Australian thin capitalization and subsidiary disclosure measures introduced into Parliament

Executive summary

Following consultation on Exposure Draft (ED) legislation and submissions by EY and others, the Australian Government has introduced the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share — Integrity and Transparency) Bill 2023, which contains measures relating to Australia’s thin capitalization rules and certain additional disclosures in respect of subsidiaries.

The Bill seeks to align Australia with the Organisation for Economic Co-operation and Development’s (OECD’s) earnings-based best practice model, which limits an entity’s interest expense deductions to a benchmark earnings ratio (30% of its tax EBITDA) while offering flexibility by allowing access to two alternative tests (provided certain conditions are met), being the Group Ratio Test and the Third-Party Debt Test (for general class investors and financial entities that are not ADIs).

New disclosure of subsidiaries’ requirements will apply for public company financial reporting.

Other elements of the Government’s multinational tax integrity package — to deny deductions for payments by significant global entities to low-tax jurisdictions relating to intangible assets (intangibles integrity rule) and introduce public country-by-country reporting — were not included in the Bill.

Thin capitalization and subsidiary disclosure measures

The Bill to implement changes to Australia’s thin capitalization interest limitation rules was introduced into Parliament on 22 June 2023.

Following is a brief summary and initial high-level analysis of the measures, which include new debt creation rules.

Importantly, the Bill does not address the other multinational enterprise (MNE) tax integrity and transparency measures following previous EDs:

• Denial of deductions for payments by significant global entities to low-tax jurisdictions relating to intangible assets (intangibles integrity rule)
• Tax transparency — public country-by-country (CbC) reporting

The Government had announced that both of these measures will apply from 1 July 2023 (with some drafting uncertainty as to whether the public CbC reporting applies to entities with substituted accounting periods from years starting on 1 January 2023).

Parliament does not sit again until 31 July and there has been no announcement from the Government as to why these measures were not included in the Bill or whether there may be any changes. Absent such an announcement, business should proceed on the basis that the application dates will not change when we eventually see the law introduced.

Note however that, for the public CbC reporting proposals, Treasury has proposed in an “impact analysis” included in the explanatory memorandum to the Bill that some CbC reporting data disclosures should be removed, proposed to defer the measure’s application by 12 months, to apply from 1 July 2024, and noted that further consultation may be beneficial.

Thin capitalization interest limitation rule changes

In addition to proposing to replace the current asset-based thin capitalization rules for general class investors with the three new tests outlined above (Default Fixed Ratio, Group Ratio, Third-Party Debt), the new rules also include transfer pricing changes that will apply to income years commencing on or after 1 July 2023.

Key changes from the previous ED include:

1. Fixed Ratio Test — calculation of tax EBITDA:

a. Depreciation add-back includes all deductions under Division 40 and Division 43 of the Income Tax Assessment Act 1997 (ITAA 1997) except amounts that are immediately deductible (e.g., amounts deducted under subdivision 40-H of the ITAA 1997).

b. Tax EBITDA will exclude franking offsets that are included in assessable income and dividends that are included in an entity’s assessable income under section 44 of the Income Tax Assessment Act 1936 (ITAA 1936) (this is to ensure there is no duplication of EBITDA capacity).

c. Definitional changes have been made so that the Fixed Ratio Test applies appropriately to partnerships and trusts. Adjustments are also made to ensure amounts included in the net income of a partnership/trust are not also taken into account in calculating the tax EBITDA of the partners/beneficiaries (this only applies where the partners/beneficiaries are an associate entity of the partnership/trust) (again to prevent duplication of EBITDA capacity).

2. 15-year carry forward under Fixed Ratio Test — FRT disallowed amounts:

a. For companies — ability to rely alternatively on the Business Continuity Test (BCT) has been added; therefore, FRT-disallowed amounts are treated in a similar manner to tax losses

b. Transfer to tax consolidated group — made easier by having access to BCT for the trial year; head company can cancel the transfer of the FRT disallowed amount

3. Conditions to use alternative tests:

a. Various amendments to extend access to Third-Party Debt Test

b. New rules to allow the choice to use these tests revoked in some circumstances

Affected businesses should finalize their analysis of the new rules’ potential impact and determine what action may be appropriate in response to potential denials of interest deductions and plan how these will be implemented. Significant additional work could be required to determine if the alternative tests can be used.

