Our advocacy work: Amendments to thin capitalisation legislation

Pitcher Partners Advisors Proprietary Limited ABN 80 052 920 206

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5 January 2024

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Senate Standing Committees on Economics Parliament House PO Box 6100 CANBERRA ACT 2600

By Email: economics.sen@aph.gov.au Dear Committee Secretary GOVERNMENT AMENDMENTS TO TREASURY LAWS AMENDMENT (MAKING MULTINATIONALS PAY THEIR FAIR SHARE—INTEGRITY AND TRANSPARENCY) BILL 2023 1.

Thank you for the opportunity to provide comments to the Economics Legislation Committee’s (“Committee”) inquiry of the Government Amendments on sheet RU100 (“Amendments”) to the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share—Integrity and Transparency) Bill 2023 (“Bill”).

2.

Pitcher Partners specialises in advising taxpayers in what is commonly referred to as the middle market. Accordingly, we service many clients, including investors, fund managers, managed investment schemes and businesses that would be impacted by changes to the thin capitalisation rules and the introduction of the new interest limitation rules.

3.

Broadly, we believe that the Amendments represent a substantial improvement to the Bill. However, we are still of the view that there are a number of improvements that should be made to the Bill to rectify technical issues as well as to ensure that the rules operate as intended and result in fair outcomes that meet policy objectives. In this regard, our recommended improvements in this submission do not disturb the broader policy objective of appropriately limiting debt deductions for multinational groups and protecting Australia’s tax base from base erosion and profiting shifting activities.

4.

Our submission contains (at Appendix B) a detailed list of issues we have identified with the Amendments as well as other outstanding items in the Bill previously addressed in earlier submissions that have not been addressed by the Amendments.

Appendix B also includes recommendations to resolve these issues.

5.

In addition, we make the following key submissions regarding some of the key aspects of the Bill.

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A R YEO M J HARRISON P W TONER T SAKELL G I NORISKIN

A T DAVIDSON K L BYRNE C D WHATMAN S D WHITCHURCH A E CLERICI

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A BLIZZARD S CRAIG L MALCOLM S VISWANATHAN J MITCHELLHILL

2

Removal of debt deduction creation rules until proper consultation occurs 6.

The introduction of the Debt Deduction Creation Rules (“DDCR”) contained in proposed Subdivision 820-EAA1 was not announced by the Government prior to their introduction in the Bill on 22 June 2023, nor were they contained in the March 2023 exposure draft legislation.

7.

The exposure draft of the Amendments released for public comment on 18 October 2023 contains substantial proposed changes to the rules, including a limited transitional rule. Subsequently, the Amendments introduced into the Senate on 28 November 2023 contained further proposed changes and a wholesale deferred start date.

8.

However, as currently drafted, contrary to the Explanatory Memorandum to the Bill,2 the DDCR could apply to ordinary commercial and wholly domestic transactions that in no way shift profits outside of Australia or pose a threat to Australia’s tax base.

9.

The changes made since the introduction of the Bill and the proposed wholesale deferral highlight that the DDCR are complicated with far-reaching implications and still require significant work to get right.

10.

We believe that the process to implement these rules cannot be undertaken with the attention it deserves in a condensed timeframe before the Bill progresses further through the Senate, which we assume will occur in early 2024.

11.

The state of the DDCR represent the most glaring issue in the Bill which we consider will require a separate and detailed consultation process.

12.

We believe the remainder of the changes to the thin capitalisation rules in Schedule 2 to the Bill (as modified by the Amendments) should generally operate appropriately with some modifications that can easily be made (e.g. refer to those contained in the Appendix). Given the proposed start date of the new thin capitalisation rules is 1 July 2023, the need to reform the DDCR should not otherwise hold up the progress of the Bill.

13.

Further to this, the DDCR should not be rushed through just so that the broader reforms can become law as soon as possible.

14.

