Impact of Australia’s new thin capitalisation rules on inward investments

Broadly these are Australian entities that:

1. Control a foreign entity or carry on business at or through an overseas permanent establishment; 
2. Are an associate entity of (1); or 
3. Are Foreign controlled Australian entities or Foreign entities with Australian permanent establishments.

Importantly, the thin capitalisation rules do not apply where the debt deductions of an entity and its associates do not exceed AUD 2 million. 

There are three new thin cap tests, with the Fixed Ratio Test (FRT) being the default test. Unless an entity has made an election to apply the Group Ratio Test (GRT) or the Third Party Debt Test (TPDT), the FRT will apply. Whilst an entity has the flexibility of selecting the test it wishes to apply each year, it is important to carefully consider which test to apply, as a choice can only be revoked in limited circumstances.

FRT allows an entity to claim net debt deductions up to 30% of its tax earnings before interest, taxes, depreciation, and amortization (EBITDA). The excess deductions can be carried forward for up to 15 years. However, a company must satisfy the modified continuity of ownership test (COT) or business continuity test (BCT) to use the excess deductions. Therefore, when investing in a company which has the benefit of carry forward debt deductions, and where the COT is not satisfied, the investor should consider whether the BCT will be met. 

Investors should note that any changes in ultimate ownership of the Australian company could cause a failure of COT, and that the BCT can be difficult to satisfy. Thus, utilisation of excess deductions in future years should be carefully monitored. Further, if the company chooses to use the GRT or TPDT while carrying forward excess deductions under the FRT, the balance of the FRT debt deductions will be lost.

GRT is beneficial to a group that is highly leveraged in Australia, as it could allow more debt deductions than the FRT. However, audited, consolidated financial statements or a global financial statement must be prepared for the global parent entity.

TPDT is not suitable where there is significant related party funding, as essentially only external debt deductions are allowed. It is designed to be a narrow test that will not be viable for most taxpayers. 

Acquirers of Australian businesses should ensure their due diligence includes a thorough review of the target’s existing thin capitalisation rules, as well as a consideration of which test would be the most beneficial to the group post-acquisition. Some difficult choices may have to be made, such as whether to forfeit the balance of future FRT debt deductions in order to access greater debt deductions under the GRT test. Also, ensuring future excess deductions are not lost should become part of the tax management regime for the Australian entity.

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Tony Nunes has over 25 years’ experience in providing tax advice to clients, especially on issues affecting cross-border transactions, acquisitions and restructures, and on all aspects of structuring the ownership and financing of corporations and their operations.

Charm Jayatileka is a qualified lawyer. She specialised in corporate law in Sri Lanka, a fellow Commonwealth country, prior to commencing her career in tax in Australia. Charm works with SMEs and high-net-worth individuals from diverse industries. Her areas of tax expertise include tax residency, cross-border transactions, and capital gains tax.