Denial of deductions for interest expenses incurred to derive certain NANE income “deferred”

The Bill does not include proposals from the March 2023 thin capitalization ED to amend sections 25-90 and 230-15 of the ITAA 1997 to deny a deduction for interest expenses incurred to derive certain non-assessable, non-exempt (NANE) income (i.e., dividends from foreign subsidiaries and branch profits). The changes were proposed to apply to income years commencing on or after 1 July 2023.

The explanatory memorandum to the Bill states that the proposed amendments have been deferred and will be considered via a separate process. We are monitoring for Government announcements to clarify the application date for this proposal.

Impacted businesses should continue to consider how borrowings may be affected and should remain ready to identify and/or progress work required to track affected deductions and consider available financing responses to the proposal when its status is clarified.

New debt creation rules included

As part of the thin capitalization changes, the Bill includes the unexpected reintroduction of debt creation rules that would deny a deduction for interest on borrowings to either acquire assets from related parties, or to fund dividends or other distributions to related parties.

Although the interest denial would only be from 1 July 2023, it appears that, subject to further clarification, the related-party acquisition or related-party funding of distributions may be covered even if it occurred before 1 July 2023.

Multinational tax transparency — disclosure of subsidiaries

The Bill introduces new Corporations Act requirements for Australian public companies (listed and unlisted) to disclose information about their subsidiaries in their annual financial reports, for financial years commencing on or after 1 July 2023.

If the accounting standards require a public company to prepare financial statements in relation to a consolidated entity, the “consolidated entity disclosure statement” in the company’s annual financial reports must provide the following information in relation to entities within the consolidated entity:

• The name of each entity at the end of the financial year
• Whether the entity was a body corporate, partnership or trust at the end of the financial year
• Whether at the end of the financial year, the entity was a trustee of a trust within the consolidated entity, a partner in a partnership within the consolidated entity or a participant in a joint venture within the consolidated entity
• If the entity is a body corporate, (i) where the entity was incorporated or formed and (ii) the public company’s percentage ownership (whether directly or indirectly) of each of those entities that are part of the body corporate at the end of the financial year
• The tax residency of each of those entities during the financial year

Public companies that are not subject to the rule (i.e., no consolidated statements) must state this in their annual financial report.

There are no substantive changes from the previous ED to the Bill.

Impacted companies should ensure policies and processes are updated to comply with these new requirements.

For additional information with respect to this Alert, please contact the following:

Ernst & Young (Australia), Sydney

• Alf Capito, Tax Policy

• Lachlan Cobon, International Tax and Transaction Services
  
  
• Sean Monahan, International Tax and Transaction Services
  
  
• Matt Weerden, International Tax and Transaction Services
  
  
• Daryl Choo, International Tax and Transaction Services
  
  
• Simon Jenner, Global Compliance and Reporting
  
  
• Danielle Donovan, International Tax and Transaction Services

Ernst & Young (Australia), Brisbane

• Reid Zulpo, International Tax and Transaction Services

Ernst & Young (Australia), Melbourne

• Richard Goodwin, International Tax and Transaction Services
  
  
• Tony Merlo, Tax Policy
  
  
• Liz Cullinan, International Tax and Transaction Services
  
  
• Peter Janetzki, Global Compliance and Reporting
  
  
• Sarah Diss, Global Compliance and Reporting

Ernst & Young (Australia), Perth

• Andrew Nelson, International Tax and Transaction Services
  
  
• Mathew Chamberlain, International Tax and Transaction Services
  
  
• Joe Lawson, Transfer Pricing
  
  
• Caroline Walker, International Tax and Transaction Services

Ernst & Young LLP (United States), Australia Tax Desk, London

• Naomi Ross

Ernst & Young LLP (United Kingdom), Australia Tax Desk, London

• James Poulos

Published by NTD’s Tax Technical Knowledge Services group; Carolyn Wright, legal editor

For a full listing of contacts and email addresses, please click on the Tax News Update: Global Edition (GTNU) version of this Alert.