House of Representatives

Explanatory Memorandum

(Circulated by authority of the Assistant Minister for Competition, Charities and Treasury, the Hon Dr Andrew Leigh MP)

Chapter 2: Thin capitalisation

Outline of chapter

2.1 Schedule 3 to the Bill strengthens the thin capitalisation rules in Division 820 of the ITAA 1997. The amendments address risks to the domestic tax base arising from the excessive use of debt deductions, which amount to base erosion or profit shifting arrangements. The amendments introduce new thin capitalisation earnings-based tests for a certain class of entities, replacing the existing asset-based rules for those entities. The amendments also establish a new arm's length debt test, in the form of a third party debt test.

2.2 Schedule 3 introduces new Subdivision 820 EAA – debt deduction creation rules. These rules disallow deductions to the extent that they are incurred in relation to debt creation schemes.

2.3 All legislative references in this Schedule are to the ITAA 1997 unless otherwise specified.

2.4 The amendments apply to income years commencing on or after 1 July 2023.

Context of amendments

2.5 Excessive interest deductions (or debt deductions) pose a significant risk to Australia's domestic tax base.

2.6 The OECD's BEPS project outlines the problem of using third party, related party, and intragroup debt to generate excessive deductions for interest and other financial payments. ^[1] In particular, the OECD notes that "the use of third party and related party interest is perhaps one of the simplest of the profit-shifting techniques available in international tax planning. The fluidity and fungibility of money makes it a relatively simple exercise to adjust the mix of debt and equity in a controlled entity."

2.7 In the 2022-23 October Budget, the Government announced that they will strengthen Australia's thin capitalisation rules to address risks to the domestic tax base arising from the use of excessive debt deductions. The Government's Budget announcement was informed by the OECD's best practice guidance. The measure will apply to income years commencing on or after 1 July 2023.

2.8 The thin capitalisation regime is Australia's current approach to limiting debt deductions. The rules were designed to limit the debt deductions that an entity can claim for tax purposes based on the amount of debt used to finance its operations compared with its level of equity, by restricting the amount of debt deductions a company can have based on its level of assets.

2.9 This approach indirectly limits the amount of debt an entity can use to generate allowable interest deductions. The OECD best practice sets out a direct approach to limit the interest expenses an entity can claim.

2.10 For certain entities (namely, general class investors), the amendments replace the existing asset-based rules with earnings-based rules which are in line with those recommended in the OECD best practice guidance. In addition, financial entities (non-ADI) will be subject to the new third party debt test in place of the former arm's length debt test. Financial entities and ADIs will otherwise continue to be subject to their existing asset-based debt deduction safe harbour and worldwide gearing tests. This is because the OECD recognises that the earnings-based tests are unlikely to be effective for these types of entities, partly as they are net lenders and subject to regulatory capital rules.

2.11 The introduction of the fixed ratio and group ratio rules align with the OECD best practice guidance, which recommends limiting an entity's deductions for net interest, and payments economically equivalent to interest, to a percentage of the entity's EBITDA. This reflects the view that aligning debt deductions with taxable economic activity is a more robust approach to address base erosion and profit shifting.

2.12 The earnings-based tests are supplemented by a third party debt test, which allows debt deductions to be deducted where those expenses are attributable to genuine third party debt which is used to fund Australian business operations. That is, deductions for related party debt will be entirely disallowed under this test. The third party debt test replaces the existing arm's length debt test for 'general class investors' and financial entities (non-ADI), as announced in the October 2022-23 Budget.

Summary of new law

2.13 Schedule 2 introduces new earnings-based tests for 'general class investors', specifically, a fixed ratio test replaces the existing safe harbour test, and a group ratio test that replaces the existing worldwide gearing test. In addition, Schedule 2 introduces a third party debt test for general class investors and financial entities that are not ADIs. The new rules may disallow all or part of a general class investor's debt deductions for an income year.

2.14 Schedule 2 also introduces new Subdivision 820-EAA – debt deduction creation rules. These rules disallow debt deductions to the extent that they are incurred in relation to debt creation schemes.

2.15 The 'general class investor' concept represents a consolidation of the existing 'general' classes of entities, being 'outward investor (general)', 'inward investment vehicle (general)' and 'inward investor (general)'. Entities which previously fell into one of those classes of entities will now fall under the new 'general class investor' definition. This approach simplifies elements of the thin capitalisation regime, while being clear that financial entities and ADIs are not within the scope of that concept.

Fixed ratio test

2.16 The fixed ratio test allows an entity to claim net debt deductions up to 30 per cent of its 'tax EBITDA', which is broadly, the entity's taxable income or tax loss adding back deductions for interest, decline in value, and capital works. This is a relatively straightforward rule to apply and ensures that an entity's debt deductions are directly linked to its economic activity. It also directly links these deductions to an entity's taxable income, which makes the rule more robust against tax planning.

2.17 Under the fixed ratio test, 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 per cent of its 'tax EBITDA' for an income year. Debt deductions disallowed over the previous 15 years can be claimed under this special deduction rule, subject to certain conditions.

2.18 The special deduction is included as part of the fixed ratio test to address year-on-year earnings volatility concerns for businesses which can limit their ability to claim debt deductions depending on their economic performance for an income year.

Group ratio test

2.19 The group ratio test can be used as an alternative to the fixed ratio test. The group ratio test allows an entity in a sufficiently highly leveraged group to deduct net debt deductions in excess of the amount permitted under the fixed ratio rule, based on a ratio that relies on the group's financial statement.

2.20 If the group ratio test applies, the amount of debt deductions of an entity for an income year that are disallowed is the amount by which the entity's net debt deductions exceed the entity's group ratio earnings limit for the income year.

Third party debt test

2.21 The third party debt test allows all debt deductions which are attributable to third party debt and that satisfy certain other conditions. This test replaces the arm's length debt test.

Comparison of key features of new law and current law

Table 2.1 Comparison of new law and current law

Detailed explanation of new law

New 'general class investor' definition

2.22 Schedule 2 to the Bill introduces new thin capitalisation tests for 'general class investors'. Entities which are general class investors must apply one of the new thin capitalisation tests. The new tests are the fixed ratio test, the group ratio test, and the third party debt test. Entities which are not general class investors will continue to be subject to the existing thin capitalisation tests, with the exception of the arm's length debt test.

2.23 'General class investor' is a new concept introduced by Schedule 2. The concept represents a consolidation of the existing 'general' classes of entities, being 'outward investor (general)', 'inward investment vehicle (general)' and 'inward investor (general)'. Entities which previously fell into one of those classes are now intended to fall under the new 'general class investor' definition.

2.24 An entity is a 'general class investor' for an income year provided:

•

it is not, for all the year, a financial entity or an ADI that is either an outward or inward investing entity; and

•

on the assumption that the entity was a financial entity, it would be either an outward or inward investing financial entity that is not an ADI for the income year. [Schedule 2, item 29 and 126, sections 820-46 and subsection 995-1(1)]

2.25 The general effect of the definition of 'general class investor' is that the following entities, which are not financial entities or ADIs, will be general class investors:

•

an Australian entity that carries on a business in a foreign country at or through a permanent establishment or through an entity that it controls;

•

an Australian entity that is controlled by foreign residents; and

•

a foreign entity having investments in Australia.

2.26 Entities which are financial entities or ADIs for all an income year will need to consider if they fall under one of the other classes of entities.

2.27 An entity will effectively need to be a financial entity or an ADI for an entire income year to be precluded from being a general class investor for the income year. This is because the existing asset-based rules that apply to entities which are not general class investors are generally more favourable than the rules which apply to general class investors.

