What you need to know
On 18 October 2023, Treasury released Exposure Draft Legislation proposing amendments to the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share – Integrity and Transparency) Bill 2023 (Bill), which remains before the Australian Parliament. The Exposure Draft was released following a report of the Senate Economics Committee released on 22 September 2023 (Committee Report). The Committee Report outlined various submissions in respect of the workability of the Bill, but ultimately recommended that the Bill be passed subject to 'technical amendments foreshadowed by Treasury' during submissions.
The Exposure Draft proposes substantial amendments to the Bill, most of which should improve its operation. The problems identified with the Bill were significant, and a summary of some of the issues can be read here.
However, there remain a number of issues that Treasury has not resolved via the Exposure Draft Legislation, as well as some further issues that arise with the Exposure Draft Legislation itself. Given taxpayers are now a third of the way through the income year in which most of the measures are expected to take effect, it is crucial that improvements are made to the Exposure Draft Legislation. The Exposure Draft Legislation is open to public consultation until 30 October 2023.
What you need to do
Given the Bill will generally operate in respect of income years commencing on or after 1 July 2023, taxpayers should immediately consider the impact the Bill (as amended by the Exposure Draft Legislation) would have on their thin capitalisation position. Taxpayers who have previously considered the implications in respect of the Bill should now re-assess their position in the light of the Exposure Draft Legislation.
Key Highlights of the Exposure Draft
In summary, the Exposure Draft contains amendments that positively address issues raised before the Committee. The principal amendments include:
- Under the Bill as introduced, the third party debt test was limited to Australian resident companies – it did not apply to trusts or partnerships. Thankfully, the Exposure Draft legislation would extend the third party debt test to trusts with an Australian resident trustee or where the central management and control of the trust is in Australia, and partnerships (although, with respect to partnerships, a direct participation interest of 50% or more must be held by an Australian resident individual, company or an Australian trust).
- Under the Bill as introduced, the conduit financer regime, which was intended to allow the third party debt conditions to be satisfied where an entity borrowed and on-lent on back to back terms, strangely prohibited the conduit financer from holding "associate entity debt". That is, it expressly prohibited certain forms of on-lending. The Exposure Draft legislation remedies this.
- Under the Bill as introduced, the third party debt conditions in the case of direct borrowing (i.e., not through a conduit financer) required that the lender have recourse only over the assets of the borrower. Standard lending arrangements would see the lender also having (as a minimum) security over the equity in the borrower, as well as potentially downstream entities. The Exposure Draft Legislation permits a broader range of security arrangements, including (for example) security over Australian assets of Australian entities that are part of the obligor group (as defined), as well as security consisting of membership interests in the borrower. These changes are welcome, and reflect common security arrangements in standard third party arrangements.
- Under the Bill as introduced, the third party debt conditions denied deductions on interest rate swap arrangements entered into by the entity to which a conduit financer on-lent. It is very common, for example, for a conduit financer to borrow and on-lend on back to back terms, and for the entity to which it has on-lent to enter into interest rate swap arrangements (being the entity that has the real economic exposure to interest rate fluctuations). However, the Bill expressly treated debt deductions arising on the swap at this level as non-deductible, which has been remedied by the Exposure Draft Legislation. Note that a range of other issues with swap arrangements (discussed below) have not been remedied.
- Under the Bill as introduced, guarantees or other forms of credit support provided by non-residents (which generally will result in a failure of the third party debt conditions) were expressly permitted in the context of finance to develop land assets, provided the foreign entity was not an associate entity (by reference to a 50% threshold). The Exposure Draft Legislation extends this development asset concession to certain movable property (which is relevant and incidental to the land). However, there remain issues with the development assets concession (discussed below).
