Australia’s New Thin Capitalization Rule Changes and Potential Impact on Companies’ Debt Structuring Approach

The new rules in the context of the global environment

On 8th April 2024, the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share – Integrity and Transparency) Bill 2023 was passed and enacted into the Australian law, after various consultation processes and improvement suggestions since its announcement in the 2022-2023 Federal Budget.?The Bill amended the thin capitalization rules (hereafter thin-cap rules) and the debt deduction creation rules in Division 820 of the Income Tax Assessment Act 1997. The amendment intends to strengthen Australia's thin capitalisation regime, aligning it more closely with the best practice of OECD’s Base Erosion and Profit Shifting (BEPS) Actions. Specifically, the changes are to limit the amount of income tax deductions for interest, thus to address the risk of erosion to Australia’s tax base arising from excessive interest deductions.

Avoiding erosion of the tax base is a big challenge for many countries. Operating internationally provides multinational companies (MNCs) with opportunities to exploit gaps and mismatches of different countries' tax systems, leading to lowering or even eliminating the tax they should pay. Globally countries lost hundreds of billions of USD in income annually (around 4-10% of the global corporate tax income revenue)1 due to BEPS practice. These practices are in most cases perfectly legal but deemed immoral. The G20 countries, together with OECD, implemented 15 BEPS action plans aiming to tackle tax avoidance and profit shifting, improve the coherence of international tax rules and ensure a more transparent tax environment2. The ultimate goal is to ensure that MNCs pay a fair share of tax wherever they operate (also see Do you pay your fair share of Taxes?) and to restore trust in domestic and international tax systems.?

MNCs can shift their profits between countries to minimize their tax liability, by arranging their debt in a way whereby they excessively borrow in high-tax countries where interest expenses are deductible, with loans extended from parent or affiliates in low-tax countries where interest income is part of the corporate tax base. Thin-cap rules have thus been adopted by many countries to prevent business from using debt shifting for tax planning purpose. Two commonly used mechanisms for thin-cap rules include “safe harbour rules” (debt-to-equity ratio) and more recently emerged “earnings stripping rules” (debt interest to pretax earnings ratio)3. For most countries, thin-cap rules only applies to internal debt/related party debt.

This article explores the relevance of Australia’s new thin-cap rule changes as it pertains to intra-group financing, and shares the best practice from MNCs of using alternative structures for intra-group funding to minimize the impact brought by the new thin-cap rules. The content is summarized as follows:

1.???? Key changes of Australia’s new thin-cap rules

2.???? Relevance of the new rules with MNC’s financing arrangements

3.???? Using Cash Pool as alternative solution for intra-group financing

4.???? Conclusions

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1.????? Key changes of Australia’s new thin-cap rules

The changes are composed of two components: 1) debt deduction creation rules; 2) thin-cap rules. An entity's debt deductions must first be considered under the debt deduction creation rules and, if applicable, reduced before applying the thin-cap rules.

Debt Deduction Creation Rules (DDCR) are to limit the scope of financing arrangements that may fall within the ambit of the debt deduction. The rules essentially deny debt deductions arising only in connection with related party debt, in two broad scenarios.

The 1st scenario is to disallow debt deductions on related party debt whereby the debt has been used to fund the acquisition of a capital gains tax (CGT) asset directly or indirectly from a related party (chart 1). In this scenario, a no-go area is that an entity (the Lender/Disposer) lends related party debt to its affiliate (the Borrower). The Borrower uses the proceeds to fund the Lender for the acquisition of CGT asset of the Borrower itself, making the loan artificial. DDCR applies to deny the interest expense incurred by the Borrower to the extent it relates to the acquisition of the CGT asset from the Borrower.

The 2nd scenario is to disallow debt deductions on related party debt whereby the debt has been used or to pay dividend, profit like distribution, capital return or royalty (these are prohibited payments)4 (chart 2). One scenario is that the Payer enters into a financial arrangement with an associated entity where it borrows related party debt. The payer uses the proceeds to fund the payment of a prohibited dividend payment to an associate recipient. DDCR applies to deny the interest expense incurred by the payer to the extent it relates to the payment of the dividend to the associate recipient.