Definition of 'financial entity'

2.28 Schedule 2 strengthens paragraph (a) of the definition of 'financial entity' in subsection 995-1(1) by adding two additional conditions to that part of the definition. Current paragraph (a) of the definition of 'financial entity' provides that "financial entity, at a particular time, means an entity other than an ADI that is ... a registered corporation under the Financial Sector (Collection of Data) Act 2001 ...". This is a broad definition that is used for different policy reasons regarding the collection of financial data. Non-ADI corporations may register even though the financial transactions relating to which they register are relatively minor when compared to their other business activities. Given the changes in 2018 to broaden the definition, an increasing number of entities are now claiming to be financial entities for tax purposes.

2.29 'Financial entities' and ADIs continue to have access to the existing thin capitalisation tests (with the exception of the arm's length debt test for financial entities, which is being replaced by the third party debt test). The existing asset-based tests are generally more favourable to taxpayers than the new earnings-based tests which only apply to general class investors. This has given rise to integrity concerns regarding whether entities which satisfy current paragraph (a) should genuinely be considered financial entities for income tax purposes, with access to the generally more favourable taxation treatment.

2.30 The additional conditions under paragraph (a) include requirements for the entity to be carrying 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. The entity must also derive all, or substantially all, of its profits from that business. The term 'all, or substantially all' is adopted to cover circumstances where all of the entity's profits are derived from that business but accommodating other minor or incidental profits. The additional requirements are an integrity measure to ensure the thin capitalisation rules are fit for purpose and that the amendments to introduce the new earnings-based rules are not undermined. [Schedule 2, items 124 and 125, subsection 995-1(1)]

New thin capitalisation tests

Application of the new tests

2.31 The new thin capitalisation rules may disallow all or part of a general class investor's debt deductions for an income year. The amount of debt deductions disallowed (if any) is determined through the application of one of the new thin capitalisation tests. The new tests are the fixed ratio test, the group ratio test, and the third party debt test. An entity chooses which test to apply for all of its debt deductions for an income year. [Schedule 2, item 29, section 820-46]

Application of the fixed ratio test

2.32 The fixed ratio test is the default test that applies for general class investors that do not make a choice to use either the group ratio test or the third party debt test. [Schedule 2, item 29, section 820-46]

Application of the group ratio test

2.33 The group ratio test requires an entity to determine the ratio of its group's net third party interest expense to the group's EBITDA for an income year. Therefore, the group ratio test is only available if the entity is a member of a relevant group.

2.34 Specifically, a general class investor can only choose to use the group ratio test if it is a member of a 'GR group' and the 'GR group EBITDA' for the period is at least zero. A 'GR group', for a period, is the group comprised of the relevant worldwide parent entity or a global parent entity and each other entity that is fully consolidated on a line-by-line basis in the relevant financial statements. The definition of GR group parent ensures that offshore and domestic parent entities can access the group ratio test. [Schedule 2, items 29 and 124, section 820-46 and subsection 995-1(1)]

2.35 A 'GR group' cannot be comprised of just one entity. [Schedule 2, item 29, subsection 820-53(2)]

2.36 The worldwide parent or global parent entity is referred to as the 'GR group parent' and must have financial statements that are audited consolidated financial statements for the period. Where a GR group has a global parent entity, the equivalent global financial statements must be prepared for the period. Each entity that is fully consolidated on a line-by-line basis in the GR group parent's financial statements is referred to as a 'GR group member'. [Schedule 2, item 29 and 126, subsections 820-53(2)-(5) and 995-1(1)]

2.37 The reliance on accounting concepts is intended to minimise compliance costs, as the calculation of the GR ratio will be based on figures that are already required to be calculated as part of the worldwide or global parent's consolidated financial reports, similar to the current process of calculating worldwide debt under the asset-based rules.

2.38 The GR group EBITDA is relevant to calculating the group ratio earnings limit, which is discussed below from paragraph 3.72. The requirement for the GR group EBITDA to be at least zero is necessary to ensure the meaningful application of the group ratio test and prevent entities from exploiting its operation to claim excessive debt deductions that are not linked to their profits. This is consistent with the OECD best practice guidance.

Application of the third party debt test

2.39 General class investors may choose to apply the third party debt test in relation to an income year. [Schedule 2, item 29, section 820-46]

2.40 General class investors are deemed to have made a choice to use the third party debt test if certain conditions are satisfied. This is intended to prevent a group of related entities from choosing different thin capitalisation tests for the purposes of maximising their tax benefits under each test.

2.41 Broadly, if the entity that issues a debt interest chooses to use the third party debt test, then their associate entities in the obligor group in relation to the debt interest are all deemed to have chosen that test. Additionally, entities that have entered into a cross staple arrangement together are also deemed to have chosen the third party debt test if one of those entities chooses to use that test. [Schedule 2, item 29, sections 820-48]

2.42 The obligor group is a new concept introduced by Schedule 2. An entity is a member of an obligor group in relation to a debt interest if the creditor of that debt interest has recourse for payment of the debt to the assets of the entity. The borrower in relation to the debt interest is also a member of the obligor group. A reference to 'entity' in 820-48 and 820-49 is intended to capture all members of consolidated groups and multiple entry consolidated groups. [Schedule 2, items 29, 131 and 133, section 820-49 and subsection 995-1(1)]

2.43 A modified definition of 'associate entity' applies for the purposes of the choice deeming rule. In determining whether an entity is an associate entity of another entity, the reference in paragraphs 820-905(1)(a) and 820-905(2A)(a) of the Act to "an *associate interest of 50% or more" is instead treated as being a reference to "a *TC control interest of 20% or more". 'TC control interest' is defined in 820-815 and its meaning is affected by sections 820-820 to 820-835. [Schedule 2, item 29, subsection 820-48(2)]

2.44 The modified definition of 'associate entity' strengthens the existing definition and helps ensure that entities cannot structure their affairs in a manner which avoids the application of the definition and, by extension, the restrictions placed on making a choice to use the third party debt test.

Procedure of choices

2.45 A choice for an income year to use either the group ratio test or the third party debt test must be made:

•

in the approved form; and

•

on or before the earlier of the day the entity lodges its income tax return for the income year and the day the entity is required to lodge its income tax return for the income year. [Schedule 2, item 29, subsections 820-47(1)-(2)]

2.46 The Commissioner may allow a later time for the choice to be made. [Schedule 2, item 29, paragraph 820-47(2)(b)]

2.47 The Commissioner may defer the time within which an approved form is required to be given (see section 388-55 in Schedule 2 to the TAA 1953).

2.48 A choice for an income year cannot be revoked, unless the Commissioner is satisfied of certain matters and allows the entity to revoke its choice. [Schedule 2, item 29, subsections 820-47(3)-(4)]

2.49 The entity that has made a choice (other than a choice that is taken to have made under 820-46(5)) may subsequently apply to the Commissioner, in the approved form, to revoke the choice where the Commissioner is satisfied it is fair and reasonable to do so. In deciding whether to revoke a general class investor's choice, the Commissioner must be satisfied that at the time the entity made the choice it was reasonable to believe that the chosen test allowed for a higher earnings limit for the entity than the fixed ratio test. This is intended to be an objective requirement and ensures that taxpayers cannot unreasonably seek to apply a particular test to maximise their debt deductions but still allow for, in certain circumstances, the ability to default into the fixed ratio test. [Schedule 2, item 29, subsections 820-47(6)-(7)]

2.50 If an entity revokes their choice, then the entity is taken to have never made the choice. This has the effect that choices previously taken to have been made under 820-46(5) are instead taken to have never been made. [Schedule 2, item 29, subsections 820-47(5)]

Operation of the new tests

2.51 The amount of debt deductions of an entity for an income year that is disallowed is the amount by which the entity's:

•

if the default fixed ratio test applies – net debt deductions exceed the entity's 'fixed ratio earnings limit' for the income year; or

•

if the entity has made a choice to use the group ratio test for the income year – net debt deductions exceed the entity's 'group ratio earnings limit' for the income year; or

•

if the entity has made a choice to use the third party debt test for the income year – debt deductions exceed the entity's 'third party earnings limit' for the income year. [Schedule 2, item 29, sections 820-45, 820-46 and 820-50)]

2.52 This approach to disallowing debt deductions is consistent with the OECD best practice guidance in relation to the fixed and group ratio tests. The 'earnings limit' is the absolute cap on the net debt deductions that an entity is entitled to deduct. Debt deductions are denied by the amount by which net debt deductions exceed the relevant earnings limit.

