Important Update: The below summarises the Government's amendments to the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share – Integrity and Transparency) Bill 2023 that were introduced into the Australian Senate on 28 November 2023. On 5 December 2023, the Senate agreed to amend the motion that the Bill be read a second time, and instead moved that the Government's amendments be referred to the Senate Economics Legislation Committee for inquiry and report by 5 February 2024, and that further consideration of the Bill be made an order of the day for the first sitting day after the Committee has reported. Accordingly, the amendments referred to below will now be the subject of further scrutiny by the Senate Economics Legislation Committee.
What you need to know
On 28 November 2023, amendments to the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share – Integrity and Transparency) Bill 2023 were introduced into the Australian Senate. The Bill is currently at second reading stage.
The amendments are based on Exposure Draft Legislation that was released for public consultation on 18 October 2023, although there have been some substantial changes to the Exposure Draft Legislation. A summary of the Exposure Draft Legislation, and some of the critical tax issues, is available here. Earlier commentary on the thin capitalisation measures is available here and here.
Detailed analysis of the amendments is provided below, but a key summary of the main changes are as follows:
- The ability for upstream entities to include downstream entity excess thin capitalisation capacity in determining their fixed ratio earnings limit has been expanded beyond trust structures, and now also applies to companies and partnerships (whether upstream or downstream). However, the other requirements to pick up excess thin capitalisation capacity remain, including that excess thin capitalisation capacity can only be included upstream where there are direct holdings of 50% or more, the downstream (or upstream) entity does not apply the group ratio test or the third party debt test, and the relevant entities are general class investors.
- Material changes have been made to the third party debt test, including the conduit financing elements of that test, with an intention to broaden the forms of permissible recourse, as well as the forms of permissible guarantees, securities, and credit support. Other changes have been made to facilitate testing the conduit financing conditions on a debt interest by debt interest basis, as well as to permit a broader range of arrangements to recover costs or pass on benefits associated with third party swaps, provided this is done under the on-lending agreement. While these changes are welcome, there remains substantial complexity with the rules. Unfortunately, and inconsistently with the policy intent, many taxpayers with genuine third party debt or other arrangements will fail the third party debt conditions.
- The debt deduction creation rules were originally included in the Bill introduced on 22 June 2023 without any form of public consultation in either the discussion document or the relevant Exposure Draft Legislation, and with just eight days for taxpayers to consider the implications before they took effect under the Bill as introduced. The amendments defer the application of the debt deduction creation rules, and they will now apply to income years commencing on or after 1 July 2024. However, they will continue to apply on a retrospective basis from that time (i.e., to arrangements entered into before 1 July 2024).
- The debt deduction creation rules no longer have any application in respect of an income year where the entity has elected to apply the third party debt test. In addition, further limitations have been included in respect of the debt deduction creation rule that applies where a taxpayer makes a payment or distribution to an associate pair, in the form of a list of prescribed payments and distributions that are potentially subject to the rules. However, that prescribed list remains broad in its application, such that taxpayers should carefully consider their related party arrangements, noting that the rules can apply to very common arrangements between non-consolidated groups of entities.
One of the issues identified with the Bill was that the thin capitalisation measures contained no ordering rule, with the consequence that both the debt deduction creation rules, and the other elements of the thin capitalisation measures, could apply to debt deductions. One consequence of this was that a greater quantum of debt deductions could be denied than was expected (and, it seems, intended).
The amendments contain an ordering rule, which requires a taxpayer to first work out whether debt deductions are disallowed under the debt deduction creation rules. Once such a determination has been made, any disallowed debt deductions under those rules are disregarded in applying the thin capitalisation provisions applicable to general class investors and financial entities.
Fixed ratio test
The principal change to the fixed ratio test is to permit upstream entities to include excess thin capitalisation capacity from downstream entities in determining the upstream entity's fixed ratio earnings limit, in certain circumstances.
In particular, excess thin capitalisation capacity is determined by taking the downstream entity's fixed ratio earnings limit, and subtracting from it the downstream entity'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).
The Exposure Draft Legislation included this change with respect to certain unit trusts that held controlling interests in certain downstream unit trusts. The amendments have expanded this rule beyond unit trusts, so that the rule now applies to certain unit trusts, and companies and partnerships that are Australian entities. However, there remain a number of restrictions to these rules that result in adverse implications in certain common scenarios:
- 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 thin capitalisation measures, 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. There is no clear policy rationale 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 is limited to companies and partnerships that are Australian entities, as well as resident trusts for CGT purposes and managed investment trusts. It is not clear why a non-resident corporate entity that derives income indirectly from an Australian unit trust, and has issued debt, should be unable to access the excess thin capitalisation capacity arising at the Australian trust level.
