Before the recent election, the Labor Party announced that, if elected, it would ‘adopt the OECD’s recommended approach for limiting the deductions multinational firms can claim for interest payments’ and ‘adapt Australia’s rules on deducting interest to fit with the OECD’s recommended approach to limit net interest expenses to 30 per cent of profits’ (EBITDA) while still allowing interest deductions substantiated ‘under the arm’s length test or worldwide gearing ratio test’. In August the newly elected Government released a consultation paper which invited feedback on the legal and economic implications of the proposed rules, options for their design, and their interaction with other rules. The October Budget Papers now indicate the direction of the Government’s thinking on a number of key issues in this area.
The proposed commencement date of the changes is 1 July 2023. Their projected impact includes an increase in tax revenue of $370 million in the 2025 financial year and $350 million in 2026.
Scope
Labor’s pre-election policy statement did not expressly say which classes of entities would be affected by the new rule. The present thin capitalisation rules apply different fixed ratio rules to authorised deposit-taking institutions (ADIs, namely banks), non-ADI financial entities, and non-ADI general entities. The fixed ratio rule for ADIs is based on the level of equity capital. The corresponding rules for non-ADIs are based on debt to equity ratios. For financial entities, the ratio is 15:1; for general entities, 1.5:1. General discussion of thin capitalisation tends to start with the treatment of general non-ADI entities. The policy statement can be understood in that light, but it leaves open what changes, if any, should be made to the treatment of other entities. That question was addressed by the consultation paper released after the election, and is answered in the Budget Papers: only general non-ADI entities will be affected. For those entities, the fixed ratio rule will shift to an earnings-based measure, 30% of EBITDA. Non-ADI financial entities will retain the existing debt-based rule and ADIs the existing capital-based rule.
Fixed ratio rule
The recommendations of the OECD/G20 Base Erosion and Profit Shifting (BEPS) Project on thin capitalisation are expressed in the general report on Action 4 (base erosion involving interest deductions), first issued in 2015 and updated in 2016. Its primary recommendation is an earnings-based fixed ratio rule set at a rate between 10% and 30% of EBITDA. The proposed amendments come in at the top of this rate. The Action 4 report recognises that different considerations apply to banks and insurance companies.
Each of the present fixed ratio rules may be relieved by alternative rules. If the entity is consolidated with other entities for accounting purposes, a worldwide gearing rule allows interest deductions up to a level calculated by reference to the worldwide debt to equity ratio of the group in the case of a non-ADI or worldwide capital ratio in the case of an ADI. Interest deductions are also allowed under an arm’s length rule. If the deduction limit is higher under an alternative rule than under the fixed ratio rule, deductions are permitted to that higher limit.
Group ratio rule
In light of the proposed switch to an earnings-based fixed ratio rule, the Australian Government’s consultation paper raised the possibility of an earnings-based group ratio rule to supplement or to replace the debt-based worldwide gearing rule. The Budget Papers reveal that the Government has decided to replace the worldwide gearing rule, but only for non-ADI general entities. This means that the fixed ratio rule and the group will have the same conceptual and evidentiary frame of reference. Depending on design choices yet to be revealed, these may be the relevant commercial accounts. If the commercial accounts are used, tax-based modifications will be necessary.
The Action 4 report approves the use of an earnings-based group ratio rule. This is presented as a primary position. The adoption of an earnings basis corresponds with the method of the fixed ratio rule and has the further advantage of enabling the use of accounting data, which exists anyway. To avoid anomalies and abuse, it is however necessary to make some modifications to the raw accounting data; the Action 4 report discusses these at length. The report also recognises that a group ratio rule based on debt to equity ratios may legitimately be adopted in conjunction with an earnings-based fixed ratio rule, as is done for example in Germany and Finland. It is evident from the Budget Papers that the Government is running with the primary OECD position. This means that there will be two group ratio rules for non-ADI entities: an earnings-based rule for general entities and the existing debt-based rule for financial entities.
The design of an Australian earnings-based group ratio rule raises its own complexities and challenges in defining both the numerator (group net interest) and the denominator (group EBITDA) for the purposes of the rule. It remains to be seen which of the strategies discussed in the Action 4 report are adopted.