2.53 It is important to note that, contrary to the fixed and group ratio tests, the third party debt test denies debt deductions by the amount by which debt deductions (not net debt deductions) exceeds the relevant earnings limit. This approach is taken to ensure that test achieves its policy of effectively denying all debt deductions which are attributable to related party debt.

2.54 If one of the new tests operates to disallow all or part of an entity's debt deductions, then each individual debt deduction is disallowed in the same proportion. This approach is broadly consistent with the existing thin capitalisation rules and ensures that entities cannot choose to disallow certain debt deductions in preference to others.

Operation of the fixed ratio test

2.55 The fixed ratio test disallows debt deductions to the extent that net debt deductions exceed a specified proportion (30 per cent) of tax EBITDA. This is a relatively straightforward rule to apply and ensures that an entity's debt deductions are directly linked to its economic activity. It also directly links these deductions to an entity's taxable income.

2.56 If the fixed ratio test applies, the amount of debt deductions of an entity for an income year that is disallowed is the amount by which the entity's net debt deductions exceed the entity's fixed ratio earnings limit for the income year. [Schedule 2, item 29, section 820-50]

2.57 An entity's 'fixed ratio earnings limit' for an income year is 30 per cent of its tax EBITDA for that income year. [Schedule 2, item 29 and 126, section 820-51 and subsection 995-1(1)]

Tax EBITDA

2.58 An entity's 'tax EBITDA' for an income year is worked out according to the following steps:

•

Step 1: Work out the entity's taxable income or tax loss for the income year (disregarding the operation of the thin capitalisation rules and treating a tax loss as a negative amount).

•

Step 2: Add the entity's 'net debt deductions' for the income year.

•

Step 3: Add the sum of the entity's decline in value and capital works deductions (if any) for the income year.

•

Subject to Step 4, the result of Step 3 is the entity's tax EBITDA for the income year.

•

Step 4: If the result of Step 3 is less than zero, treat it as being zero. [Schedule 2, item 29 and 141, section 820-52 and subsection 995-1(1)]

2.59 These steps allow for an entity's tax EBITDA to be calculated according to concepts from Australia's income tax system.

2.60 Adjustment to an entity's tax EBITDA may also need to be made in accordance with the regulations. Australia's income tax system is complex. Accordingly, a regulation making power is appropriate to ensure the tax EBITDA calculation can be readily updated should further adjustments be desirable. [Schedule 2, item 29, paragraph 820-52(1)(d)]

2.61 In calculating tax EBITDA, all entity types must disregard amounts that are included in their assessable income under Division 207 (concerning franked distributions). Without this adjustment, franking credit amounts would increase an entity's tax EBITDA despite no tax being paid on those amounts. Similarly, dividends that are included in an entity's assessable income under section 44 of the ITAA 1936 are excluded from the entity's tax EBITDA. This avoids double counting income as the dividend represents profits which have already been taxed at the company level and are referable to the company's tax EBITDA. [Schedule 2, item 29, section 820-52]

2.62 An entity's 'net debt deductions' for an income year is worked out according to the following steps:

•

Step 1: Work out the sum of the entity's debt deductions for the income year.

•

Step 2: Work out the sum of each amount included in the entity's assessable income for that year that is:

-

interest, an amount in the nature of interest, or any other amount economically equivalent to interest; or

-

any amount directly incurred by another entity in obtaining or maintaining the financial benefits received by the other entity under a scheme giving rise to a debt interest; or

-

any other expense that is incurred by another entity and that is specified in the regulations.

•

Step 3: Subtract the result of Step 2 from the result of Step 1.

•

The result of Step 3 is the entity's net debt deductions for an income year. The entity's net debt deductions may be a negative amount, which has the effect of that amount being subtracted from tax EBITDA. [Schedule 2, item 29 and 134, section 820-50 and subsection 995-1(1)]

2.63 These steps allow for an entity's net interest expense to be calculated according to concepts from Australia's income tax system and consistent with the OECD best practice guidance. This includes interest on all forms of debt, payments economically equivalent to interest, and expenses incurred in connection with the raising of finance (refer to paragraph 3.157 on the definition of debt deduction).

2.64 The regulation making power is necessary to ensure that appropriate amounts of interest income can be readily accounted for if they are identified at a later time.

2.65 In calculating the amount of depreciation deductions to add back to the tax EBITDA calculation, all deductions under Division 40 and Division 43 are generally allowed, except to the extent they are immediately deductible. For example, a taxpayer that claims a deduction under Subdivision 40-H that deals with capital expenditure is immediately deductible, and therefore that expenditure is not added to tax EBITDA.

2.66 The exclusion of non-assessable non-exempt income from tax EBITDA is in line with OECD best practice to prevent an entity benefiting from a higher level of interest capacity as a result of receiving non-taxable income.

2.67 A special deduction in relation to debt deductions previously disallowed under the fixed ratio test may be available to taxpayers. The special deduction is discussed below from paragraph 3.110.

Application to partnerships and trusts

2.68 Partnerships and trusts calculate tax EBITDA in effectively the same manner as other entity types. However, due to the operation of the tax legislation in relation to these types of entities, certain adjustments are made to ensure correct outcomes are achieved. Notably, the adjustments account for the fact that partnerships and trusts have 'net income' rather than 'taxable income'. [Schedule 2, item 29, section 820-52]

2.69 In calculating tax EBITDA for partners of a partnership and beneficiaries (and trustees) of a trust, certain adjustments are made to ensure that amounts included in the net income of partnerships and trusts are only counted towards tax EBITDA once. These adjustments aim to ensure that such amounts only count towards the tax EBITDA of partnerships and trusts, and not the tax EBITDA of the entities (partners, beneficiaries and trustees) to which such amounts may ultimately be assessed. These adjustments only apply where the partner or beneficiary are an associate entity of the relevant partnership or trust. [Schedule 2, item 29, section 820-52]

2.70 In working out whether a partner or beneficiary are an associate entity of the relevant partnership or trust, the same modified definition of 'associate entity' discussed in paragraph 3.43 above applies (although with a 10% modification instead of 20%). [Schedule 2, item 29, section 820-52]

2.71 For trusts, subsection 820-52(5) ensures that capital gains, franked distributions and franking credits are dealt with as part of the net income of trusts and are not otherwise removed from their net income. [Schedule 2, item 29, section 820-52]

Operation of the group ratio test

2.72 The fixed ratio test does not specifically account for the fact that groups in different sectors may be leveraged differently for genuine commercial reasons. To supplement the operation of the fixed ratio test and account for more highly leveraged groups, Schedule 2 also introduces a group ratio test.

2.73 Broadly, the group ratio test allows an entity in a sufficiently leveraged group to deduct net debt deductions in excess of the amount permitted under the fixed ratio rule, based on a ratio of the group's profits after adding back certain expenses.