- The rule does not apply where either of the entities has elected to apply 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. Again, it is unclear why excess thin capitalisation capacity should not flow up the structure in these circumstances.
- Where the controlled entity has issued shares, units, or partnership interests that carry different rights, the rule measures "TC direct control interests" by reference to the lesser of the relevant rights. This could result in an upstream entity including effectively all of the income arising from the downstream entity in its assessable income, and being required to exclude that income in calculating its Tax EBITDA, and then not picking up any excess thin capitalisation capacity. In these circumstances, it is possible that no upstream entity would be able to pick up any excess thin capitalisation capacity. Again, the logic for this approach is not clear.
Some other less material changes have also been made to the fixed ratio test, as follows:
- The fixed ratio test (per the Bill), which sets the fixed ratio earnings limit at 30% of Tax EBITDA, required that dividends and franking credits were excluded in determining Tax EBITDA. The Exposure Draft Legislation sought to limit that exclusion to dividends received from an associate entity (applying a 10% threshold), although it required the exclusion of all franking credits. The amendments ensure that franking credits are excluded from Tax EBITDA only where they are received from an associate entity.
- The fixed ratio test (per the Bill) applied in an inconsistent way for AMITs (compared to other trusts). A series of changes have been included in the amendments with the intended effect of providing equivalent treatment of AMITs.
Third party debt test
Substantial changes have been made to the "base test", the "conduit financing test", and the way in which the third party debt test applies to certain swap arrangements.
The base test
One of the critical concerns with the base test (as introduced in the Bill) is that it limited permissible recourse of the lender to Australian assets that were held by the issuer of the debt interest (i.e., the borrower). This requirement to satisfy the base third party debt test was entirely inconsistent with prevailing market practice associated with third party debt arrangements, where the lender would ordinarily take security over (at least) the assets of the borrower, the equity interests in the borrower, and potentially assets held by upstream and downstream entities from those entities.
The amendments expand the forms of permissible recourse in the following ways:
- "Minor and insignificant" assets are to be disregarded in considering the assets to which the holder of the debt interest has recourse for payment of the debt. This is intended to address a concern that if an entity granted general security over all of its assets, and it had immaterial foreign assets, that it would automatically fail the base third party debt test. The Supplementary Explanatory Memorandum provides no clear guidance as to how "minor and insignificant" assets are to be determined, other than noting that it is intended to prevent the requirements being failed for "inadvertent and superficial reasons". To take an example, it is not clear whether disregarding minor and insignificant assets includes assets that are material in value but fleeting by reference to time – such as, for example, an asset consisting of material cash in a foreign bank account, that is then withdrawn after a short period into an Australian bank account. More generally, it is also not clear why this is not a permissible asset, given that the bank account would be expected to contribute towards the tax base of Australia (i.e., where it is interest earning). Similarly, and if the rule is intended to not result in the requirements being satisfied for "inadvertent and superficial reasons", it is not clear if long standing (but de minimis by value) assets could be considered to give rise to a failure for "inadvertent" reasons; certainly, the asset may be intended to be held for a long period (and in that sense the granting of security over it is not "inadvertent"), notwithstanding that it is not material by value.
- Permissible assets over which recourse can be had for payment of the debt now includes not only Australian assets held by the borrower, but also includes (as alternatives) membership interests in the borrower (unless the borrower has a legal or equitable interest, whether directly or indirectly, in an asset that is not an Australian assets), or assets that are held by an Australian entity that is a member of the obligor group in relation to the debt interest. The drafting of this section can produce some unusual results. To take an example, if the holder of equity in the borrower has granted specific security over its shares in the borrower, and the borrower holds (directly or indirectly) foreign assets, the relevant requirements will be failed, as the grantor of that security will not be a member of the obligor group. If, however, the holder of the equity has granted all asset security, including over the shares in the borrower, and the holder of the equity does not itself hold foreign assets, that will (at least arguably) be permissible notwithstanding that the borrower holds (directly or indirectly) foreign assets. It seems unusual that such different outcomes arise depending on whether the grantor of the security is or is not a member of the obligor group. However, that appears to be the effect of the amendment as drafted.
The Bill (as introduced) also contained a prohibition on rights under or in relation to a guarantee, security, or other form of credit support. It was not clear how this operated in the context of permissible recourse beyond the assets of the borrower (or if the borrower's assets included, for example, a guarantee). While the amendments retain a prohibition on certain forms of guarantees, security, or credit support, this prohibition does not apply to:
- Rights that provide recourse, directly or indirectly, only to one or more Australian assets; and
- Rights that give the holder of the debt interest recourse against entities that are non-associate entities (by reference to a 20% threshold) of the borrower (e.g., third party guarantees).