We therefore recommend that the DDCR (i.e. Subdivision 820-EAA and associated provisions) be removed from the current Bill and re-introduced once proper consultation has been completed. This could be accompanied by a recommendation that the Government commit to re-introducing the DDCR at a later time but maintaining the proposed 1 July 2024 application date. This is preferable to rushing the legislation through and making corrections within the next year, which we would believe would be the inevitable outcome if the Bill is passed (even with the Amendments). Such an approach would impose significant costs on taxpayers attempting to comply with the rules as well as unnecessarily draw on ATO resources to provide guidance on and administer the rules until they are inevitably revised.

1

All legislative references in this submission are to the Income Tax Assessment Act 1997 unless otherwise indicated.

Refer to paragraphs 2.146 and 2.149 of the EM which state that the DDCR addresses risks arising out of schemes that lack genuine commercial justification and allow for profits to be shifted out of Australia.

2

3

15.

In Appendix A we highlight some of the key problems with the DDCR to illustrate the need for a wholesale reconsideration of the measures.

Other key submissions De minimis rule should be based on net debt deductions 16.

The current provisions contain a $2 million de minimis exclusion. As outlined in a 2014 Explanatory Memorandum,3 the de minimis rule exists to “reduce compliance costs and ensure that small businesses are protected from the effects of the thin capitalisation debt tests”.

17.

The new thin capitalisation measures are likely to have a disproportionately high compliance burden for taxpayers in the middle market given the added complexity. By way of example, we highlight the use of the term “associate entity” and the numerous modifications that the Amendments make to it resulting in a different meaning depending on the purpose for which it is being considered. This alone makes navigating the rules highly challenging.

18.

Furthermore, the proposed DDCR introduce an extremely complex regime that is likely to be more complex for non-corporate taxpayers to comply with as they cannot disregard certain payments and loans under tax consolidation.

19.

As the provisions have moved to a ‘net debt deduction’ concept for taxpayers, we propose that the $2 million de minimis rule should equally be amended in a similar manner to ensure compliance costs are appropriately balanced for amounts that are relatively small.

19.1.

By way of example, if a taxpayer is required to apply the FRT and had $2.1m of debt deductions, but also derives $2m of interest income, the maximum net debt deductions that can be denied under the new rules is $100,000 (previously $2.1m was subject to the rules and potential denial).

19.2.

That is, in the example, as net debt deductions are only $100,000, the taxpayer should be excluded from the burden of complying with the provisions. Based on a net debt deduction concept, the potential risk to revenue in this case would be minimal and there needs to be a balance between integrity and compliance costs.

20.

Accordingly, we believe it is critical that a simple amendment be made to 820-35 to ensure that the reference to ‘debt deductions’ is changed to ‘net debt deductions’ where the relevant taxpayer is a general class investor that could apply the FRT method for the current income year.

21.

We believe that this proposed amendment would be relatively simple to implement and would retain the status quo for middle market taxpayers under the new rules, would provide integrity to the provisions on a group basis, and would appropriately reduce unwarranted compliance costs.

3

Tax and Superannuation Laws Amendment (2014 Measures No. 4) Bill 2014.

4

The excess tax EBITDA amount should be transferable to discretionary trusts and individuals 22.

We note that the proposed excess tax EBITDA mechanism in section 820-60 is a welcome amendment to the Bill. However, the rules should not discriminate against taxpayers that are Australian discretionary trusts and resident individuals.

23.

While we do not suggest that discretionary trusts and individuals should be able to attribute any of their own excess amounts to other entities, it should not be the case that unit trusts, managed investment trusts, companies and partnerships are only able to transfer their excess to controlling entities that are limited to unit trusts, managed investment trusts, companies and partnerships.

24.

Many resident taxpayers in the middle market hold controlling investments in subsidiaries as individuals or through discretionary trusts. Where these controlling entities are subject to the thin capitalisation rules and incur debt deductions to fund that investment, the rules should not discriminate against such structures. Instead, the rules should allow for such entities to increase their tax EBITDA based on their share of their subsidiary’s excess tax EBITDA amount.