2.74 If the group ratio test is chosen, the amount of an entity's debt deductions for an income year that are disallowed is the amount by which the entity's net debt deductions exceed the entity's group ratio earnings limit for the income year.

2.75 An entity's 'group ratio earnings limit' for an income year is its 'group ratio' for the income year multiplied by its tax EBITDA for the income year. [Schedule 2, items 29 and 126, subsections 820-51(2) and 995-1(1)]

2.76 An entity's 'group ratio' for an income year is calculated by reference to information contained in the relevant audited financial statements for the GR group parent for the group for the period corresponding to the relevant income year. In certain circumstances, taxpayers will be required to make adjustments to the amounts disclosed in the relevant financial statements to include amounts equivalent to interest and to disregard certain payments to associate entities.

2.77 An entity's 'group ratio' for an income year is worked out according to the following steps:

•

Step 1: Work out the GR group net third party interest expense of the GR group.

•

Step 2: Work out the GR group EBITDA of the GR group. Note, paragraph 820-46(3)(b) effectively prohibits an entity from applying the group ratio test if the GR group EBITDA is zero or less.

•

Step 3: Divide the result of Step 1 by the result of Step 2.

•

Subject to Step 4, the result of Step 3 is the entity's group ratio for the income year.

•

Step 4: If the result of Step 2 is zero, the entity's group ratio for the income year is zero. [Schedule 2, items 29 and 126, subsections 820-53(1) and 995-1(1)]

2.78 The 'GR group net third party interest expense' of a GR group for a period is the amount that would be the group's financial statement net third party interest expense if the relevant financial statements were prepared on the basis that the following were treated as interest:

•

an amount in the nature of interest;

•

amounts economically equivalent to interest. [Schedule 2, item 27 and 124, subsections 820-54(1) and 995-1(1)]

2.79 Treating those amounts as interest ensures that amounts that are economically equivalent to interest are used to calculate the GR group net third party interest expense.

2.80 The 'financial statement net third party interest expense' of a GR group for a period is the amount disclosed as such in the relevant financial statements for the period, disregarding certain payments made to or by associate entities outside the group. If no such amount is disclosed in the financial statements, then it is the amount of the group's third party interest expenses reduced by the amount of the group's third party interest income as disclosed in the relevant financial statements for the relevant period (disregarding certain payments made to or by associate entities outside the group). [Schedule 2, item 29 and 126, subsections 820-54(2)-(3) and 995-1(1)]

2.81 To ensure only third party amounts are used in the calculation of net third party interest expense, payments between GR group members and their associate entities that are outside the group are disregarded. For these purposes, the same modified definition of 'associate entity' discussed in paragraph 3.43 above applies. This prevents inappropriate inflation of the group ratio. [Schedule 2, item 29, subsection 820-54(5)]

2.82 The 'group EBITDA' of a GR group for a period is the sum of the following (as disclosed in the relevant financial statements for the GR group for the period):

•

the GR group's net profit (disregarding tax expenses);

•

the GR group's adjusted net third party interest expense; and

•

the GR group's depreciation and amortisation expenses. [Schedule 2, item 29 and 126, subsections 820-55(2) and 995-1(1)]

2.83 However, in working out the GR group EBITDA which includes one or more entities with a negative entity EBITDA amount, those negative amounts are disregarded. This ensures the operation of the group ratio test cannot be exploited by an entity to allow them to claim excessive debt deductions. [Schedule 2, item 29, subsection 820-55(3)]

2.84 The 'entity EBITDA' of an entity for a period is the sum of the following for the period:

•

the entity's net profit (disregarding tax expenses) – which may be expressed as a negative amount;

•

the entity's adjusted net third party interest expense; and

•

the entity's depreciation and amortisation expenses. [Schedule 2, item 29 and 123, subsections 820-55(1) and (4) and 995-1(1)]

2.85 The 'adjusted net third party interest expense' of an entity or a group for a period, is the amount that would be the entity's or group's net interest expense for the period if the following payments were disregarded:

•

a payment made by the entity to an associate entity;

•

a payment made by an associate entity to the entity. [Schedule 2, item 29 and 120, subsections 820-54(4) and 995-1(1)]

2.86 These adjustments ensure that only third party amounts are used in the calculation of 'adjusted net third party interest expense'. For the purposes of the adjustments, the same modified definition of 'associate entity' discussed in paragraph 3.43 above applies. [Schedule 2, item 29, subsection 820-54(5)]

Group ratio records

2.87 Entities are required to prepare and keep records of how they worked out their group ratio. Specific record keeping rules are necessary because entities may work out their group ratio using information that is not publicly available or otherwise accessible.

2.88 The records must contain the particulars that have been taken into account in working out the group ratio and must be sufficient for a reasonable person to understand how the group ratio has been calculated. The entity must prepare the records on or before the day the entity lodges, or is required to lodge, its income tax return for the income year. [Schedule 2, item 103, section 820-985]

Operation of the third party debt test

Overview of the third party debt test

2.89 The third party debt test effectively disallows an entity's debt deductions to the extent that they exceed the entity's debt deductions attributable to third party debt and which satisfy certain other conditions. This test replaces the arm's length debt test for general class investors and financial entities. However, ADIs will continue to have access to the arm's length capital test.

2.90 The third party debt test operates effectively as a credit assessment test, in which an independent commercial lender determines the level and structure of debt finance it is prepared to provide an entity.

2.91 The test is intended to be a simpler and more streamlined test to apply and administer than the former arm's length debt test, which operates based on valuation metrics and the 'hypothesised entity comparison'.

2.92 The third party debt test is designed to be narrow, to accommodate only genuine commercial arrangements relating only to Australian business operations. This is a considered design approach and is not intended to accommodate all debt financing arrangements that may be accepted as current practice within industry.

2.93 In this regard, the third party debt test balances the tax integrity policy intent and the need to ensure genuine commercial arrangements are not unduly impeded.

Operation of the third party debt test

2.94 If the third party debt test applies for an income year, the amount of an entity's debt deductions for the income year that is disallowed is the amount by which the entity's debt deductions exceed the entity's third party earnings limit for the income year. [Schedule 2, item 78, section 820-427]

2.95 An entity's 'third party earnings limit' for an income year is the sum of each debt deduction of the entity for the income year that is attributable to a debt interest issued by the entity that satisfies the third party debt conditions in relation to the income year. For these purposes, debt deductions of an entity that are:

•

directly associated with hedging or managing the interest rate risk in respect of the debt interest; and

•

not referrable to an amount paid, directly or indirectly, to an associate entity of the entity;

are taken to be attributable to the debt interest (this rule is intended to only cover conventional 'interest rate swap' arrangements between unrelated parties). 'Debt interest' takes its meaning as defined in Subdivision 974-B. [Schedule 2, item 78 and 142, subsections 820-427A(1)-(2) and 995-1(1)]

Third party debt conditions

2.96 A debt interest issued by an entity satisfies the 'third party debt conditions' in relation to an income year if the following conditions are satisfied:

•

the entity is an Australian resident;

•

the entity issued the debt interest to an entity that is not an associate entity of the entity;

•

the debt interest is not held at any time in the income year by an entity that is an associate entity of the entity;

•

the holder of the debt interest has recourse for payment of the debt only to Australian assets held by the entity. However, recourse to assets of the entity that are rights under or in relation to a guarantee, security or other form of credit support are prohibited, unless specified circumstances apply; and

•

the entity uses all, or substantially all, of the proceeds of issuing the debt interest to fund its commercial activities in connection with Australia. The term 'all, or substantially all' is adopted to cover circumstances where all of the proceeds are used for the relevant activities but accommodating a minor or incidental use of the proceeds for other activities. [Schedule 2, items 78 and 142, subsections 820-427A(3) and 995-1(1)]

2.97 These conditions aim to ensure the third party debt test only captures genuine third party debt which is used to fund Australian business operations.

