Australia’s New Thin Cap Rules

Australia’s thin capitalisation rules were overhauled in 2024, following a circuitous two-year legislative journey beginning with the initial announcement of proposed changes to the regime on 27 April 2022 to the enactment of the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share – Integrity and Transparency) Act 2024 on 8 April 2024 (Thin Cap Act).

The new rules generally apply from 1 July 2023, except for the debt deduction creation rules (which apply from 1 July 2024).

This article is aimed at providing a high-level overview of the relevant rules (other than the debt deduction creation rules) as they apply to general class investors. A separate article is intended to be published regarding the debt deduction creation rules.

The Basics

Broadly, the thin cap rules operate to limit interest and other debt deductions in Australia for foreign entities investing in Australia either directly or via Australian investment vehicles (i.e. inward investors) or Australian entities investing overseas (i.e. outward investors) where those debt deductions exceed $2 million in a particular year.

Debt Deductions

The definition of ‘debt deductions’ includes not only interest, but also includes amounts ‘in the nature of interest’, amounts ‘economically equivalent to interest’ and the discount on discount instruments (among other things).

The extension of the definition to amounts ‘economically equivalent to interest’ is one of the changes made to the definition by the Thin Cap Act. There is significant uncertainty on what this term means. Given that the definition of ‘debt deductions’ is fundamental to the operation of the thin cap rules, this uncertainty raises questions as to the precise parameters of the thin cap rules.

Investor Classes

The rules and tests that apply to determine the limit beyond which debt deductions (where those debt deductions exceed $2 million) will be denied for the entity depend on the ‘class’ to which the entity belongs.

The classes under the new rules are as follows:

1. ‘general class investors’ (this class covers both inward investors and outward investors);
2. one of two classes of financial entities (non-ADI), being:
   1. ‘inward investing financial entities (non-ADI)’; and
   2. ‘outward investing financial entities (non-ADI)’; and
3. one of two classes of financial entities (ADI), being:
   1. ‘inward investing financial entities (ADI)’; and
   2. ‘outward investing financial entities (ADI)’.

Importantly, the new rules do not apply to ADIs (authorised deposit-taking institutions). ADIs remain subject to the old thin cap rules.

In categorising entities, advisors should be aware that the definition of ‘financial entity’ has been significantly tightened under the new rules and it is now no longer sufficient for an entity to simply be registered under the Financial Sector (Collection of Data Act) 2001 (Cth) for the entity to qualify as a ‘financial entity’. Rather, for the entity to be a financial entity, the entity is now also required to:

1. carry on a business of providing finance, but not predominately for the purposes of providing finance directly or indirectly to, or on behalf of, the entity’s associates; and
2. derive all, or substantially all, of its profits from that business.

This article focuses on general class investors, which are subject to the new thin cap rules.

The New Tests

General class investors have the option of applying one of three tests to calculate their debt deduction limit:

1. the ‘fixed ratio test’ (FRT) (this replaces the ‘safe harbour debt test’ under the previous thin cap rules);
2. the ‘group ratio test’ (GRT) (this replaces the ‘worldwide gearing test’ under the previous rules); and
3. the ‘third party debt test’ (TPDT) (this replaces the ‘arm’s length debt test’ under the previous rules).

The default test is the FRT, with the GRT and the TPDT being elective tests (i.e. alternative tests that an entity has the choice to apply).

FRT

The FRT denies debt deductions to the extent that ‘net debt deductions’ of the entity exceed its ‘fixed ratio earnings limit’. The fixed ratio earnings limit is calculated as 30% of the entity’s ‘tax EBITDA’, as defined in the legislation.

The test essentially represents an acceptance that, where net deductions represent 30% or less of the entity’s tax EBITDA, the entity is not regarded as claiming excessive debt deductions.

GRT

The GRT is available where an entity is a member of a ‘GR group’. The test operates to deny debt deductions to the extent that the net debt deductions of the entity exceed its ‘group ratio earnings limit’.

The group ratio earnings limit is calculated as the entity’s tax EBITDA multiplied by the ‘group ratio’. The group ratio is the proportion that the GR group net third party interest expense bears to the GR group EBITDA.

The effect of the above calculation is that the group ratio earnings limit is the same proportion of the entity’s tax EBITDA as the proportion that the GR group net third party interest expense bears to the GR group EBITDA. If the proportion that the GR group net third party interest expense bears to the GR group’s EBITDA is greater than 30%, the limit under this test will be greater than under the FRT. The limit under the GRT will therefore be higher than under the FRT test if the entity is part of a highly leveraged group.

The test is broadly designed to assess whether an entity in a group has a disproportionate amount of debt that is deductible in Australia when compared with the debt of the group as a whole.

TPDT

The TPDT denies debt deductions to the extent that debt deductions (i.e. on a gross, not net, basis) exceed the ‘third party earnings limit’.

The third party earnings limit is calculated as the sum of each debt deduction of the entity that is attributable to a debt interest issued by the entity that satisfies the ‘third party debt conditions’.