25.

We consider that the proposed amendment to rectify this issue is relatively simple and reflects previous associate entity excess rules that allow for excess safe harbour amounts to be transferred to discretionary trusts.

If you would like to discuss any aspect of this submission, please contact either Leo Gouzenfiter on (03) 8612 9674 or me on (03) 8612 9204.

Yours sincerely

B P FARRELLY Executive Director

5

APPENDIX A – KEY ISSUES IN SUBDIVISION 820-EAA No exclusion from the DDCR if section 820-37 applies 26.

The DDCR replicate two of the three exclusions to the thin capitalisation rules more broadly, being those contained in sections 820-35 and 820-39. They also provide for additional exclusions for ADIs and securitisation vehicles. However, they inexplicably do not contain an exclusion for those entities otherwise excluded from thin capitalisation rules due to section 820-37 (broadly, those outward groups whose global assets consist of at least 90% Australian assets). Such entities are recognised as having little risk of profit shifting through the use of debt deductions.

27.

An Australian entity that owns a dormant foreign company (with no assets) may be subject to the DDCR even though its group assets are 100% Australian assets, and all transactions occur within Australia. The mere presence of a foreign subsidiary should not be the difference between the DDCR applying or not applying. This renders meaningless the requirement for the entity to be an outward investing entity to be subject to the DDCR. If the rules can apply to wholly domestic groups (that hold a controlling interest in a dormant foreign subsidiary) then there should not even be a requirement for the entity to otherwise be an inward or outward entity.

28.

An allowance for minor or insignificant foreign investments is appropriate, which section 820-37 provides for and which should be extended to provide an exclusion to the DDCR.

Application to transactions before commencement and becoming subject to the DDCR 29.

The old debt deduction creation rules in former Division 16G of Part III of the Income Tax Assessment Act 1936 (“ITAA36”) only applied to acquisitions of assets that occurred on or after 1 July 1987.4 The proposed DDCR are not limited in this way.

Therefore, they may apply in respect of assets that were acquired before the rules commence, and perversely, to asset acquisitions that occurred before 1 July 1987.

30.

In addition to an unfair retrospective application of the rules, taxpayers who are not ultimately subject to denial of debt deductions would still face a highly costly exercise merely to prove that the DDCR rules do not apply to their arrangements. Taxpayers with any related party debt deductions will have to consider the historical ownership of all of their assets and determine if they were acquired from an associate. Because of the application of the rule to indirect acquisitions (e.g. via one or more interposed entities), this can greatly expand the inquiry. Such related party acquisitions may have occurred within tax consolidated groups or may have been benign transactions such as restructures pursuant to CGT roll-overs. Costs to comply with the rules are inevitably borne disproportionately by private groups who may need to seek specialist tax advice.

Further, information may not be readily available for transactions occurring many years prior.

31.

The DDCR would also impose current obligations on entities who are not subject to the rules but may become subject to the rules in the future (e.g. where their business and level of debt deductions grows and/or they begin to expand offshore). The first year that any entity becomes subject to the rules may require them to consider all their historic arrangements which could suddenly result in debt deductions being denied. Effectively, it puts all taxpayers on notice in respect of their current transactions, should they one day become subject to the DDCR. This can be contrasted with, for example, the

4

See former section 159GZZD(b) of ITAA36.

6

Taxation of Financial Arrangement (“TOFA”) rules which only apply to financial arrangements that entities start to have after they meet the relevant thresholds.

Temporal aspects are unclear 32.

The rules are not sufficiently clear as to when certain elements are required to be tested. For example, the asset acquisition rule in proposed subsection 820-423A(2) requires an asset (or obligation) acquisition from an associate as well as a debt deduction for an amount paid to an associate. However, it is not clear when the associate relationships are tested.