2.98 'Australian assets' is intended to capture assets that are substantially connected to Australia. The following assets are not intended to be Australian assets:

•

Assets that are attributable to the entity's overseas permanent establishments.

•

Assets that are otherwise attributable to the offshore commercial activities of an entity.

2.99 Recourse to rights under or in relation to forms of credit support (referred to in the following paragraphs as 'credit support rights') are generally prohibited to ensure that multinational enterprises do not have an unfettered ability to fund their Australian operations with third party debt. Given Australia's relatively high corporate tax rate, multinational enterprises may seek to fund their Australian operations with high levels of debt relative to their operations in other jurisdictions.

2.100 Subsection 820-427A(3) has the effect of allowing recourse to credit support rights in specified circumstances. Such recourse is allowed where the right relates wholly to the creation or development of a CGT asset that is, or is reasonably expected to be, real property situated in Australia (including a lease of land, if the land is situated in Australia). 'Real property' is intended to capture CGT assets such as land and buildings. In determining whether a right relates wholly to the creation or development of real property, incidental relations to other matters are disregarded. [Schedule 2, item 78, subsections 820-427A(4)-(5)]

2.101 To prevent 'debt dumping' into Australia, recourse cannot be had to credit support rights that would, in turn, allow for recourse against a foreign entity that is an associate entity of the holder of the right (e.g., a multinational parent entity). In particular, paragraph 820-427A(3)(b) provides that recourse cannot be had to a credit support right where that recourse would reasonably be expected to allow for, either directly or indirectly, recourse to be had against a foreign entity that is an associate entity of the holder of the right. [Schedule 2, item 78, paragraph 820-427A(4)(b)]

2.102 A credit support right only relates wholly to the creation or development of real property where the right arises under an arrangement the borrowing entity enters into wholly in the course of creating or developing real property. For example, an arrangement under which the borrowing entity has the right to a commitment from investors to provide equity capital on a fixed and capped investment timeline wholly in relation to creating or developing real property.

2.103 The connection between a credit support right and the creation or development of real property must be tested continuously. Where a credit support right does not relate wholly to the creation or development of real property, then the exception provided by subsection 820-427A(3) does not apply. For example, where a credit support right initially related wholly to funding the creation or development of real property, but subsequently relates to other business activities in later income years in relation to the same real property (such as an investment holding activity where the real property development activity is completed), then the exception provided by subsection 820-427A(3) will not apply.

2.104 The exception provided by subsection 820-427A(3) is intended to cater for 'greenfield investments' or real property projects in development phase, where an entity would not yet have assets which a lender would consider sufficient security to support appropriate levels of third party debt funding. In such scenarios, in order for the project to proceed it may be necessary for investors to directly support the borrowing entity with the creation or development of real property (for example, equity commitment arrangements where equity is provided on a fixed and staged basis). The exception does not apply to credit support rights that support business activities beyond the creation or development of the relevant real property.

Conduit financing conditions

2.105 Additional rules allow for conduit financer arrangements to satisfy the third party debt conditions in certain circumstances. Such arrangements are generally implemented to allow one entity in a group to raise funds on behalf of other entities in the group. This can streamline and simplify borrowing processes for the group.

2.106 In the context of the third party debt test, conduit financer arrangements exist where an entity (a 'conduit financer') issues a debt interest to another entity (an 'ultimate lender') and that debt interest satisfies the third party debt conditions. The conduit financier then on-lends the proceeds of that debt interest to one or more associate entities on substantially the same terms as the debt interest issued to the ultimate lender.

2.107 Broadly, the debt interest that the associate entities (the 'ultimate borrowers') issue to the conduit financier (the 'relevant debt interest') will satisfy the third party debt conditions if all of the following conduit financing conditions are satisfied:

•

the conduit financer and the borrowers are Australian residents;

•

the conduit financer financed the amount loaned under the relevant debt interest only with proceeds from another debt interest (the 'ultimate debt interest');

•

the conduit financer issued the ultimate debt interest to another entity (the 'ultimate lender');

•

the borrowers are associate entities of each other and the conduit financer;

•

the borrowers issue the relevant debt interests to either the conduit financer or another borrower;

•

the amount loaned under each relevant debt interest does not exceed the proceeds of the ultimate debt interest;

•

the terms of the relevant debt interest are the same as the terms of the ultimate debt interest, where those terms relate to a cost incurred in relation to the relevant debt interest (for example, terms relating to interest payments). However, for these purposes, the following terms are to be disregarded:

-

terms of a debt interest to the extent that those terms relate to the amount of the debt; and

-

terms of the ultimate debt interest that have the effect of allowing the recovery of reasonable administrative costs that relate directly to the ultimate debt interest; and

-

terms of a relevant debt interest issued to the conduit financer that have the effect of allowing the recovery of reasonable administrative costs of the conduit financer that relate directly to the relevant debt interest; and

-

terms of a relevant debt interest that have the effect of allowing the recovery of costs of the conduit financer that are a debt deduction of the conduit financer and are treated as being attributable to the ultimate debt interest under subsection 820-427A(2) (concerning interest rate swap arrangements); and

•

the ultimate debt interest satisfies the third party debt conditions in relation to any income year. [Schedule 2, item 78, section 820-427C]

2.108 When applying the third party debt conditions to a debt interest under the conduit financing conditions, the following modifications are made to the third party debt conditions:

•

for a relevant debt interest – the allowance for debt deductions under interest rate swap arrangements under subsection 820-427A(2) does not apply, meaning that debt deductions of borrowers under interest rate swap arrangements are disallowed;

•

for a relevant debt interest – the entity is deemed to satisfy paragraphs 820-427A(2)(a) and (b) (requiring an entity issue the debt interest to an entity which is not an associate entity); and

•

for a relevant debt interest or ultimate debt interest – recourse can only be had to the following assets;

-

the Australian assets of the Australian resident conduit financer;

-

the Australian assets of each Australian resident member of the obligor group in relation to the ultimate debt interest. [Schedule 2, item 76, section 820-427B]

2.109 For conduit financing arrangements, the intention is that recourse can only be had to assets and entities which are sufficiently connected to Australia and the relevant Australian business operations.

2.110 To ensure the third party debt conditions are effective and cannot be readily avoided, the same modified definition of associate entity discussed in paragraph 3.43 above applies. [Schedule 2, item 78, subsection 820-427D]

Special deduction for fixed ratio test disallowed amounts under the fixed ratio test

2.111 A special deduction for debt deductions disallowed under the fixed ratio test over the previous 15 years is available to general class investors in certain circumstances.

2.112 The special deduction available as part of the fixed ratio test addresses year-on-year earnings volatility concerns for businesses which are limited in their ability to claim debt deductions depending on their economic situation in a particular year. The rule also accommodates entities with initial periods of high upfront capital investment relative to their initial income or which incur interest expenses on long-term investments that are expected to generate taxable income only in later years. Such entities may be start-ups, tech firms and greenfield investments.

2.113 The special deduction allows entities to claim debt deductions that have been previously disallowed within the past 15 years under the fixed ratio test in a later income year when they are sufficiently profitable and where their fixed ratio earnings limit exceeds their net debt deductions.

2.114 The 15-year period is introduced to limit the tax benefit of disallowed amounts to a defined period. This reduces the impact of debt deductions being permanently disallowed and allows for the level of an entity's net debt deductions to be linked to its earnings over time.