- With respect to the fixed ratio test, the Bill as introduced prevented upstream non-consolidated entities from including income (e.g., distributions, dividends, and franking credits) from downstream entities in determining their tax EBITDA, but also did not provide for them to pick up excess thin capitalisation capacity (which the current rules permit). This applied to all interests in companies, and associate entity interests in trusts and partnerships (calculated by reference to a 10% threshold). This would have effectively meant that there was no or limited capacity for upstream gearing (even where there was no downstream gearing) in non-consolidated structures. Under the Exposure Draft Legislation, upstream trusts may now pick up excess thin capitalisation capacity (called trust excess tax EBITDA amount) from downstream trusts in which a membership interest of 50% or more is held, when applying the fixed ratio test. The rationale for limiting this to trusts, and limiting it to a 50% threshold, is not clear – this is discussed further below.
- The Bill as introduced resulted in potentially multiple denials of what was effectively the same amount, under both the debt deduction creation rules and the thin capitalisation tests, meaning a larger share of debt deductions would have been denied than was logical. The Exposure Draft Legislation contains an ordering rule which prevents this from occurring.
- The Bill as introduced would have applied to all entities that were subject to thin capitalisation to the debt deduction creation rules, other than entities whose associate-inclusive debt deductions were below $2 million. The Exposure Draft Legislation extends the entities which are not subject to the debt deduction creation rules to certain qualifying insolvency remote special purpose entities, securitisation vehicles, and ADIs.
- The Bill as introduced included the debt deduction creation rules when those rules had not been consulted on. The rules as introduced were broad ranging, and effectively retrospective – the rules could apply to debt interests issued previously where the relevant conditions were satisfied. Under the Exposure Draft Legislation, the operation of the debt deduction creation rules has been deferred from applying to financial arrangements issued before 22 June 2023, until 1 July 2024. However, the rules remain retrospective in effect from 1 July 2024, i.e., they will apply to any debt interest that remains on issue.
- Finally, the debt deduction creation rules in the Bill were incredibly broad, and would have applied to many common arrangements. For example, the rules would have applied to internal restructures of assets where external debt was moved to reflect the revised asset holding structure. The Exposure Draft Bill has reduced the breadth of the debt deduction creation rules, primarily by limiting it to related party debt arrangements, and also introducing a number (but not all) of the exceptions contained in Australia's former debt creation rules.
While the above changes are generally positive, there remain a number of issues, as well as some new issues arising from the Exposure Draft Legislation. We have highlighted some of these below.
Fixed Ratio Test – Excess Thin Capitalisation Capacity
As noted above, the Fixed Ratio Test is proposed to be amended to permit excess thin capitalisation capacity from downstream trusts to be utilised by upstream trusts, where the upstream trust directly holds an interest of 50% or more.
Excess thin capitalisation capacity is determined by taking the downstream entity's fixed ratio earnings limit, and subtracting from it the downstream trust's net debt deductions, as well as the unused FRT disallowed amounts for the preceding 15 years (i.e., effectively, the carried forward denied deductions that have not been utilised). To determine the upstream entity's share of that excess thin capitalisation capacity, the formula requires that you add up the percentage interests held in that vehicle for each day (where it was 50% or more), and divide it by the total number of days in the income year. This amount is applied to the excess thin capitalisation capacity, and then divided by 0.3 (i.e., to gross up for the fact that the amount is included in Tax EBITDA).
While this change is positive, there remain a number of issues:
- The rule is limited to certain trusts that hold interests in other trusts. That is, the rule does not assist where trusts hold interests in companies or partnerships; nor does it apply where the holding entity is a company or partnership. It is entirely unclear why the rule is not entity agnostic, as, indeed, the current rules are. This approach is likely to adversely impact structures that use a corporate or partnership vehicle. Partnership vehicles are not uncommon in both the infrastructure and real estate sectors (e.g., tenants in common interests). Non-consolidated corporate structures are also very common.
- The rule is limited to direct holdings of 50% or more. This requirement materially disadvantages upstream holders of non-portfolio, non-controlling interests. Under the Bill, these entities are required to exclude from their Tax EBITDA the income arising from their holdings, but they receive no share of the excess thin capitalisation capacity arising from the downstream entities. Again, there is no reason for why these structures should be adversely impacted. Given the size of certain assets (e.g., in the infrastructure sector), this limitation is likely to significantly adversely impact consortia of investors who have funded large infrastructure projects, among others. In addition, the rule will disadvantage structures with split holdings, as it requires a direct holding of 50% or more – if interests are split between two entities with an upstream single holder, and if one of those entities holds an interest below 50%, the rule will adversely impact the structure.