33.

For example, Entity A may have acquired an asset from Entity B at a time when they were associates, with the acquisition funded by third party debt. Years later, Entity A is acquired by Entity C who refinances that debt. Entity B is not acquired and thereafter becomes an unrelated party to Entity A and continues to be unrelated to Entity A when the debt deductions for amounts paid to Entity C are incurred.

34.

If the DDCR can apply to such transactions, it may cause unintended outcomes that stifle M&A activity. In any case, the actual operation of the rules as currently drafted are not entirely clear and will lead to disputes between taxpayers and the ATO. As part of a broader consultation, these aspects need to be clarified, with all implications thought through carefully.

The indirect rule is far too broad 35.

The DDCR can apply to indirect payments and acquisitions made through interposed entities. However, the mechanism used is one that links two transactions that are otherwise not connected in any meaningful way. That is, a “sufficient if they exist” and “not necessary to demonstrate that one funded the other” test is adopted.

36.

This is a mechanism adopted from the imported hybrid mismatch rules in Subdivision 832-H. The compliance obligations imposed to comply with such a broad rule are extraordinary. Refer to PCG 2021/5 which outlines the ATO’s expectations of taxpayers to obtain the information needed to comply with a rule of this kind.

37.

This broad approach to indirect payments and acquisitions further compounds the complexities outlined above in respect of the unclear temporal aspects of the rules.

38.

Fundamentally, this is the wrong approach to an integrity rule that is targeted at certain schemes that are artificial or lack commercial justification. The denial of a debt deduction for a related party borrowing because of a completely unrelated transaction occurring between entities multiple steps removed from the borrowing (which was demonstrably used for a completely different purpose) is antithetical to the rules.

39.

Instead of this broad approach, an approach to an ‘indirect rule’ that requires two or more transactions to be linked in some coherent way would be more appropriate. An example of this is the reasonable person test contained in the Division 7A rules (e.g. section 109T of ITAA36).

Exclusions in former Division 16G should be maintained 40.

Former Division 16G had sensible exclusions for acquisitions of trading stock as well as arrangements that do not result in any net increase in Australian debt (e.g. where debt is used to pay down other existing debt). Further, the exclusion in proposed section

7

820-423AA for the acquisition of new membership interests in entities applies to companies where the entity is a foreign entity but does not apply to acquisitions of membership interests in foreign trusts or foreign partnerships. The exclusion should be expanded to cover such acquisitions as these are less likely to pose a risk to the tax base since the taxable net incomes of foreign trusts and partnerships generally flow through to Australian members on an annual basis. By comparison, the profits of foreign company subsidiaries may be accumulated and (subject to the CFC rules) result in Australian tax being deferred until a dividend is paid.

41.

Such exclusions should be considered to ensure the rules are appropriately targeted and do not prevent business from entering into ordinary commercial transactions.

Application to acquisition of obligations is unclear 42.

The rule in proposed subsection 820-423A(2) applies to acquisitions of CGT assets as well as legal or equitable obligations. It is not immediately apparent how an entity’s debt deductions can relate to the acquisition of an obligation. Normally debt deductions relate to asset acquisitions because borrowed funds are used to fund the acquisition of an asset. Generally one does not borrow to fund the acquisition of an obligation.

Instead, the obligation may be acquired in order to reduce the price otherwise payable for an asset.

43.

Additionally, it is not apparent if an entity is even able to “acquire” an obligation under the meaning of that term in section 995-1. The meaning of “acquire” is defined in a way that only relates to CGT assets. If an obligation is acquired merely by borrowing money, then this could make the application of the rules unnecessarily broad particularly in conjunction with the overly broad interposed entity rules. For example, many private groups that are not consolidated for tax purposes have complex financing arrangements involving many loans and unpaid present entitlements to trust income.

Trying to comply with the DDCR by tracing through potentially an enormous number of possible chains of payments and obligations would be highly complex.

