of the Thin Capitalisation Rules and Debt Deduction Creation Rules

Exposure Draft bill released - There's still time to restructure affected arrangements 8 min read

On 18 October 2023, Treasury released exposure draft parliamentary amendments (the Exposure Draft) in relation to the thin capitalisation rules and debt deduction regime (DDCR) contained in the Treasury Laws Amendment (Making Multinationals Pay their Fair Share – Integrity Transparency) Bill 2023 (Bill). The Exposure Draft follows the release on 22 September 2022 of the Senate Economics Legislation Committee's report on the Bill, which recommended the Bill be passed with technical amendments.

The key design elements of the new thin capitalisation rules remain in the Bill, with some clarifications and improvements in the drafting. The DDCR will remain in the Bill, but its scope has been narrowed.

In this Insight, we provide clarity to tax managers, CFOs and commercial managers seeking to evaluate the cost/benefits of undertaking a transaction, particularly with a related party.

Key takeaways

• The start date of the new thin capitalisation measures remains unchanged, with the amendments to apply to income years commencing on or after 1 July 2023. However, the application of the DDCR to financial arrangements entered into before 22 June 2023 has been delayed until 1 July 2024. The delayed introduction of the DDCR gives you time to restructure affected arrangements. You will need to consider the tax implications of doing so.
• There will be amendments to improve the application of the new thin capitalisation rules. The improvements to the Third Party Debt Test are welcome, but will be viewed by many as not going far enough.
• Some amendments will be made to the DDCR that narrow its scope (eg the DDCR will not apply to the issue of new shares or the acquisition of certain depreciating assets). Despite these amendments, the DDCR is likely to increase tax and compliance costs for many taxpayers.
• The consultation period is short—it will conclude on 30 October 2023.

Thin capitalisation: tinkering with the third party debt test

The third party debt test (TPDT) is one limb of the new thin capitalisation rules. The amendments introduced by the Exposure Draft will broaden the range of third party debt arrangements that may apply the TPDT.

Australian trusts and partnerships can apply the TPDT

The Exposure Draft makes it clear that Australian trusts and partnerships may choose to apply the TPDT (the Bill previously inadvertently excluded both from access). For a partnership to be eligible to choose to apply the TPDT, it must be an 'Australian entity', which requires that Australian residents together hold at least a 50% direct participation interest in the partnership.

The obligor group has been both narrowed and expanded

Under the new thin capitalisation rules, an entity will be deemed to have chosen to apply the TPDT if:

• the entity is a member of an obligor group in relation to a debt interest issued by an issuer entity;
• the entity is an associate of the issuer entity; and
• the issuer entity has chosen to apply the TPDT.

Prior to the Exposure Draft, an entity would be a member of an obligor group if it owned membership interests in the issuer entity and the external lender had recourse over those membership interests. Under the Exposure Draft, the entity that grants security over its membership interests in the issuer entity to the external lender, but recourse over no other assets, will not be a member of the obligor group and so will not be deemed to have chosen to apply the TPDT. This is an improvement. It means the parent of a Finco will not be brought into the obligor group where it is granting security over its membership interests in a Finco (which is common) and no other assets.

Prior to the Exposure Draft, an entity would arguably be a member of an obligor group if the external lender had recourse over all but not some of the entity's assets. Under the Exposure Draft, an entity will be a member of the obligor group where the external lender has recourse to any of the entity's assets (and the other conditions of the obligor group are satisfied). This amendment broadens the scope of the obligor group.

Assets to which a third party lender is permitted to have recourse

Under the new thin capitalisation rules, the TPDT permits the taxpayer to claim deductions in relation to debt interests that satisfy the third party debt conditions.

One of the third party debt conditions is the requirement that the third party lender only have recourse to specified categories of assets. Under the Exposure Draft, the categories of assets to which the third party lender is permitted to have recourse (and satisfy this limb of the third party debt conditions) will be expanded to be:

• Australian assets held by the borrower entity (in the case of a conduit financer, this condition refers to the Australian assets of the conduit financer and borrowers);
• Australian assets that are membership interests in the borrower entity, but not if the borrower entity has an interest in an asset that is not an Australian asset (in the case of a conduit financer, this condition refers to membership interests in the conduit financer and borrowers, and the exclusion in relation to non-Australian assets applies); and
• Australian assets held by an Australian entity that is a member of the obligor group.