Finally on the base test, the development asset concession has also been expanded to cover not only the development of land assets (per the Bill) and certain incidental movable property (per the Exposure Draft), but also to cover certain offshore renewable energy infrastructure and offshore electricity transmission infrastructure. While this is positive, the development asset concession does not apply to certain onshore 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 have been expanded straightforwardly to permit this, by referring to economic infrastructure assets as defined in the Taxation Administration Act 1953 (Cth). Unfortunately for the Government's commitment (both internationally and domestically) to a Net Zero economy by 2050, this change has not been included in the amendments.
In addition, and for completeness, no changes have been made to the rule that prohibits guarantees, security, or other forms of credit support being provided by non-resident associate entities (by reference to a 50% threshold). Accordingly, foreign investors are likely to face a greater quantum of debt deduction denial where they hold controlling interests in development assets. If the rationale of the development asset concession is not to adversely impact the willingness to invest in development assets (in light of lender requirements), it is not clear why the rules produce more favourable outcomes for residents or, indeed, for foreign investors with non-controlling interests.
The conduit financing test
There have also been substantial changes to the conduit financing test. The material changes are as follows:
- One of the technical drafting issues with the conduit financing test was that it was intended to modify the application of the base test so that it applied appropriately in a conduit financing context. However, those modifications only applied where the ultimate debt interest (i.e., the debt interest issued by the conduit financer) satisfied the base third party debt test. In order for the ultimate debt interest to satisfy the base third party debt test, it was necessary to access the modifications under the conduit financing test (such as the modification that permitted the use of funds to hold associate entity debt). In other words, there was a circularity issue, in that the modifications were needed for the ultimate debt interest to satisfy the base third party debt test, but in order to access those modifications there was a requirement to meet the base third party debt conditions. This issue has been resolved by the amendments, as it is no longer a conduit financing requirement for the ultimate debt interest to satisfy the third party debt conditions (that is a requirement when testing the ultimate debt interest under the modified base third party debt conditions).
- Another issue associated with the conduit financing conditions is that it required all "relevant debt interests" to satisfy the modified base third party debt test in order for the conduit financing conditions to be satisfied. The amendments provide that where a debt interest satisfies the conduit financing conditions, then the modified base third party debt conditions apply in relation to both the relevant debt interest and the ultimate debt interest. This should ensure that where the ultimate debt interest finances multiple relevant debt interests, and only some of those relevant debt interests satisfy the conduit financing conditions, that the debt deductions on qualifying arrangements are not adversely impacted.
- The amendments also allow the conduit financing conditions to apply multiple times (i.e., where there are multiple conduit financers within a group), which is a change from the Exposure Draft Legislation which (inadvertently) prevented this.
- Finally, a critical change has been made in respect of the "same terms" requirements associated with costs. Under the Bill and the Exposure Draft Legislation, the same terms requirements related to any costs under the terms of the relevant debt interest (i.e., the on-lending). The amendments provide that the same terms requirements relate to costs "incurred by the borrower". This means that where the costs arise under the terms of the relevant debt interest for the lender, there is no requirement that they are the same as the cost-related terms of the ultimate debt interest. This has material impacts for certain embedded swap arrangements (discussed below).
The treatment of swaps
There have been a number of important changes to permitted interest rate swap arrangements under the third party debt test.
First, the amendments have 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 Supplementary Explanatory Memorandum), it would be clearer if the legislation referred to the debt interest or debt interests.
Second, both the Bill and the Exposure Draft permitted an extremely unusual form of embedded swap arrangement under the terms of conduit financing on-lending. In particular, they permitted the conduit financer to on-lend and recover (from the borrower) swap-related costs it had incurred, but did not allow the conduit financer to pass on receipts it received under the external swap. As the receipts under a swap may be higher than the payments (e.g., if the swap is in the money), this would have resulted in the conduit entity no longer being a genuine conduit – it would have taxable income. The change contained in the amendments referred to above, which only requires testing the same terms requirements with respect to costs incurred by the borrower (and not costs incurred by the conduit financer), should now permit the conduit financer to pass on swap-related benefits under the terms of the on-lending agreement.