44.

The application of the DDCR to the acquisition of obligations needs to be properly explained and reconsidered.

Potential application of the ‘payment or distribution’ rule to ordinary trust arrangements 45.

The rule in proposed subsection 820-423A(5) applies to payments and distributions covered in subsection 820-423(5A) which includes distributions by trusts and payments or distributions of a similar kind. In accordance with the ATO’s guidance on trust distributions to corporate beneficiaries (refer to TD 2022/11 and PCG 2022/2), corporate beneficiaries are encouraged to convert their unpaid trust entitlements into loans where the parties intend for the trust to retain the funds representing the entitlement. This may involve the satisfaction a trust entitlement considered to be a distribution accompanied by the entering into a financial arrangement to fund that distribution. Such a transaction generally occurs between associates.

46.

It is possible that the DDCR would apply to deny debt deductions in respect of this kind of common arrangement that occurs between members of private groups and supported by the ATO in the context of Division 7A and section 100A.

47.

Such an outcome is inappropriate and careful consideration needs to be given to the potentially unintended application of the rules to ordinary transactions of this kind that occur within private groups.

8

APPENDIX B Issues with amendments in sheet RU100 Amending Item

ITAA 1997 Provision

Issue

Priority

(34)

82052(6B)(a)

The same circumstances rule may result in members holding <10% in AMITs having to exclude assessable distributions from that AMIT.

Medium

The “same circumstances” rule in s 276-80(2)(b) has the effect of putting the member into the shoes of the AMIT. Refer to paragraph 8 of LCR 2015/6. Examples 2 and 4 of the LCR make it clear that section 276-80 does not assess members of AMITs and it is the underlying provision that would apply as if the amount was derived (e.g. section 44 for dividend income).

For example, if an entity holds less than 1% of an AMIT and the AMIT holds a 10%+ shareholding interest in a company, the effect of the same circumstances rule could be interpreted to mean that the member of the AMIT may be treated as having received a dividend from a company in which it holds a 10%+ interest and result in that dividend income being excluded from the member’s tax EBITDA under s 820-52(3). This outcome would appear to be inconsistent with the proposed amendments.

This could also result in significant compliance costs for AMITs as they would have to track and report amounts referable to distributions from subsidiary trusts, companies and partnerships in which they hold an interest of 10% or more. Such amounts may become “characters” that are required to be treated differently from other amounts due to the effect that they have on the tax treatment of its members.

These issues could be resolved by including a provision that states that for the purposes of working out tax EBITDA, despite s 276-80(2)(b), a member of an AMIT not covered by s 820-52(6B) is not affected by sections 820-52(3), (6), (6B) and (8) as a result of companies, trusts and partnerships being associate entities of the AMIT.

9

Amending Item

ITAA 1997 Provision

Issue

Priority

(34)

82052(6)(b)

Further clarity on the effect of disregarding distributions

Medium

82052(6B)(b)

Paragraph 1.16 of the Supplementary EM states that this amendment is to ensure distributions from trusts that are associate entities are disregarded in calculating tax EBITDA in the event they are considered ordinary income under section 6-5 in the hands of the beneficiary or member.

We believe a broad interpretation of these provisions could also have the effect of disregarding the CGT consequences of trust distributions (e.g. capital distributions). A distribution by a unit trust could result in CGT event E4 or E10 occurring for the member.

While the comment in the Supplementary EM is useful, it would be preferable if a provision or note was included in the legislation. For example, this could state that disregarding distributions does not exclude the effect of the distribution on the operation of Part 3-1 of the ITAA 1997 (i.e. the CGT provisions).

(37)

820-52(10)

Tax EBITDA should exclude depreciation for R&D entities The effect of subtracting all notional deductions of an R&D entity is to reduce tax EBITDA by amounts representing tax depreciation amounts.