- The rule does not apply to the group ratio test, meaning that where there is upstream gearing in a non-consolidated group, adverse implications are likely to arise where an election is made to apply the group ratio test.
Third Party Debt Conditions – Permissible Recourse
The Exposure Draft Legislation expands the range of permissible recourse, and the rules now reflect common security arrangements for third party debt. However, there remain some gaps:
- In a non-development asset context, the rules still prohibit guarantees, security, or credit support. As drafted, these rules appear to prohibit even third party arrangements. To take an example, a lessor will often secure a guarantee from an entity of substance for a lessee's lease obligations. Accordingly, if the creditor takes security over all of the assets of the lessor, the creditor will indirectly have access to an asset consisting of the third party guarantee, and the third party debt conditions will be failed. Given that guarantees from third parties are relatively common, and that these arrangements are genuine third party arrangements, it is unusual that these arrangements are not permitted. It will significantly reduce the number of taxpayers who are able to rely on the third party debt test.
- The rules still require that security is granted only over Australian assets. Many taxpayers grant all assets security to a lender, and if there are any foreign assets in the security pool, this will result in a failure of the third party debt conditions. Examples of foreign assets that would commonly arise would be, for example, a receivable from a foreign entity, or a foreign bank account. The rules bear no proportion to the materiality of these arrangements – i.e., a single foreign asset of de minimis value would result in a failure of the third party debt conditions.
Third Party Debt Conditions - Swaps
The Bill provided for a very limited form of swap structure in a conduit financing scenario. Effectively, it denied debt deductions if the interest rate swaps were entered into at the ultimate borrower level, and also prohibited back to back swaps through the conduit financer. It did permit the conduit financer to embed swap costs into the on-lending arrangement. However, each swap was required to hedge exposure to a particular debt interest, so hedging on a pool basis would have resulted in denied debt deductions.
The Exposure Draft Legislation now provides that debt deductions are available where the ultimate borrower enters into interest rate swaps with third parties. However, a number of the other problems remain, as follows:
- The Exposure Draft Legislation, based on the Explanatory Memorandum, has sought to permit hedging on a pooled basis. However, the way in which this change has been made is to permit the debt deduction "to the extent that" the debt deduction is directly associated with hedging or managing interest rate risk in respect of the debt interest. If a borrower has issued two debt interests, one for $60 million, and one for $40 million, and has also entered into an interest rate swap with a notional principal of $80 million, it remains unclear how this rule applies. For example, it is not clear how taxpayers are to show the swap is "directly associated" with hedging or managing interest rate risk in respect of a particular debt interest. Although it is clear the changes are intended to permit this (per the Explanatory Memorandum), it would be clearer if the legislation referred to the debt interest or debt interests.
- The conduit financer provisions also constrain the type of swap structures that may be deployed. For example, back to back swap arrangements remain problematic – from the perspective of the ultimate lender, debt deductions will be denied on back to back swaps, as they are referable to an amount paid to an associate entity. This is an unusual outcome, as ultimately the funds flow to a non-associate entity. Similarly, while the rules permit the conduit financer to embed swap costs into an on-lending agreement, the rules do not permit the conduit to pass on swap benefits (i.e., receipts under the swap). As the receipts may be higher than the payments (e.g., if the swap is in the money), this will result in the conduit entity no longer being a genuine conduit – it will have taxable income.
- Finally, cross-currency interest rate swaps remain problematic. Cross-currency interest rate swaps hedge interest rate fluctuations in a foreign currency. It remains unclear if these debt deductions are available, as the arrangement goes beyond hedging or managing interest rate risk.