While this is positive, the most common form of swap arrangements in a conduit financing scenario remains prohibited by the rules. The most common form of swap arrangement would be for the conduit financer to enter into a swap, and then to enter into back-to-back swap arrangements with the entities to which it is on-lending. These very common arrangements are not permissible under the third party debt test, because the back-to-back swap arrangements will result in debt deductions that are referable to amounts paid or payable to an associate entity. Accordingly, taxpayers will be required to enter into economically equivalent (but structurally different) arrangements by embedding swap-elements into the on-lending arrangements. This will likely result in income tax implications on closing out the back-to-back swap, and also has the potential to result in the conduit financer ceasing to be a pure conduit for income tax purposes (i.e., where it does not close out, at the same time, the third party swap arrangements). Given the substance of these arrangements are materially the same, it is unclear why the amendments have not facilitated the ordinary type of arrangements entered into in a conduit financing scenario.
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. This is likely to impact taxpayers who have borrowed in a foreign currency, as cross-currency interest rate swaps are very common in this scenario.
The debt deduction creation rules
As noted above, the debt deduction creation rules were included in the Bill as introduced without consultation, and with extremely limited time for taxpayers to consider their impact. This was particularly problematic, as the rules were drafted in an extraordinarily broad manner, and also applied (in effect) retrospectively, in that they applied to arrangements entered into before the Bill was introduced. Accordingly, the debt deduction creation rules, as included in the Bill, caused significant issues for a large number of taxpayers, even where their arrangements were relatively straightforward and common.
In a temporary reprieve for taxpayers, the amendments defer the application of the debt deduction creation rules to income years commencing on or after 1 July 2024. However, the rules will apply retrospectively from that point. The Supplementary Explanatory Memorandum indicates that schemes involving a "mere restructuring" of an arrangement that would otherwise be caught by the debt deduction rules is permitted, provided there is no associated artificiality or contrivance. Accordingly, taxpayers who are undertaking restructures should consider not only the technical application of the debt deduction creation rules, but also the potential application of both specific and general anti-avoidance rules.
Some of the critical changes to the debt deduction creation rules are as follows:
- The amendments, consistent with the Exposure Draft Legislation, ensure that the debt deduction creation rules only to apply where related party debt (or related party financial arrangements) are entered into. In addition, the amendments provide that the debt deduction creation rules do not apply for any income year in which the relevant entity has elected to apply the third party debt test. While this is welcome, given the restrictiveness of elements of the third party debt test, taxpayers who are unable to satisfy the third party debt conditions will need to consider any related party arrangements in detail in considering the potential application of the debt deduction creation rules.
- While the debt deduction creation rules continue to apply in respect of an acquisition of a CGT asset, or a legal or equitable obligation, the debt deduction creation rules now exclude (per the amendments) acquisitions of certain assets. These excluded assets are membership interests in Australian entities or foreign companies (it is unclear why the exclusion does not encompass acquisitions of membership interests in, for example, foreign trusts), certain tangible depreciating assets, and debt interests. The differential treatment of borrowing to acquire membership interests in foreign companies as compared to foreign trusts is perplexing, given that it is more likely that investments in foreign trusts would ultimately contribute to the Australian tax base (noting there is no participation exemption for trusts).
- The debt deduction creation rule related to payments or distributions made to associate pairs has been pared back, and now only applies to certain types of payments or distributions. For example, it applies to dividends, distributions (including non-share distributions), returns of capital, a payment or distribution in respect of the redemption or cancellation of membership interests, royalties or similar payments or distributions for the use of, or right to use, an asset, and the repayment of principal under a debt (in certain circumstances). It also includes a catch-all for payments or distributions of a "similar kind".
Although it is positive that the concept of a payment or distribution has now been constrained, the list remains very broad. To take a very simple example, if an entity borrows from a conduit financer (i.e., ultimately sourced from a third party), and makes a lease payment to an associate entity, that would arguably be similar to a payment of a royalty and is for the use of an asset. Accordingly, the debt deduction creation rules may apply. In many instances, the logic of the application of these rules is not clear – in the example given, the payment would be treated as assessable income and subject to tax, and the ultimate source of the funding is from a third party. It would have been straightforward to exclude related party debt where it is a relevant debt interest that satisfied the conduit financing rules. Instead, taxpayers will now have to consider all of their related party arrangements, and may be denied debt deductions in circumstances where there is no identifiable tax-related mischief.
The above summary is a snapshot of some of the key changes arising from the amendments; there are others. The thin capitalisation measures, once enacted, represent a highly complex set of rules which have the potential to have significantly adverse impacts on taxpayers. In addition, elements of the rules do not appear to have a clear policy rationale. While the measures represent an improvement on the Bill as introduced, it is likely that the measures will decrease Australia's attractiveness as a destination for capital.
Authors: Steve Whittington, Partner; Vivian Chang, Partner; Sanjay Wavde, Partner; and Ian Kellock, Partner.