In order to achieve consistency between deductions and notional deductions for R&D entities, notional decline in value deductions (i.e. tax depreciation amounts) should NOT be subtracted from tax EBITDA. This would result in an appropriate tax EBITDA for R&D entities which would not result in a reduction of the FRT limit as a result of depreciation.

Medium

10

Amending Item

ITAA 1997 Provision

Issue

Priority

(39)

820-60(1)(2)

Excess tax EBITDA rule should accommodate for custodian arrangements

Critical

Many registered schemes hold their property via a custodian. These creates a further trust relationship. That custodian trust may not itself be a unit trust or managed investment trust. As a result, this may prevent a transfer of a trust excess tax EBITDA amount from a subsidiary trust through to a parent trust where the custodian is regarded as a trust.

We note that section 276-115 covers this scenario for AMITs. It applies if “a trust that is a custodian is a member of an AMIT in respect of an income year”. Where this is the case, section 276-115(3)(a) ignores the custodian and treats the underlying member as the relevant member of the AMIT. We recommend a similar modification is made to section 820-60 to ensure that interposed custodians or bare trusts are disregarded for these purposes and are not regarded as a trust (other than a unit trust).

(39)

82060(1)(a)(ii) & (2)(b)(ii)

Replacing “resident trust for CGT purposes” with “Australian trust” A resident trust for CGT purposes has to have property of the trust situated in Australia or carry on a business in Australia. A trust that is a mere holding trust may not be considered to carry on a business. Further if the trust merely holds units in subsidiary trusts, it is not clear that those units are “situated in Australia”. As intangible assets, they may not be considered to be situated in any geographical location.

More broadly, the thin capitalisation provisions generally use concepts from the CFC rules such as “Australian trust” or “Australian entity”. The use of “resident trust for CGT purposes” in just this one part of Division 820 seems to create an unusually and inexplicable inconsistency.

We therefore recommend that “resident trust for CGT purposes” is replaced with “Australian trust” in the tax EBITDA excess rule.

Medium

11

Amending Item

ITAA 1997 Provision

Issue

Priority

(39)

820-60(3)

Excess tax EBITDA amounts where entities have different accounting periods

Low

The trust excess tax EBITDA does not specifically consider the situation of a controlled entity having a Substituted Accounting Period that does not align to the controlling entity’s income year.

A notional calculation for the controlled entity might be necessary in such situations or it may be the case that the controlling entity’s excess tax EBITDA amount is based on the controlled entity’s tax EBITDA for the income year that ends during the controlling entity’s income year.

The legislation or EM should clarify this.

(39)

820-60(3) Step 1(a)

Inconsistent treatment of negative net debt deductions The deeming of negative net debt deductions as nil in step 1(a) of the method statement creates inconsistent outcomes between a standalone entity and entities in non-consolidated groups.

Having negative net debt deductions allows an entity to increase its excess under section 820-56(1)(b) for the purpose of deducting prior year FRT disallowed amounts. However, such an excess cannot be attributed up to a controlling entity to enable the controlling entity to deduct prior year FRT disallowed amounts.

For example, if a controlled entity has interest income of $1,000 resulting negative net debt deductions of $1,000, this enables it to deduct $1,000 of prior year FRT disallowed amounts. However, the controlled entity is not able to allocate any of this excess to its controlling entity to enable the controlling entity to increase its tax EBITDA to allow it to deduct any additional prior year FRT disallowed amounts (or current year debt deduction).

This creates yet another inconsistency between consolidated groups and non-consolidated groups without a clear policy reason. We recommend that negative net debt deductions are not treated as nil at step 1(a) of the method statement in section 820-60(3).

Medium

12

Amending Item

ITAA 1997 Provision

Issue

Priority

(39)

820-60(4)

Excess tax EBITDA amount should be attributed where a controlled trust has a loss

Critical

The modification to section 351 treating references to “greater of those percentages” to “lesser of those percentages” can result in an unintended outcome where a trust does not have actual income for the year (i.e. a loss year).