Third Party Debt Conditions – Development Assets Concession
While the Exposure Draft Legislation expands the development assets concession to moveable property that is relevant and incidental to land, there remain a number of gaps or unusual features of the concession:
- The concession does not apply to certain large infrastructure development projects where the underlying assets are not land. For example, certain renewable energy projects do not qualify as interests in land, such that the development assets concession will not be available for the development of these projects. Given the size of investment needed to assist in Australia's energy transition, and the importance of this to the Government's agenda, this is counter intuitive. The development assets concession could be expanded relatively straightforwardly to permit this, by referring to economic infrastructure assets as defined in the Taxation Administration Act 1953 (Cth).
- The concession is not available where a foreign entity that is an associate entity (by reference to a 50% threshold) provides a guarantee or other form of credit support. This requirement creates an unlevel playing field for development assets – Australian entities which hold 50% or more are permitted to provide a guarantee (even where the assets of the Australian entity are foreign assets), while non-residents are not permitted to provide a guarantee in these circumstances (even if their assets are Australian assets). Similarly, a consortium of foreign investors each holding less than 50% can provide guarantees. If the purpose of the development assets concession is to encourage investment in development of material Australian assets, any foreign entity should be able to provide a guarantee during the development phase.
- Finally, the concession ends at completion of the development, but standard development loan arrangements will provide that the guarantee ceases when certain financial covenants are satisfied (e.g., interest coverage ratios are satisfied, such as at stabilisation of the asset).
Debt Deduction Creation Rules
The debt deduction creation rules as introduced in the Bill would have caused significant issues, and applied to a number of common arrangements.
The Exposure Draft has refined the operation of the rules to operate in a more targeted manner. The Supplementary Explanatory Memorandum notes at [1.38], the debt deduction creation rules now target instances where the "related party debt deduction condition" is satisfied, and notes that where a related party transaction is financed with related party debt, there is often no real economic cost to the group.
While the debt deduction creation rules continue to apply in respect of an acquisition of a CGT asset, or legal or equitable obligation (i.e., s820-423A(2)), the debt deduction creation rules now concern "financial arrangements between associate pairs". In addition, certain assets are excluded from the rules' operation, including (for example) newly issued debt or equity interests, and tangible depreciating assets.
The debt deduction creation rule for borrowing from an associate pair to make a payment or distribution to an associate pair has also been amended to include (effectively) a conduit financing exception, reflecting that the ultimate borrowing is external to the group. However, the rule has more generally been broadened, in that that Bill required that the entity used the funds "predominantly" to fund, facilitate the funding of, or increase the ability of an entity to make, one or more payments or distributions. The "predominantly" requirement has been removed. Given the breadth of meaning of facilitating the funding of, or increasing the ability of an entity to make, a payment or distribution, this provision retains a potentially very wide application to common arrangements. On one view, any borrowing increases the ability of an entity to make a payment or distribution, as it increases the cash available to them.
In addition, the "associate pair" concept has been amended for unit trusts, to treat unit trusts as more like companies (given the very broad meaning of associate for trusts).
Finally, the debt deduction creation rules will not apply in the income year commencing 1 July 2023 in respect of debt arrangements that were entered into prior to 22 June 2023 (being the date on which the Bill was introduced into Parliament). While this is a positive change, for income years commencing on or after 1 July 2024, the debt deduction creation rules will effectively apply retrospectively, which will require taxpayers to consider the circumstances in which the debt interest was issued, potentially for income tax years for which they are no longer required to keep records.
There also remain a number of other issues or new issues:
- The conduit financing exemption applies only where the on-lending is on the same terms with respect to costs. However, and compared to the conduit financing provisions in the third party debt test, certain costs are not disregarded. Accordingly, taxpayers may have to choose whether to satisfy two different conduit financing regimes. It would be preferable if the rules were consistent regarding which costs are to be tested.
- The debt deduction creation rules can apply where an arrangement results in no net increase in the level of debt in a group. The rationale for this is not clear.
- The debt deduction creation rules can apply where a related party debt is used to make a payment or a distribution that is treated as assessable income or is subject to withholding tax. It is not clear why this is appropriate.
Authors: Steve Whittington, Partner; Vivian Chang, Partner; Sanjay Wavde, Partner; and Ian Kellock, Partner.