2.115 For the special deduction to apply, the entity must be using the fixed ratio test for the income year and its fixed ratio earnings limit for the income year must exceed its net debt deductions. An amount of those previously disallowed debt deductions up to the excess amount may be able to be deducted, subject to satisfying further criteria. If net debt deductions are equal to or higher than the fixed ratio earnings limit, then no previously disallowed debt deductions can be deducted. [Schedule 2, item 29, subsection 820-56(1)]

2.116 The amount of the deduction for an income year is worked out according to the following steps:

•

Step 1: Work out the amount by which the entity's fixed ratio earnings limit exceeds its net debt deductions for the income year.

•

Step 2 (the apply against excess step): Apply against that excess each of the entity's fixed ratio test disallowed amounts for the previous 15 income years (to the extent that they have not already been applied under this step in a previous income year).

•

Step 3: The amount of the deduction is the total amount applied under Step 2. [Schedule 2, item 29, subsection 820-56(2)]

2.117 An entity has a 'fixed ratio test disallowed amount' for an income year equal to the debt deductions of the entity for the income year that are disallowed under the fixed ratio test for that income year. [Schedule 2, item 29 and 126, sections 820-57 and 995-1(1)]

2.118 If an entity uses the fixed ratio test in an income year and chooses another test in a subsequent income year, the entity loses the ability to carry forward any existing fixed ratio test disallowed amounts for income years going forward. Entities must continue to use the fixed ratio test every income year to maintain access to their balance of carried forward fixed ratio test disallowed amounts. However, the mere fact that Division 820 does not apply to an entity in a subsequent income year will not result in fixed ratio test disallowed amounts being lost. The entity must choose another test for fixed ratio test disallowed amounts to become lost. [Schedule 2, item 29, sections 820-58]

2.119 Fixed ratio test disallowed amounts must be applied in sequence, such that fixed ratio test disallowed amounts attributable to the earliest income year, subject to the 15-year limit, are applied first. [Schedule 2, item 29, subsection 820-56(3)]

Loss rules for disallowed amounts

2.120 If an entity is a company or trust, they must pass the company or trust loss rules in relation to their fixed ratio test disallowed amounts. [Schedule 2, item 29, subsections 820-59(1)-(3)]

2.121 If an entity is a company, they must pass a modified version of the COT or BCT in relation to each of their fixed ratio test disallowed amounts they are seeking to apply under Step 2 (the apply against excess step). If the modified COT or BCT is not passed in relation to a fixed ratio test disallowed amount, then the company cannot apply the amount under Step 2. [Schedule 2, item 29, subsection 820-59(4)]

2.122 Where the entity is a trust, they must pass a modified version of the trust loss rules in Schedule 2F to the ITAA 1936 in relation to each of their fixed ratio test disallowed amounts they are seeking to apply under Step 2 (the apply against excess step). If the modified trust loss rules are not passed in relation to a fixed ratio test disallowed amount, then the trust cannot apply the amount under Step 2. [Schedule 2, item 29, subsection 820-59(5)]

2.123 In line with the policy objectives of the loss rules, these provisions are intended to prevent the trading of fixed ratio test disallowed amounts between the beneficial owners of those amounts, prevent market distortions, and ensure tax neutrality.

The special deduction and consolidated groups

2.124 To align with the tax consolidation rules that allow the transfer of tax losses into a tax consolidated group when an entity joins the group and limits the rate at which those losses can be utilised, the fixed ratio test disallowed amounts may also be transferred to and utilised by the head company of a tax consolidated group.

2.125 When an entity with a fixed ratio test disallowed amount joins a tax consolidated group, that fixed ratio test disallowed amount is transferred to the head company of that group at the joining time. This transfer occurs even where the joining entity becomes the head company of the tax consolidated group at the joining time. [Schedule 2, item 90, section 820-590]

2.126 However, the fixed ratio test disallowed amount is transferred only to the extent (if any) that the fixed ratio test disallowed amount could have been applied by the joining entity under Step 2 (the apply against excess step) in respect of an income year (the trial year). The trial year is generally the period commencing 12 months before the joining time to just after the joining time). [Schedule 2, item 90, section 820-590]

2.127 Specifically, the fixed ratio test disallowed amount is transferred at the joining time from the joining entity to the head company if:

•

at the joining time, the joining entity had not become a member of the joined group (but had been a wholly-owned subsidiary of the head company if the joining entity is not the head company); and

•

the amount applied by the joining entity under Step 2 (the apply against excess step) in respect of the trial year were not limited by the joining entity's excess. [Schedule 2, item 90, section 820-590]

2.128 If a fixed ratio test disallowed amount cannot be transferred, then the amount is effectively lost and cannot be applied under Step 2 (the apply against excess step) by any entity. [Schedule 2, item 90, section 820-590]

2.129 The rules outlined above aim to ensure that fixed ratio test disallowed amounts can only be transferred if the joining entity is able to apply the fixed ratio test disallowed amounts under Step 2 (the apply against excess step). Otherwise, taxpayers may be able to circumvent the policy and rules relating to fixed ratio test disallowed amounts through the consolidation process.

2.130 If a fixed ratio test disallowed amount is successfully transferred, then the head company is treated as having that amount for the same income year in which the joining entity had the amount. This preserves the effect of the 15-year limit for fixed ratio test disallowed amounts.

2.131 However, for the purposes of applying the modified COT, the head company is treated as acquiring fixed ratio test disallowed amounts at the joining time. This rule is similar to that provided by existing section 707-140 in relation to tax losses and is necessary to ensure the modified COT is not automatically failed for income years occurring after consolidation. This is not a refresh of the 15-year utilisation period. [Schedule 2, item 90, subsection 820-591]

2.132 A head company may choose to cancel the transfer of fixed ratio test disallowed amounts that would otherwise be transferred by the joining entity. If the transfer is cancelled, the income tax law operates for the purposes of income years ending after the transfer as if the transfer had not occurred. That is, the loss cannot be utilised by any entity for those income years. [Schedule 2, item 90, sections 820-592 and 820-593]

2.133 When a tax consolidated group forms, or one or more entities join a tax consolidated group, tax costs for the assets of each joining entity are calculated by reference to the ACA for the joining entity. The ACA is essentially the sum of the cost base of membership interests in the joining entity and the joining entity's liabilities and certain profits. The cost base of the membership interests in the joining entity is effectively transferred to the assets of that entity. The ACA is generally allocated to the assets the subsidiary brings into the group in proportion to their market values.

2.134 On exit from the group, the process is reversed and the group's cost base of the equity in the leaving entity is derived from the net assets of the leaving entity at the designated time. [Schedule 2, item 90, section 820-594]

2.135 A new step is added to the how the ACA of a joining entity is worked out under existing section 705-60 of the Act. New step 6A requires taxpayers to subtract from the result of step 6 the step 6A amount worked out under section 705-112. [Schedule 2, items 5 and 6, table item 6A in section 705-60]

2.136 The purposes of new step 6A is to stop the joined group getting benefits both through higher tax cost setting amounts for the joining entity's assets and through fixed ratio test disallowed amounts transferred to the head company. This is similar to purpose of step 6, which is about tax losses.

2.137 The step 6A amount worked out under new section 705-112 is generally worked out by multiplying the sum of the transferred fixed ratio test disallowed amounts by the corporate tax rate. [Schedule 2, item 9, section 705-112]

2.138 Step 6A is considered where a reduction under subsection 165-115ZA(3) of the ITAA 1936 is to some extent attributable to a (realised) loss that is taken into account in an amount subtracted under step 6A, then that reduction is, to that extent, added back. [Schedule 2, items 7 and 8, paragraphs 705-65(5A)(b) and (d)]

Exemptions to the thin capitalisation rules

2.139 Section 820-37 currently provides an exemption to the thin capitalisation rules for outward investing entities in certain circumstances.

