Australia: Changes to interest limitation rules

The Federal Government released exposure draft legislation in relation to proposed changes to the thin capitalisation rules. The rules are proposed to apply for income years beginning on or after 1 July 2023.

The draft legislation would modify the thin capitalisation rules in a manner broadly consistent with the Federal Government’s 2022-23 October Budget announcement. 

However, it includes additional substantive changes not previously announced that would affect many Australian groups, in particular the denial of interest deductions on borrowings that have funded equity investments in foreign subsidiaries.

These rules govern the tax deductibility of interest expenses, and under current rules, most taxpayers rely on the “safe harbour debt amount” test (broadly, debt limited to 60% of the average value of the entity’s Australian assets). Other taxpayers rely on the alternative “arm’s length debt test.”

The new fixed ratio test would limit deductions for net interest to 30% of tax earnings before interest, taxes, depreciation, and amortization (EBITDA), and replace the existing safe harbour test. This change aligns with the OECD’s recommendations in base erosion and profit shifting (BEPS) Action 4.

For general class investors, the existing worldwide gearing test would be replaced by the group ratio test. The group ratio text, available by choice, requires an entity to determine the ratio of its worldwide group’s net third party interest expense to the group’s EBITDA for an income year. This ratio can then be multiplied by an entity’s tax-EBITDA to calculate an allowable amount of debt deductions.

The arm’s length debt test (ALDT) would no longer be available. In its place, taxpayers would choose to apply a much narrower test, the external third-party debt test. This test disallows debt deductions to the extent that they exceed the entity’s debt deductions attributable to external third-party debt and which satisfy certain other conditions. In particular, in order for an entity to elect for the external third-party debt test to be applied, all associate entities (using a 10% threshold) must also make the election for the external third-party debt test to apply in that income year.

There are a number of other features of the new thin capitalisation, including the following:

• The definition of “debt deductions” (relevant to determining what type of deductions are disallowed under the thin capitalisation rules) would be expanded, and a reduction mechanism to that item would be introduced for interest income (“net debt deductions”).
• The de minimis exemptions for debt deductions not exceeding AUD 2 million, and for Australian based groups with Australian assets not exceeding 90%, would remain.
• The complying superannuation funds would be carved out from the “associate entity” definition, so that their domestic portfolio investments would not be subject to thin capitalisation rules.

This new measure would likely affect many Australian entities with foreign investments and may require tracing and apportionment exercises to determine the extent to which debt has funded an entity’s foreign operations (including on an ongoing basis).

Given the application of these proposed changes is imminent, Australian entities with interest deductions need to immediately take steps to assess the implication of these changes.