The third party debt conditions are broadly as follows:

1. the entity (i.e. the borrower) is an Australian entity;
2. the entity issued the debt interest to an entity that is not an associate entity (i.e. the lender is a third party) and the debt interest was not held at any time in the relevant year by an associate entity;
3. disregarding minor or insignificant assets, the lender only has recourse to Australian assets that are ‘covered’ by the legislation and are not impermissible credit support rights (i.e. guarantees, securities or other forms of credit support that are not expressly permitted by the legislation); and
4. the entity uses all, or substantially all, of the proceeds to fund commercial activities in connection with Australia (subject to certain carve outs).

The effect of the TPDT, broadly, is that where the third party debt conditions are satisfied, debt deductions attributable to the relevant debt interest are allowed. However, where the third party debt conditions are not satisfied (e.g. if it is associate entity debt), debt deductions attributable to the relevant debt interest are disallowed.

The third party debt conditions are modified where the conduit financier provisions are satisfied. These provisions broadly allow an entity to satisfy the third party debt conditions where the entity borrows from an associate that has on-lent funds that it borrowed from a third party where certain conditions are satisfied (including that the on-lending is on the same terms as the original loan).

The TPDT is the most complex of the three tests that are applicable to general class investors and is fraught with interpretational challenges. These challenges include:

1. interpreting the meaning of ‘minor or insignificant assets’;
2. interpreting the meaning of ‘Australian asset’ (and therefore what is not an Australian asset) for the purpose of the determining whether membership interests in the entity (i.e. the borrower) is a covered asset;
3. the extent of the tracing exercise that will be required in determining whether the entity used the proceeds to fund commercial activities in connection with Australia;
4. interpreting the meaning of ‘commercial activities’ and ‘in connection with Australia’;
5. interpreting the meaning of ‘all, or substantially all’; and
6. the time at which it is necessary to determine whether an entity is an ‘associate entity’ or a ‘controlled foreign entity’ for the purpose of the carve outs for determining whether the proceeds were used to fund commercial activities in connection Australia.

Some of these interpretational issues are addressed (and not necessarily in a particularly concessional manner) in Draft Taxation Ruling TR 2024/D3 ‘Aspects of the third party debt test in Subdivision 820-EAB of the Income Tax Assessment Act 1997’ and in Schedule 3 of Draft Practical Compliance Guideline PCG 2024/D3 ‘Restructures and the thin capitalisation and debt deduction creation rules – ATO compliance approach’, both of which were released on 4 December 2024.

In addition to navigating these interpretational challenges, it is crucial for advisors to understand the precise nature of particular loan arrangements (including credit support arrangements) and structuring/restructuring arrangements as required to satisfy the third party debt conditions. For example, is the loan a limited recourse loan (with recourse limited to permitted assets only) or is it a loan that is not limited recourse but merely supported by a specific security over permitted assets? In the case of a guarantee provided by a foreign parent, is recourse limited to covered Australian assets (e.g. membership interests in the borrower) or is the guarantee not limited recourse but merely supported by covered Australian assets?

If it is intended to restructure a debt interest to take advantage of the TPDT, care must be taken to ensure that the entity does not fall foul of Part IVA. Schedule 4 of PCG 2024/D3 contains draft guidance on the application of the ATO’s compliance resources where such restructures are undertaken.

Choice of Test

The choice as to which test to apply will often be driven by the limit calculated under each test, with a preference for applying the test that yields the highest limit. However, it is important to bear in mind that there will be other consequences depending on which test is applied. These other consequences should also be factored in when deciding which test to apply. For example:

1. the debt deduction creation rules do not apply if the TPDT is chosen;
2. the ability for an entity to transfer ‘excess tax EBITA’ to a higher level entity is only available if the FRT is applied;
3. the ability to carry forward debt deductions that are denied under the rules is only available where the FRT is applied. Where the FRT is applied, FRT denied deductions can be carried forward for up to 15 years;
4. any FRT denied deductions carried forward from previous years will no longer be able to be carried forward if the GRT or the TPDT is applied for a later year; and
5. if the TPDT is chosen, the TPDT will be deemed to have been elected by all associates of the entity.

Conclusion

The new thin cap rules represent a fundamental change to Australia’s thin cap regime. Advisors should ensure that they familiarise themselves with the new rules so that they can:

1. calculate the extent of allowable debt deductions under the new rules and make elections as appropriate;
2. structure or restructure debt arrangements to minimise the extent to which debt deductions are denied under the relevant tests; and
3. take appropriate measures in the event of any uncertainty e.g. arising from the expanded definition of ‘debt deductions’, the application of the TPDT or Part IVA risk associated with a restructure of debt arrangements. This may involve seeking a legal opinion, preparing a reasonably arguable position paper or applying for a private ruling depending on the circumstances.

The new rules are complex, so specialist advice should always be sought when in doubt.

This article in no way constitutes legal advice. It is general in nature and is the opinion of the author only. You should seek legal advice tailored to your individual circumstances before acting on anything related to this article.