If a trust has no income for the year of income, then the share of income to which beneficiaries are entitled may be considered to be nil. This type of risk is acknowledged in section 152-78(2) for the purpose of the small business CGT concessions.

This may not ordinarily impact a section 351 calculation, as the provision ordinarily requires the greater of the income and corpus percentages to be calculated (thus allowing one to count the capital rights).

Where a “lesser of those percentages” is adopted, provision should be made to deal with trust loss scenarios. This could be achieved by requiring, in a loss year, the rights to the trust’s income to be determined by assumption that the trust had a positive amount of income for the income year.

(51) & (54)

820423A(2)(g) & (5)(f)

Exclusion from debt deduction creation rules should extend to financial entities who make third party debt test election Exclusions from Subdivision 820-EAA apply where the entity makes a TPDT choice. However, reference is only made to choices under subsection 820-46(4). This only covers general class investors.

The exclusion should also be extended to choices made under subsections 820-85(2C) and 820-185(2C) which apply to financial entities.

Medium

13

Amending Item

ITAA 1997 Provision

Issue

Priority

(68)-(71)

820-427A

No definition of Australian assets in recourse requirements

High

Section 820-427A makes various references to “Australian assets” as a critical component of the recourse requirement in the third party debt conditions. However, there is no definition of this term in the legislation.

This is likely to give rise to significant uncertainty when applying the provisions, particularly in the context of intangible assets such as shares, units, financial instruments and other rights.

An existing definition of “average Australian assets” in the thin capitalisation rules is contained in section 820-37 and could be adopted for these purposes (with appropriate modifications).

(68)

820427A(3)(c)

Recourse requirement should be satisfied if only assets held are permitted assets It is not clear whether recourse to Australian assets needs to be expressly limited in the terms and conditions of any loan agreement or whether this condition can be satisfied by the borrower (and/or obligors) by merely not holding any of the excluded assets during the relevant income year?

Many taxpayers would be relying on satisfying this condition on the basis that they hold no foreign assets even though they have entered into a loan agreement that does not limit recourse to Australian assets only (i.e. if the entity were to acquire a foreign asset then the lender would have recourse to that asset). In practice, third party lenders are unlikely to limit their rights as a creditor only to Australian assets and taxpayers would instead ensure they do not hold foreign assets in order for their borrowings to meet the third party debt conditions.

To avoid doubt and disagreements about the interpretation of this provision it should be clarified that the recourse requirements are deemed to be satisfied if the relevant entity does not hold any of the non-permitted assets at any time during the income year.

High

14

Outstanding issues in June 2023 Bill not addressed in sheet RU100 Bill Item (Sch 2)

ITAA 1997 Provision

Issue

Priority

29

820-48(3)

Deemed choice for cross staple arrangements should be limited

Critical

The deemed choice for cross staple arrangements may apply to closely-held private structures. The definition of cross staple arrangement is contained in s 12-436, Sch 1 to the Taxation Administration Act 1953. This definition requires common (80%+) ownership of an asset entity and operating entity (i.e. one trading entity and one non-trading entity).

While section 12-437 then makes certain income non-concessional MIT income (“NCMI”) of an asset entity that is a MIT, the concept of cross staple arrangement as defined is broad and does not require any of the entities to be MITs or even trusts.

Therefore, extending the deemed choice in section 820-48(3) may unintentionally capture private arrangements. For example, a family group may consist of a number of operating companies and a single unit trust that holds an investment property (that is leased to each of the operating companies). If the trust makes a TPDT election (e.g. because it is only financed by a bank loan) this may result in the operating companies also being deemed to have made a TPDT election despite not providing any security for the trust’s borrowings. We do not believe that this is outcome is intended.

