Australian Treasury releases Exposure Draft Bills on thin cap changes and tax transparency disclosure of information

Executive summary

Following previous announcements and consultation (See EY Global Tax Alert, Australian Treasury releases Discussion Paper on new thin cap rules, royalty deduction rules and public tax disclosure rules, dated 5 August 2022), the Australian Treasury has now released two Exposure Draft Bills and Explanatory Material for consultation, to implement the Government’s proposed changes to:

• Amend the thin capitalization rules to limit debt deductions of MNEs to 30% of EBITDA

• Require listed and unlisted Australian public companies to disclose information on the number of subsidiaries and their country of tax domicile

The Government has yet to consult on other elements of its multinational tax integrity package - denying deductions for intangibles, and other aspects of its tax transparency package.

Detailed discussion

Strengthening Australia’s Interest Limitation (Thin Capitalization) Rules

The thin capitalization ED Bill (website link here) proposes to replace the current asset-based rules with debt deductions based on “tax EBITDA” for “general class investors” (i.e., not financial entity/authorized deposit-taking institution (ADI)). The ED introduces:

• A new fixed ratio test that replaces the existing safe harbor test, and a group ratio test that replaces the existing worldwide gearing test:

  • The fixed ratio test allows an entity to claim net debt deductions up to 30% of its “tax EBITDA.” A special deduction is allowed for debt deductions that were previously disallowed under the fixed ratio test if the entity’s net debt deductions are less than 30% of its “tax EBITDA” for an income year. Debt deductions disallowed over the previous 15 years can be claimed under the special deduction rule (with modified loss testing)

  • The group ratio test, can be used as an alternative to the fixed ratio test, and allows an entity in a highly leveraged group to deduct net debt deductions in excess of the amount permitted under the fixed ratio rule, based on a relevant financial ratio of the worldwide group

• An external third-party debt test for general class investors and financial entities that are not ADIs

  • The external third-party debt test allows all debt deductions which are attributable to third-party debt and can satisfy other conditions. This test replaces the arm’s-length debt test

Entities/groups must elect to use the group ratio or external third-party debt test for the financial year in the approved form, however, once the choice is made for an income year it cannot be revoked.

The new rules have a revised exemption for outward investing entities in certain circumstances and the AU$2m de-minimis (debt deductions not disallowed if total debt deductions of entity/associate entities are less than $2m) is retained.

Surprise disallowance of deductible borrowings to invest in foreign non portfolio investments

The ED Bill includes unexpected, proposed amendments to Sections 25-90 and 230-15 of the Income Tax Assessment Act 1997 (ITAA97) to remove a deduction for interest expenses incurred to derive s768-5 ITAA97 non-assessable, non-exempt (NANE) income (e.g., dividends from foreign subsidiaries). Most commonly, this will be where an Australian company has borrowed funds to invest in, or to acquire, equity interests in a foreign subsidiary. Companies will need to consider the potential impact on both their existing structures and merger and acquisition transactions currently in progress, which may require immediate consideration.

The proposed rules are complex and detailed, and as such will require careful attention.

This measure is proposed to apply to income years commencing on or after 1 July 2023. Treasury is accepting submissions by 13 April 2023.

Tax Transparency - Disclosure of Subsidiary Information

The multinational tax transparency disclosure of subsidiaries ED Bill (Treasury website link here) proposes to:

• Impose a requirement for Australian public companies to disclose information on the number of subsidiaries and their country of tax domicile and, as part of their annual financial reporting regime, provide a “consolidated entity statement”:

  • If the accounting standards require the public company to prepare financial statements in relation to a consolidated entity, the consolidated entity statement must include disclosures about entities within the consolidated entity at the end of the financial year

  • If, however, the accounting standards do not require the public company to prepare financial statements in relation to a consolidated entity, the public company must provide a statement to that effect

• Alongside the general reporting obligations, directors, chief executive officers and chief financial officers must also declare that the consolidated entity statement is in their opinion true and correct

This measure is proposed to financial statements prepared by public companies for each financial year commencing on or after 1 July 2023. Treasury is accepting submissions by 13 April 2023.

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

Thin Capitalization

Ernst & Young (Australia), Sydney   

• Alf Capito, Tax Policy

• Sean Monahan, International Tax and Transaction Services

• Matt Weerden, International Tax and Transaction Services

• Simon Jenner, Financial Services Tax

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 & Reporting

Ernst & Young (Australia), Brisbane

• Reid Zulpo, International Tax and Transaction Services

Ernst & Young (Australia), Perth

• Andrew Nelson, International Tax and Transaction Services

• Joe Lawson, Oceania Transfer Pricing Leader

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

• Naomi Ross

Disclosure of Information

Ernst & Young (Australia), Sydney

• Fiona Moore, Tax Controversy

• Sandra Farhat, Tax Controversy

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

• Naomi Ross

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