A separate limb of the third party debt conditions is the requirement that the third party lender not have recourse to a guarantee, security or other form of credit support, subject to a carveout for credit support relating to the creation or development of Australian real property assets.

Despite criticism, this requirement will not be removed under the Exposure Draft. However, the Exposure Draft will expand the carveout. That is, it is permissible for the third party lender to have recourse to credit support relating to land or other real property in Australia, as well as moveable property situated on land where the moveable property is incidental and relevant to ownership of the land and is situated on the land for a majority of its useful life. This expansion of the carveout will provide relief to situations where the third party lending is used to fund the construction of, for example, wind turbines and related facilities, electricity transmission facilities, and like assets.

Interest rate swaps and other hedges

Under the TPDT, costs that are debt deductions and are directly associated with hedging interest rate risk will be included in the quantum of deductions that are regulated by the TPDT. Prior to the Exposure Draft, this aspect of the TPDT was criticised on the basis that it was limited to hedging instruments, such as interest rate swaps, which hedge specific debt interests but would not cover hedging instruments that covered multiple debt interests (ie portfolio hedging).

The Exposure Draft will introduce amendments to this aspect of the TPDT, which the Explanatory Memorandum says will expand the TPDT to cover costs associated with hedging multiple debt interests. In a conduit financing structure, borrowers can recover these costs from other borrowers further down the 'borrowing chain'.

Conduit financing rule

Under the new thin capitalisation rules, the TPDT is modified by the conduit financing rule to provide for one entity in a group to raise funds and on-lend to other entities in the group.

The Exposure Draft will introduce a number of technical amendments to improve the drafting of the conduit financing rule.

Other changes to the thin capitalisation rules

The Exposure Draft contains other changes to the new thin capitalisation rules, including changes to the application of the Fixed Ratio Test and the calculation of Tax EBITDA.

Debt deduction creation rule

Broadly, the DDCR would apply to (1) the acquisition of assets or obligations from a member of an associate pair; or (2) a borrowing from an associate pair to fund a payment or distribution to a relevant associate.

Some new exceptions to the DDCR, broadly modelled on former Division 16G ITAA 1936, are introduced in the Exposure Draft:

• In relation to an acquisition of a CGT asset from an associate pair, there are now exceptions for the acquisition of a new membership interest in an entity, acquisition of certain new tangible depreciation assets, and acquisition of certain debt interests issued by associates.
• In relation to payments or distributions made to an associate, there are now exceptions for on-lending to an Australian entity on the same terms, and payments entirely referable to the repayment of the principal under a debt interest.

In addition, several other amendments have been made so that the DDCR better targets financial arrangements that 'lack genuine commercial justification':

• ADIs, securitisation vehicles and special purpose entities are excluded from the application of the DDCR.
• The DDCR will now only apply to limit debt deductions in respect of related party debt.
• The DDCR will apply before the general thin cap rules in Division 820; denied deductions under the DDCR would not count in an entity's total debt deductions to which the thin cap rules may otherwise apply.
• The definition of 'associate pair' has been narrowed in its application to trusts, reducing the burden and complexity of tracing.
• The Exposure Draft clarifies that the DDCR will disallow debt deductions only 'to the extent that' the borrowing has been used for the offending purpose.

The Exposure Draft allows a one-year grace period for existing financial arrangements (entered into before 22 June 2023)—the DDCR only applies to such arrangements from 1 July 2024.

Despite the Exposure Draft containing positive amendments to the DDCR, a number of challenging features remain:

• The Exposure Draft would broaden the DDCR to apply to deductions in respect of 'financial arrangements' rather than just debt interests.
• The DDCR will still apply to trading stock acquisitions and cash pooling.
• There is no purpose test to limit the DDCR's application to arrangements lacking genuine commercial justification.
• Tracing funds will still be necessary in some circumstances to determine if the DDCR applies.

Actions you can take now

Consider engaging with the Treasury during the consultation period (to 30 October 2023). We doubt that material changes to the policy or framework of the rules will be made through this period of consultation.

Taxpayers should review their related party financing arrangements to determine the impact of the new measures. For related party financing arrangements entered into before 22 June 2023 that might be caught by the DDCR, consider restructuring these prior to 1 July 2024.