The rules exclude ordinary commercial transactions i.e. third-party loans. However, if a third-party loan is taken out to repay the related-party financing, this could still fall foul of the rules. If an entity uses its cash resources to make a related-party acquisition, but has to enter into a borrowing afterwards to fund its operating outgoings, this could also be problematic. This is to prevent attempts to sidestep the application of the rules.

Thin-cap rules adopted earnings-based rules (e.g. debt interest to tax EBITDA ratio) to replace the previous safe harbour rules (e.g. debt-to-equity ratio). This brings the thin-cap practice in Australia more closely aligned with OECD’s best practice measure to limit interest deductions for tax purposes. OECD’s provided its recommended range of setting the limit of ratios to ensure?that countries apply the ratios low enough to tackle BEPS. The rules also introduced a new debt capacity analysis which is a transfer pricing assessment of debt quantum. This means that even if the debt is within the threshold of certain ratios (e.g. debt interest is within 30% of tax EBITDA), Australian tax authorities can still challenge whether the amount of debt is an arm's-length amount of debt4. MNCs will have to navigate an earnings-based ratio test with the added complication of considering the transfer pricing impacts of both the quantum of debt and the rate on interest.

2.????? Relevance of the new rules with MNCs’ financing arrangements

The new rules put more scrutiny on related party debt and limit the interest deduction capacity for the amount of debt which is not arm’s length. MNCs will have to analyze their financing arrangements to determine whether the interest associated will be deductible.

Similar to MNCs in other countries, Australian MNCs use related party debt (or intercompany loans) as a mainstream tool for intra-group funding. The purpose is to lower external borrowing and its associated costs. Nevertheless, since the debt is provided by parent company or affiliates, but not granted by an independent third party such as a bank, a more controlling mechanism is put in place by (tax) authorities to ensure that an entity doesn’t borrow excessively (i.e. thinly capitalized). This is assessed by a set of ratios. Interest paid on debt exceeding the set ratio is not tax-deductible.

Another critical aspect of related party debt is the interest rate. OECD Transfer Pricing Guidelines indicate that for financial transactions between affiliates, the arm’s length principle should be followed. This means companies have to consider the pricing conditions that independent parties would have agreed to in a commercially rational manner in comparable circumstances. Companies will also need to appropriately document the rationales of determining the pricing, as part of their transfer pricing documentation to prove their decision making process and different elements they have considered to set up a fair price, so that they won’t be challenged by tax authorities somewhere in the future.

3.????? Using Cash Pool as alternative solution for intra-group financing

In light of the more complicated regulatory environment brought by the new rules, companies can consider alternative solutions for funding the affiliates but at the same time avoid transactions to be categorized as related party debt. Cash Pool is a well-accepted solution among MNCs for managing the group’s internal liquidity. However, not every type of Cash Pool solves reduces the related party debt issues.

Physical Cash Pool

Physical Cash Pool, which involves physical movement of cash from different legal entities into one centralizing company (usually a holding entity or finance company), change the ownership of funds.

1)???? Are transactions in Physical Cash Pool under the scope of debt deduction creation rules?

There is no specific discussion of Cash Pool transactions in the changes of debt deduction creation rules. Cash Pool is usually used (or should be used) to fund the working capital needs of affiliated entities, not for the purpose of financing acquisitions, dividend payment and so on. Since funds in the pool change ownership, the underlying transactions are recorded essentially as related party debt.

However, if borrowing from the Cash Pool is not used for financing of an acquisition of an asset, dividend or royalty. It seems unlikely that the transactions may fall under the scope of debt deduction creation rules.

2)???? Is transfer pricing a challenge for Physical Cash Pool?

Yes. Transfer pricing will have to be addressed for transactions categorized as related party debt. Additionally, the interest is usually settled by the bank on the account of the centralizing company (master) based on the netted amount. The centralizing company has to re-allocate the interest to all participating companies, making the interest as intercompany interest.

3)???? Can thin-cap be properly addressed under Physical Cash Pool?

Thin-cap rules will be relevant because the transactions are intercompany and there is no control mechanism (e.g. setting up borrowing limit) on how much an entity can borrow within the pool. This is due to all borrowings being consolidated on the level of the master account. Additional controls, checks & balances would need to be implemented by the MNC independently.?

