New thin cap rules: geared property funds beware

By Anthony Bradica, Jim Koutsokostas, Vanessa Murphy and Bradley White

New thin capitalisation rules, contained in Treasury Laws Amendment (Making Multinationals Pay Their Fair Share-Integrity and Transparency) Act 2024 (Cth) (the Act), may have a substantial impact on investment funds that are significantly geared.

Importantly, the 60 per cent safe harbour (balance sheet) test has been replaced by the 30 per cent tax earnings before interest, taxes, depreciation, and amortization (EBITDA) (income statement) test.

The new rules apply for income years commencing on or after 1 July 2023, while the new debt deduction creation rules apply for income years commencing on or after 1 July 2024.

Key changes to existing thin cap rules

General class investors

• Entities previously considered as either ‘outward investor (general)’, ‘inward investment vehicle (general)’, or ‘inward investor (general)’ will now fall within the new defined class of ‘general class investors’, subject to one of three new tests:
  • Fixed ratio test (FRT): disallows net debt deductions that exceed 30 per cent of an entity’s tax EBITDA (default test) and replaces the safe harbour test (60 per cent of the average value of assets). In certain cases, any excess tax EBITDA (where net debt deductions are less than 30 per cent of tax EBITDA) can be transferred to its ‘controlling entity’.
  • Group ratio test (GRT): replaces the worldwide gearing ratio test. The GRT allows an entity that is a member of a ‘GR group’ (which also captures offshore and domestic parent entities) to claim debt deductions up to the level of the worldwide group’s net third party interest expense as a share of earnings (on election of taxpayers). Effectively, the relevant cap under the GRT is 30 per cent of the GR group’s EBITDA.
  • Third part debt test (TPDT): replaces the arm’s length debt test. The TPDT allows debt deductions for qualifying external third-party debt, but disallows all other debt deductions. This compares with the arm’s-length debt test, which disallows debt deductions where the amount of the entity’s debt exceeds the amount of debt that could have been borrowed by an independent party carrying on comparable operations as the Australian entity. The TPDT will generally be more restrictive than the arm’s-length debt test.
• General class investors will be allowed to carry forward debt deductions that were previously disallowed over 15 years under the FRT – and only under the FRT – to address year-on-year earnings volatility concerns for businesses (subject to the taxpayer continuing to use the FRT and not switching between the alternative tests). Electing out of the FRT for another test will result in FRT previously disallowed amounts to become lost.
• New debt deduction creation rules completely disallow debt deductions to the extent they are incurred in relation to debt creation schemes.
• Existing exemptions will broadly be retained, including the $2 million de minimis threshold.

Financial entities

• Financial entities and authorised deposit-taking institutions (ADIs) continue to have access to the asset-based safe harbour and worldwide gearing tests (with the exception of the arm’s-length debt test for financial entities, which is being replaced by the TPDT).
• However, the new rules limit the range of entities that fall with the definition of a ‘financial entity’ – resulting in some entities previously classified as financial entities now being classified as general class entities, and therefore subject to the new interest limitation rules.
• The new definition of ‘financial entity’ requires an entity to be a registered corporation under the Financial Sector (Collection of Data) Act 2001 (Cth), which must:
  • carry on a business of providing finance, but not predominantly for the purposes of providing finance directly or indirectly to or on behalf of the entity’s associates; and
  • derives all, or substantially all, of its profits from that business.

Simplified example of the FRT

Aus Trust is an Australian resident unit trust that falls within the ‘general class investor’ category.  Aus trust engages in various property investment activities. Aus Trust has a debt-to-equity ratio of 1:1 ($50 million equity and $50 million debt).

Debt deduction creation rules

• Effective for income years commencing on or after 1 July 2024, the new debt deduction creation rules (according to the explanatory memorandum) are designed to disallow all debt deductions incurred ‘in relation to debt creation schemes that lack genuine commercial justification’.
• The debt deduction creation rules disallow deductions in two cases where:
  • an entity uses related party debt to acquire a CGT asset or legal or equitable obligation from an associate directly, or indirectly through one or more interposed entities (subject to certain exceptions).
  • an entity obtains related party debt from a financial arrangement and uses some or all of the proceeds to fund certain payments and distributions to associates.
• The rules do not apply where an entity has chosen to apply the TPDT for the income year. ADIs and securitisation vehicles are also excluded.
• The new debt deduction creation rules are drafted broadly and are likely to deny debt deductions in circumstances that would not ordinarily be considered a debt creation scheme, including potentially payments or distributions that would otherwise be treated as assessable income.

What does this mean for investment funds?

• The move to an earnings-based FRT will likely have significant tax consequences for investment funds, particularly during the early stages of a project, where high up-front capital investment is required before earnings are generated.
• The carry forward provisions for debt deductions will allow taxpayers to respond to income volatility concerns, provided the FRT is maintained on a continuous basis. Flow-through excess tax EBITDA amounts should also be considered where unit trusts or MITs have direct control interest in downstream entities.
• If there are related party debt arrangements to which the new debt deduction creation rules may apply, entities should start considering what needs to be done to address these risks before 1 July 2024.

For more about the new thin capitalisation rules reach out to our investment funds and tax specialists who can help explain the significant impact on investment funds that are significantly geared.