Arm’s length rule
The consultation paper posed several questions about the arm’s length rule. Among them:
14. To what extent does the current arm’s length debt test permit BEPS practices to occur? What changes should be made to ensure that an arm’s length test complements the fixed ratio rule?
15. How should the different integrity concerns posed by external (third-party) debt and related-party debt be reflected in any changes to the arm’s length debt test?
16. Would differentiating between external (third-party) debt and related-party debt simplify the operation of the test?
The Action 4 report notes concerns with the use of arm’s length tests, but accepts that individual countries may still find them useful.
The Budget Papers state that the Government proposes to ‘retain an arm’s length debt test as a substitute test which will apply only to an entity’s external (third party) debt, disallowing deductions for related party debt under this test.’ As financial entities ‘will continue to be subject to the existing thin capitalisation rules’, it appears that changes to the arm’s length debt test will only apply to non-ADI general entities.
The general criteria under the new test are not elaborated. The present arm’s length rule for non-ADI entities is based on debt. There is no technical objection to the new rule still proceeding on a debt basis, but the mechanism for translating a debt limit to an interest limit would have to be shifted to a different point.
The disallowance of related party debt is new and significant. If an entity wishes to rely on the new arm’s length test, it must forego interest deductions for related party debt. It appears that the denial of deductions is to apply to all related party interest where a company chooses to rely on the arm’s length rule instead of the fixed ratio rule. If so, the new rule will not assist companies that rely on more than trivial related-party finance and will not be susceptible to abuse in that context.
Carry-forward of denied deductions
The present thin capitalisation rules do not permit denied deductions to be carried forward. Under a debt-based rule, there is no justification for it. The potential volatility of earnings, including the variation of earnings over time that is inherent in a range of enterprises, gives rise to a different set of pressures where debt deduction limits are set by reference to earnings. The Action 4 report recognises these pressures. It discusses a range of responses, including the carry-forward or carry-back of denied deductions, the carry-forward of interest capacity, and time-based limits that may be applied to their later utilisation.
Neither the pre-election policy statement nor the consultation paper said anything about the issue. The Budget Papers state the Government’s intention to ‘allow deductions denied under the entity-level EBITDA test … to be carried forward and claimed in a subsequent income year (up to 15 years)’. Particularly given the choice of a 30% ratio, this is squarely in line with the Action 4 report. It may be that the issue was left off the consultation paper because the Government, or Treasury, already had a firm idea of what it should do and why.
The transfer of denied deductions to a carried forward reserve will create spin-off issues for accountants. Should the reserve be recognised as a deferred tax asset on the balance sheet? What is the effect on the company’s effective tax rate year by year?
Overview
In the five months since the election, the main elements of the proposed reform of the thin capitalisation rules have substantially crystallised: a transition of the basis of the fixed ratio rule and group ratio rule applicable to non-ADI general entities from debt to earnings; modification of the arm’s length rule to limit its operation where the entity receives related-party finance; and a time-limited carry-forward of denied deductions. These design elements are, as they have been represented to be, consistent with the general approach of Action 4 of the BEPS Project.
The Budget Papers reveal the Government’s position on some but by no means all of the questions in the consultation paper. Full responses to the consultation process and the exact design of the new fixed ratio rule, group ratio rule, and arm’s length rule for non-ADI general entities remain to be seen. A final assessment of the reforms must, of course, await those developments.
Other 2022 October Budget articles
Improving Tax Compliance of Large Multinational Companies, by Max Bruce.
What the Budget Did Not Address – Unfair Tax Minimisation Using Discretionary Trusts, by Sonali Walpola.
Australia’s First Wellbeing Budget Leaves People Behind, by Ben Spies-Butcher, Troy Henderson and Elise Klein.
Demand-Side Climate Related Measures, by Diane Kraal.
The Vested Interests Behind the Technical Expertise of the Big Four in Global Tax Reform, by Ainsley Elbra, John Mikler and Hannah Murphy-Gregory.
Click here for 2022 March Budget articles.
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