The rule should be more appropriately targeted to widely-held entities such as managed investment trusts that were the target of the NCMI rules when the definition of cross staple arrangement was inserted into the Act. This is especially so given that an “asset entity” is defined by reference to the public trading trust provisions. Anomalous results may occur for an asset trust that hold only commercial properties (which would be classified as an asset entity) versus another trust whose assets are substantially (but not entirely) commercial property but holds insignificant other “ineligible investments” under section 102M. We recommend that application of the deemed choice rule in subsection 820-48(3) for entities who have entered into cross staple arrangements include an additional requirement that the “asset entity” in the cross staple arrangement must be a type of widely held entity such as a managed investment trust, public unit trust, managed investment scheme or public company.

15

Bill Item (Sch 2)

ITAA 1997 Provision

Issue

Priority

29

82052(1)(c)

Simplified depreciation for small business entities not added back

High

Subdivision 328-D provides deductions for entities using simplified depreciation. The current provision only adds back deductions for capital expenditure made deductible by Division 40. This unfairly discriminates against taxpayers that are or were small business entities and calculate their tax depreciation under the general small business pooling rules.

This provision should be expanded to include deductions under Subdivision 328-D. 29

820-52(1)

An appropriate mechanism should be adopted to deal with the effect of tax losses on tax EBITDA The removal of the tax loss add-back (as compared to the exposure draft) results in tax losses being utilised in priority to debt deductions (including FRT disallowed amounts) This means that tax depreciation that becomes a tax loss loses its character when it is later deducted as a tax loss. While a character retention rule for tax losses may be overly complex, a solution may be to allow for tax losses deducted to be added back, but to defer a negative tax EBITDA so that it is a reduction of tax EBITDA in a later year.

For example – In year 1, an entity could have $100 of operating losses and $200 of tax depreciation resulting in a $300 tax loss and negative $100 tax EBITDA. Rather than a deemed nil tax EBITDA arising, this negative tax EBITDA can be recognised in year 2. That is, rather than reducing tax EBITDA by tax losses deducted, reduce it only by prior year negative tax EBITDA amounts.

Taking this example further, if $500 of operating income is derived in year 2, rather than deducting the $300 tax loss (to reduce tax EBITDA to $200), instead reduce tax EBITDA to $400 for the prior year negative amount. This would allow $120 of net debt deductions to be deducted in year 2 which would be the same outcome as if all of these items arose in the one income year (i.e. effectively $400 of net operating income). Currently, the entity deducts the tax loss and has only $200 of tax EBITDA in year 2 with $60 of debt deductions allowable under the FRT. This results in arbitrary and inconsistent outcomes.

Critical

16

Bill Item (Sch 2)

ITAA 1997 Provision

Issue

Priority

29

820-52(7)

For partnerships, references to tax loss should be modified to refer to partnership loss

Low

For partnerships calculating tax EBITDA, this provision is missing a reference to ensure that a reference to a tax loss which should be treated as being a reference to the “partnership loss” of the entity. A partnership does not have a “tax loss” but has a “partnership loss” under section 90 of the ITAA36.

We highlight that subsection 815-310(2) is an example where the modification for partnerships was expressly adopted.

This can be contrasted with section 815-305 which only contains a modification for trusts in respect of its net income (i.e. because trusts do make tax losses and no modification for losses was required).

88

820-590

FRT disallowed amounts should be able to be transferred to a MEC group No reference is made to “MEC groups” for transfers of FRT disallowed amounts.

Section 719-2 only modifies the references to tax consolidated group in Part 3-90 (so that it refers to MEC Groups also) rather than the whole Act. As such, the ability to transfer amounts currently does not apply to MEC Groups. As an example, refer to section 110-35(10)(a) which contains a specific reference to MEC Groups. This is required as it is a provision outside of Part 3-90.

This could be corrected by either (1) moving section 820-590 into Part 3-90 (and renumbering it) so that the modification in section 719-2 works properly or (2) modify section 820-590 to ensure that it applies where an entity becomes a subsidiary member of a MEC group in addition to a consolidated group.

Low