Notional Cash Pool

Another type of Cash Pool is Notional Cash Pool. As the word ‘notional’ indicates, it?should not?involve any physical movement of cash among the affiliates, but ‘notionally’ regards cash balances of different legal entities as one balance (also see BEPS – combat attacks “innocent” Cash Pooling). The fact that funds do not move physically does not automatically take away the concern of related party debt. There are certain requirements to be met before the transactions of a Notional Cash Pool can be classified as transactions with an independent third party (i.e. a bank).? ???

One of the key considerations is the legal instrument used in the Cash Pool structure. A Cross guarantee is very often required by mainstream banks. Cross guarantees are arrangements between two or more associated enterprises to provide reciprocal guarantees towards each other. The risk of the bank can be significantly mitigated or entirely eliminated because any one firm of the group becomes the creditor of every other firm of the group (also see Banking – how intra-group guarantees trigger intra-group concerns).

In contrast, a pledge structure (floating charge) requires that deposits are pledged to the bank and the bank uses this deposit as collateral to lend funds to borrowing entities. As the counterparty for deposits and borrowings is the bank itself, deposits and borrowings are not linked among participating entities. A pledge is a unique tool for offering a Notional Cash Pool, but it is only allowed under a few jurisdictions, the Netherlands being one of them. Companies using Notional Cash Pools offered by a Dutch bank will be able to enjoy the benefits brought by the pledge, and to record their transactions in the Cash Pool as transactions with a bank. ?

1)???? Are transactions in Notional Cash Pool under the scope of debt deduction creation rules?

It depends on the features of Notional Cash Pool. If the transactions are in essence related party debt, they may fall under the scope of debt deduction creation rules. True notional Cash Pool should be less of a concern.

2)???? Is transfer pricing a challenge for Notional Cash Pool?

It is not uncommon that the interest rates of deposits and borrowings in certain types of Notional Cash Pool are determined by the central treasury of MNCs, instead of the bank. True Notional Cash Pools require that the interest rate is determined by the bank. The interest rate reflects the market circumstances as if entities enter into similar transactions in the market themselves. The interest is settled as bank interest on each individual account of the participating entities. The bank records the interest as bank’s profit and loss, which gets taxed accordingly. The bank is able to freely dispose of its interest income without passing the interest on to another party. This proves that the bank is the (ultimate) beneficiary owner of the interest income. These structures pose less challenges from a transfer pricing perspective.

3)???? Can thin-cap be properly addressed under Notional Cash Pool?

In a true notional pool, the pledge sets the foundation that the transactions in the Notional Cash Pool are transactions with the bank as an independent counterparty. This makes it easier for the companies to ensure that the borrowing capacity remains within the range of what an independent lender can accept, i.e. arm’s length amount of debt. Additionally, the bank should be able to allow companies to set up borrowing limits on Cash Pool accounts, to ensure that the debt amount is not exceeding the ratios.

4.????? Conclusions

The new debt deduction creation rules and thin-cap rules have added complexity to Australian MNCs or MNCs’ investing in Australia. Companies will need to address a variety of topics to analyze the nature of their debt and interest deduction capacity. Alternatively, companies can consider structuring their debt differently and move from related party debt to more tax-friendly intra-group financing arrangement, to minimize the impact of the rules.

Various Cash Pool solutions are available for intra-group financing. However, not all types of Cash Pool help address the tax issues arising from intercompany debt. It is critical that companies engage with internal and external parties with expertise to study thoroughly the Cash Pool structure and all its relevant aspects. Companies choosing the right type of Cash Pool can unravel the trick of related party debt.

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References:

1.????? International collaboration to end tax evasion (https://www.oecd.org/tax/beps/)

2.????? BEPS 2.0 What you need to know (https://www.meijburg.nl/sites/default/files/2022-04/Beps-what-to-know-flyer-web_.pdf)

3.????? The economics behind thin-cap rules (https://taxfoundation.org/blog/thin-cap-rules-economics/)

4.???? Australian thin capitalization changes and new subsidiary disclosure rules — December 2023 update (https://globaltaxnews.ey.com/news/2023-2078-australian-thin-capitalization-changes-and-new-subsidiary-disclosure-rules-december-2023-update)