The previously announced changes to the rules governing interest deductions (the thin capitalisation rules) have been released this week in the form of an Exposure Draft.
The thin capitalisation rules apply to limit interest deductions where they exceed certain prescribed levels. Historically, interest deductibility was determined by reference to asset levels, however, under the new rules, deductibility is based on a tax EBITDA level (ie a profit test).
The overhaul of the rules results in a number of previous categories of taxpayer being combined into a single “general” category as well as making a number of fundamental changes. Importantly, the de minimus thresholds for the application of the provisions remain unchanged.
Specifically, the changes provide the following tests for general taxpayers:
- a “fixed ratio test” replacing the existing safe harbour test;
- a “group ratio test” replacing the existing worldwide gearing test; and
- an “external third-party debt test” replacing the arm’s length debt test.
Fixed ratio test
- The fixed ratio test (the default test) allows an entity to claim net debt deductions up to 30% of its “tax EBITDA”. Tax EBITDA is essentially the entity’s taxable income / loss adding back deductions for interest, depreciation and capital works and prior year, tax losses.
- Where the 30% threshold is exceeded, the excess deductions can be carried forward for up to 15 years, however, there are criteria to enable the recoupment of the excess deductions including a Continuity of Ownership test and a continuation of methodology test.
Group ratio test
- This test can be used as an alternative to the fixed ratio test and will allow an entity to deduct net debt deductions based on a relevant financial ratio of the worldwide group.
- This test requires relevant audited consolidated financial statements to be prepared amongst other criteria.
External third-party debt test
- This external debt test disallows all debt deductions which are not attributable to third party debt. There are a number of other criteria that need to be satisfied under this test including the recourse being limited to the assets of the borrower only.
Historically, Australian entities could deduct interest on funds borrowed to invest in a non-resident company, even where the dividend income received on the investment was not taxable. This historical incentive is to be removed such that interest deductions to derive non assessable income will no longer be deductible.
Where to from here?
The proposed changes are to have effect for income years starting on or after 1 July 2023 and therefore for many taxpayers they will have an almost immediate effect. For taxpayers with 31 December year ends, the rules will have effect from 1 January 2024.
For those taxpayers who are subject to the thin capitalisation provisions, modelling of the expected outcome of the changes should be undertaken to quantify the impact. Taxpayers who previously were within the safe harbour threshold may no longer be able to fully deduct interest which could potentially result in (additional) tax payable.
It should also be remembered that interest deductions denied by the thin capitalisation rules are still subject to the interest withholding tax requirements.
Should you have any questions about how these changes will impact you please reach out to your Engagement Partner. As always we are here to help and explain what the changes mean for our clients.