2.140 With the introduction of the new 'general class investor' concept, section 820-37 is amended to refer to the new Subdivision 820-AA and ensure it continues to apply to outward investing entities and now applies to general class investors who, assuming those general class investors were financial entities, would be an outward investing financial entity (non-ADI). If the entity is an inward investing financial entity (non-ADI) or inward investing entity (ADI) for any part of a year then it cannot access the exemption. [Schedule 2, items 19-20, subsection 820-37(1)]

2.141 These amendments maintain the policy intention of providing an exemption from the thin capitalisation rules for outward investing entities in certain circumstances.

2.142 Section 820-35 currently provides an exemption from the thin capitalisation rules for an entity if the total debt deductions of that entity and all its associate entities for an income year are $2 million or less. Minor amendments are made to this section to ensure it includes the new thin capitalisation rules set out in new subdivision 820-AA. However, the $2 million or less threshold is unchanged. [Schedule 2, item 18, section 820-35]

2.143 Amendment are made to section 820-39 to ensure it applies to new Subdivision 820-AA. [Schedule 2, items 21 and 22, section 820-39]

Debt deduction creation rules

2.144 Excessive debt deductions pose a significant risk to Australia's domestic tax base.

2.145 The strengthened thin capitalisation rules will play an important role in limiting excessive debt deductions. However, they do not address the risk of excessive debt deductions for debt created in connection with an acquisition from an associate entity or distributions or payments to an associate entity. Such debt deductions may only ever indirectly, and at most, be partially limited by the thin capitalisation rules.

2.146 New Subdivision 820-EAA seeks to directly address this risk by disallowing debt deductions to the extent that they are incurred in relation to debt creation schemes that lack genuine commercial justification.

2.147 Subdivision 820-EAA represents a modernised version of the debt creation rules in former Division 16G of the ITAA 1936. Subdivision 820-EAA is consistent with Chapter 9 of the OECD's BEPS Action 4 Report (specifically paragraphs 173 and 174 of that report) which recognises the need for supplementary rules to prevent debt deduction creation.

2.148 Subdivision 820EAA only applies to entities that are subject to the thin capitalisation rules and are not exempt from those rules under 820-35. Broadly, this means that the rules only apply to entities that are part of a multinational enterprise and have total debt deductions of over $2 million for the income year. [Schedule 2, item 78, section 820-423A]

2.149 Subdivision 820-EAA disallows debt deductions in two cases. These cases represent integral parts of schemes where artificial interest-bearing debt is created within a multinational group. Over time, this interest-bearing debt effectively allows for profits to be shifted out of Australia in the form of tax-deductible interest payments.

2.150 The first case broadly involves an entity acquiring an asset (or an obligation) from its associate. The entity, or one of its associates, will then incur debt deductions in relation to the acquisition of that asset. The debt deductions are disallowed to the extent that they are incurred in relation to the acquisition, or subsequent holding, of the asset. For example, debt deductions arising from debt created by an entity would generally be disallowed if the debt created funded the acquisition of:

•

shares in a foreign subsidiary from a foreign associate; or

•

business assets from foreign and domestic associates in an internal reorganisation after a global merger. [Schedule 2, item 78, subsections 820-423A(2) and 820-423B(1)]

2.151 The second case broadly involves an entity borrowing from its associate to fund a payment to that, or another, associate. The entity will then incur debt deductions in relation to the borrowing. The debt deductions are disallowed to the extent that they are incurred in relation to the borrowing. For example, debt deductions arising from related party debt created by an entity to fund or increase the ability of the entity to make payments to a foreign associate as part of an entirely internal restructure would generally be disallowed. [Schedule 2, items 78 and 1220, subsections 820-423A(3), (3A) and 995-1(1)]

2.152 The payments or distributions referred to in the second case take the same meaning as in section 26BC of the ITAA 1936 and includes any amount credited, reinvested, applied to the benefit of another entity, settled on a net basis or on a non-cash basis, and the forgiveness of a debt. Payments or distributions may also include amounts of capital, such as returns of capital and repayments of principal under a debt interest. [Schedule 2, item 78, subsections 820-423A(4) and 820-423B(2)]

2.153 The provisions are drafted broadly to help ensure they are capable of applying to debt creation schemes of varying complexity. This approach is necessary given the ability of multinational groups to enter into complex debt creation arrangements.

Anti-avoidance

2.154 An anti-avoidance rule ensures the debt deduction creation rules cannot be readily avoided. Broadly, if the Commissioner is satisfied that a principal purpose of a scheme was to avoid the application of the rules in relation to a debt deduction, then the Commissioner may determine that the rules apply to that debt deduction. [Schedule 2, item 78, subsection 820-423D(1)-(4)]

2.155 A determination by the Commissioner under subsection (2) is not a legislative instrument under the Legislation Act 2003. Subsection 820-423D(5) merely confirms this result. [Schedule 2, item 78, subsection 820-423D(5)]

2.156 Where an entity is dissatisfied with a determination that the Commissioner made in relation to the entity, the determination is reviewable under Part IVC of the TAA 1953. [Schedule 2, item 78, subsection 820-423D(6)]

2.157 Limiting objections to determinations made under the debt creation rules is included to provide that an entity cannot object to part of the determination which relates to a matter already dealt with in an objection previously made. Where there has been a taxation objection against a determination under 820-423D(2), then the right to object under Part IVC of the TAA 1953 to an assessment is limited to objecting on the grounds that neither were, nor could have been, grounds for the taxation objection against the determination. This is an appropriate amendment as it has the effect of ensuring that an entity can only make an objection on new grounds that does not relate to a previous objection. [Schedule 2, item 145, paragraph 14ZVA(a)]

Definition of 'debt deduction'

2.158 The definition of 'debt deduction' in section 820-40 is amended to ensure it captures interest and amounts economically equivalent to interest, in line with the OECD best practice guidance.

2.159 It is intended that interest related costs under swaps, such as interest rate swaps, are included in the widened definition of debt deduction.

2.160 In particular, the definition is amended to ensure that a cost incurred by an entity does not need to be incurred in relation to a debt interest issued by the entity for that cost to be a debt deduction. This and other changes mean that amounts which are economically equivalent to interest, but which may not necessarily be incurred in relation to a debt interest issued by the entity, fall within the definition of debt deductions. [Schedule 2, items 23-28, section 820-40]

'Associate entity' – complying superannuation fund exemption

2.161 The definition of 'associate entity' in section 820-905 can operate too broadly in relation to superannuation funds and inappropriately restrict their ability to borrow.

2.162 The associate entity rules were introduced at a point when the Australian superannuation sector was in a relatively early stage. In the intervening period, superannuation funds have grown to have significant investments in a variety of different assets and are now an important source of capital investment for Australian assets, particularly infrastructure assets. Under the current rules, these investments may cause superannuation funds to have a relatively large number of associate entities, which would bring their investments into scope of the thin capitalisation rules. However, superannuation funds are subject to a relatively strong regulatory regime and generally do not exercise any meaningful control over their associate entities. On this basis, the associate entity definition (to the extent it relates to the thin capitalisation rules) is no longer fit-for-purpose for Australian superannuation funds.

