In the October 2022 Federal Budget, the Federal Government announced changes to thin capitalisation rules which introduced a new earnings-based test to limit debt deductions in line with an entity's profits.
Thin capitalisation - pre-1 July 2023
The current thin capitalisation regime limits debt deductions up to the maximum of three different tests:
- a safe harbour (debt to asset ratio) test
- an arms-length debt test; and
- a worldwide gearing (debt to equity ratio) test.
Multinational entities operating in Australia, and any inward or outward investor, must pass thin capitalisation rules to claim a deduction for interest expenses above $2 million.
'Thinner capitalisation' - post 1 July 2023
From 1 July 2023, a new test based on earnings will limit the entities' deductible interest expense to 30% of profit.
Profit will be defined as EBITDA, or earnings before interest, Taxes, depreciation, and amortisation.
If a multinational entity wishes to use this entity-level EBITDA earnings-based test (interest expense amounts exceeding the 30% EBITDA ratio), any debt deductions denied may be carried forward and claimed in a subsequent year (within 15 years). A second option for a multinational entity would be to allow an entity in a group to claim debt-related deductions up to the level of the worldwide group's net interest expense as a share of earnings (which may exceed the 30% EBITDA ratio).
This new earnings-based ratio will replace the worldwide gearing ratio. Further details regarding how this option operates will be contained in the legislation which is yet to be introduced into the Federal Parliament.
The arm's length debt test will be retained as a substitute test, but will only apply to the external (third party) debt of multinational entities, disallowing deductions for any related party debt under this test.
The changes will apply to multinational entities operating in Australia and any inward or outward investor and consistent with the existing thin capitalisation regime.
Certain financial institutions including banks, described as non-authorised deposit-taking institutions (non ADIs) will continue to apply the current thin capitalisation rules.
This measure is estimated to increase receipts by $720 million over the 4 years from 2022-23.
Although announced in the Federal Budget, at the date of this publication, no legislation had been introduced into the Federal Parliament regarding these measures.