2.163 To address this issue, the definition of 'associate entity' in section 820-905 is amended so that it does not apply to a trustee of a complying superannuation entity (other than a self-managed superannuation fund) and any wholly-owned subsidiaries of the complying superannuation entity. [Schedule 2, items 101 and 102, subsection 820-905(1) and (2B)]

Consequential amendments

Transfer Pricing under Division 815

2.164 Section 815-140 makes modifications to certain transfer pricing rules in Division 815 where the arm's length conditions have operated to affect costs that are debt deductions.

2.165 The existing thin capitalisation rules operate to determine an amount of maximum allowable debt. Broadly, this is the amount of debt that an entity can have before its debt deductions are disallowed.

2.166 As debt deductions are disallowed on a quantum of debt basis in existing Division 820, section 815-140 effectively disapplies the arm's length conditions in relation to the quantum of the debt interest. For example, where the arm's length conditions involve applying a rate to a debt interest, the rate worked out is applied to the debt interest the entity actually issued instead of the debt interest that would have been issued had the arm's length conditions operated.

2.167 As the new thin capitalisation tests deny debt deductions on an earnings basis, the identification of arm's length conditions is not modified for entities using the new earnings-based tests or third party debt test. For these entities the amount of debt (and/or level of capital gearing) is a relevant condition for the purpose of considering the commercial or financial relations that operate between the respective parties and is not disallowed. Consequential amendments are made to ensure this outcome. [Schedule 2, item 10, section 815-140]

2.168 The arm's length conditions applying to a debt interest are determined in accordance with the normal rules contained in section 815-130. In doing so, it is necessary to consider the conditions operating between the relevant entity and other entities in relation to the commercial or financial relations that exist between them. For example, it is appropriate to determine the amount of debt with reference to the conditions that might be expected to operate between independent entities dealing wholly independently with one another in comparable circumstances.

2.169 The arm's length rate for a particular debt interest is another arm's length condition. That rate applies to the arm's length amount of debt worked out for that debt interest. The entity's remaining debt deductions, after a transfer pricing adjustment is made to apply the arm's length conditions pursuant to section 815-115, are the relevant debt deductions for the purposes of Sub-division 820-AA.

2.170 After any other relevant parts of the ITAA 1936 and ITAA 1997, Sub-division 820-AA may reduce an entity's otherwise allowable debt deductions if the entity's net debt deductions for an income year exceed the relevant limit under the thin capitalisation tests applicable to that entity.

General consequential amendments

2.171 Section 12-5 contains a comprehensive list of the specific types of deductions. The insertion of fixed ratio test disallowed amounts under the thin capitalisation rules has been added to this list. [Schedule 2, item 3, section 12-5]

2.172 Various objects provision throughout the thin capitalisation Division are updated to align with the changes to the rules and the reference to debt deductions reflect the new earnings based tests. [Schedule 2, items 11-15, sections 820-1, 820-5, 820-10, 820-30]

General class investor consequential amendments

2.173 In line with the consolidated approach to group general investors, references to the definitions of 'outward investor (general)', 'inward investor (general)' and 'inward investment vehicle (general)' throughout Division 820 and the definition in section 995-1 have been removed. [Schedule 2, items 34-35, 37-39, 41, 59, 60, 71-73, 80, 105, 114, 127, 130, 140 subsections 820-90(1) and (2), paragraphs 820-185(3)(a) and (b), section 820-225(2), section 820-581, subparagraph 820-910(2)(a)(ii), 820-960(1)(a), and subsection 995-1(1)]

2.174 As a result of safe harbour debt amount for general investors being replaced, the steps in section 820-920 referring to associate entity excess amount is amended. Step 1 of subsection 820-920(4) is amended to refer to the updated general class investor label. [Schedule 2, item 112, subsection 820-920(4)]

Fixed ratio test consequential amendments

2.175 The safe harbour debt test is no longer an option for general class entities as the fixed ratio test is the replacement test. Accordingly, provisions relating to the safe harbour debt test are repealed. [Schedule 2, items 42, 63, 64, 126, 141 sections 820-95, 820-195, 820-205 and subsection 995-1(1)]

Group ratio test consequential amendments

2.176 The worldwide gearing debt test is no longer an option for general class investors as the group ratio test replaces it. Definitions and other provisions have been amended accordingly. [Schedule 2, items 46, 49, 66, 68, and 144, subsections 820-110(1), 820-111(1), sections 820-216, 820-218 and subsection 995-1(1)]

2.177 The repeal of section 820-110(1) has resulted in the reference to that provision in step 4(d) of subsection 820-920(3) no longer being applicable as general investors do not have access to the worldwide debt test. Financial entities under subsection 820-110(2) are unaffected and may continue to use this method statement if applicable. [Schedule 2, item 109 and 110, section 820-920(3)]

2.178 In line with the record keeping obligations amendments for entities applying the group ratio, in the case an entity is a partnership or unincorporated company the offence applies as if it were a person, but with relevant modifications. These provisions apply in conjunction with section 262A of the ITAA 1936 and Part III of the TAA 1953. This is consistent with the existing precedent and no amendments have been made to the amount of the offence. [Schedule 2, items 1, 2, 116 and 117 subsections 262A(2AA) of the ITAA 1936, paragraphs 820-990(1)(a) and 820-995(1)(a)]

Third party debt test consequential amendments

2.179 The respective provisions for inward and outward investing (non-ADI) entities have been updated to reflect the disallowed debt deduction that arises from applying the third party debt test and the corresponding calculation of the disallowed amount that is worked out by disallowing each debt deduction on a proportionate basis. [Schedule 2, item 32, 33, 52-53, 54, 58, 69 and 70, section 820-85, subsections 820-115(1)-(3), sections 820-180 and 820-185, subsections 820-220(1)-(3)]

2.180 Consequential amendments are made to paragraph 820-583(3)(a) to reflect the updated table items in subsection 820-85(2). [Schedule 2, item 84, subsections 820-583(3)(a)]

2.181 The introduction of the third party debt test results in references to the arm's length debt test being removed and the inclusion of notes that differentiate between general class investors and financial entities. The updated financial entity label change has resulted in definitions and other provisions throughout Division 820 being amended accordingly. [Schedule 2, items 30-31, 36, 40, 43-45, 47-48, 50-51, 54-55, 57, 61-62, 65, 67, 74-77, 79, 81-83, 85-89, 91-100, 104, 106-111, 113, 115-117, 121, 128-132, 136, 138-139, and 143, Subdivision 820B and section 820-65, subsections 820-90(1) and (2), sections 820-100, 820-105, subsections 820-110(2) 820-111(2), paragraph 820-120(1)(a) and Subdivision 820C, section 820-185, section 820-190(1), sections 820-215 and 820-217, subsections 820-300(1)(2) and subsection 820-395(2A)(2B), subsections 820-430(1), 820-583(1)-(2), (4)-(5), (7), 820-585(2) and 820-588(1), subsections 820-609(1), (4)-(6), subsections 820-610(2)-(3), (7), 820-630(1), and section -820-740, items , subsections 820-910(1) and (2), subsections 820-915(1), 820-920(1) and (3), paragraph 820-946(1)(a), section 820-980, and subsection 995-1(1)]

2.182 The repeal of sections 820-105 and 820-215 for general entities has the effect of not requiring records to be kept in working an amount of arm's length debt as it is no longer an option for general entities. [Schedule 2, item 117, subsection 820-980(2)]

Commencement and application provisions

2.183 Schedule 2 to the Bill commences on the first 1 January, 1 April, 1 July or 1 October after the Bill receives Royal Assent.

2.184 The amendments apply in relation to income years commencing on or after 1 July 2023. [Schedule 2, item 146]

2.185 An entity that makes a choice under 820-430(1) before the commencement of Schedule 2 to the Bill will continue to have effect. [Schedule 2, item 147]