Thin Capitalisation Legislation

Ref: AMK:lg

26 July 2023

Senate Standing Committees on Economics

Parliament House PO Box 6100

CANBERRA ACT 2600

Dear Committee Secretary

TREASURY LAWS AMENDMENT (MAKING MULTINATIONALS PAY THEIR FAIR SHARE INTEGRITY AND TRANSPARENCY) BILL 2023

Overview of submission

1. Thank you for the opportunity to provide comments to the Economics Legislation Committee’s (“Committee”) inquiry of the provisions of 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. Our submission focuses on Schedule 2 to the Bill containing changes to Australia’s thin capitalisation rules. We observe that these provisions are due to come into effect from 1 July 2023, before the completion of the Committee’s inquiry.

4. We believe that there are a significant number of issues with the Bill that need to be rectified. The provisions contain a number of drafting errors and technical problems that (as a bare minimum) need to be addressed before the Bill is passed to ensure that some of the core principles operate as intended 1

5. As currently drafted, the provisions will result in significantly inappropriate outcomes for taxpayers in the middle market that are not consistent with the policy approach recommended by the OECD in its BEPS Action 4 Report on the limitation of interest deductions Many of the rules included in the provisions were also not contained in the Exposure Draft Legislation provided for public consultation, nor the subject of any

1 By way of example, proposed subsection 820-591(3) makes reference to paragraph 820-59B(6)(b), a provision that does not exist. We are concerned that the legislation has been developed in an expedited timeframe and introduced without enough time dedicated to ensuring that it operates in an appropriate manner.

announcement and were conveyed to the public for the first time once the Bill was introduced into Parliament. This provided the public with no ability to consult on certain proposed changes. We believe that these changes in the Bill discriminate against taxpayers in the middle market as compared to taxpayers in the larger market sector

6. Our submission does not question the Government’s policy choice to adopt an earnings-based interest limitation rule to replace the asset-based thin capitalisation rule. Our submission only outlines significant issues contained in the drafting of the provisions, which appear to have been rushed

7. We urge the Committee to recommend various changes to the provisions, as outlined in our submission, to ensure that they operate in an appropriate manner.

8. In addition, given that these provisions now have a retrospective detrimental impact on taxpayers, we recommend that the Committee consider a deferred start date until these issues are properly dealt with. We highlight the recent deferred start date to the public country-by-country (CbC) reporting measures to 1 July 2024 as an example of the decision of the Government to get the legislation right rather than having to fix it later.

9. If, however, the Committee recommends that the Bill should be passed with application from 1 July 2023, we request that the Committee recommends that:

9.1. Critical amendments be made to the Bill where it is feasible for those amendments to be included within the Bill in a timely manner; and

9.2. Where amendments cannot be made before the passage of the Bill, that the Government commit to specifically outlining amendments that they are committed to making (with retrospective effect) so that taxpayers can have certainty in applying the provisions from 1 July 2023.

9.3. The Government commits to a review of the Bill (within 12 months) to develop amending legislation to correct deficiencies, with retrospective effect.

10. Importantly, we recommend that any such subsequent changes that may arise (e.g. from either 9.2 or 9.3 above) should be made before 30 June 2024 to ensure taxpayers are able to apply rules that work when first completing their 2023-24 income tax returns, rather than having to lodge amended returns that take into account any retrospective legislative corrections.

11. A commitment to correcting technical deficiencies in the Bill is an absolutely essential. Without appropriate rectification of these issues, many large projects that deliver critical housing and infrastructure will face serious issues with respect to their viability if the after-tax returns are substantially impacted by denials of debt deductions, where such denials are not consistent with the proposed policy of the provisions

12. We believe that these measures could therefore have a significant unintended consequential impact on many construction projects that are aimed at improving housing supply and infrastructure within Australia as simply funding these with less debt and more equity is not a realistic commercial option that investors will accept In our view, it is therefore critical that these issues be addressed.

Recommendation 1 – Commitment to appropriately correct provisions

We submit that the Committee recommend that:

• Technical amendments be made to the Bill prior to it being passed to the extent that they can be made in a timely manner.

• Certain provisions be removed from the Bill (such as Subdivision 820-EAA) to allow for appropriate consultation.

• Where amendments cannot be made before the passage of the Bill, that the Government commit to outlining amendments that will be made with retrospective effect (so that taxpayers can have certainty in applying the provisions from 1 July 2023).

• The Government commit to introducing amendments within 12 months of introducing the Bill to retrospectively rectify drafting errors that are otherwise identified on implementation of the provisions.

Submission key points

13. While there are a large number of technical issues with the Bill, we have focused our submission on the key matters of priority that we believe are critical to address in the current inquiry In particular we have focused our submission and key issues on taxpayers in the middle market.

14. These issues raised are by no means a comprehensive list of issues with the Bill that must be addressed in order for the provisions to operate as intended. We understand a number of other submissions have raised many of these other technical and practical issues.

De minimis rule

15. The current provisions contain a $2m de minimis exclusion. As outlined in a 2014 Explanatory Memorandum, 2 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”.

16. We highlight that the new thin capitalisation measures have a significantly high compliance cost associated with them for taxpayers in the middle market. They require taxpayers to apply very complex rules in order to determine whether the provisions would apply. This includes the application of the complex associate rules, associate entity rules, the thin capitalisation application and exclusion provisions, to work through the various requirements of the alternative methods and then to calculate the appropriate thresholds (including making a determination of whether to use a method that allows for carrying forward amounts or not). Furthermore, the proposed rules contained in Subdivision 820-EAA would be almost impossible for taxpayers in the middle market to apply. We encourage the Committee to properly work through the

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

provisions with a middle market taxpayer example in order to fully understand exactly how complex these provisions really are.

17. We believe that the great majority of taxpayers in the middle market will not be able to rely on their usual tax agent to determine whether the provisions apply or not and will need to seek assistance from specialist tax advisors, at a significant cost. Accordingly, we believe that there needs to be an appropriate balance between the integrity of the provisions and compliance for taxpayers.

18. As the provisions have moved to a ‘net debt deduction’ concept for taxpayers that apply the new fixed ratio test (“FRT”), the $2m de minimis rule should equally be amended in a similar manner to ensure compliance costs are appropriately balanced for amounts that are relatively small.

18.1. 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).

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

19. In this example, without a de minimis rule, the relevant taxpayer would be required to undertake all of the compliance activity associated with determining whether: (1) the entity is subject to the thin capitalisation rules; and then (2) in applying the rules and in correctly completing all associated tax return disclosures. This is the case even though the amount of net debt deductions that is now subject to denial is significantly well below the de minimis threshold (i.e. $100,000 in the example)

20. Furthermore, we note that taxpayers in the middle market are generally not tax consolidated (as the provisions only apply to wholly owned corporate groups). Using a gross basis (rather than a net basis) means that intra-group lending can result in double counting the same debt deduction 3 under the existing de minimis rule unless the provision changes to a net debt deduction test.

21. 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 As ‘associate entity’ deductions are counted for the purpose of that test, we highlight that any debt deductions claimed by an associate would be counted thus providing integrity on a group basis.

21.1. Example 1: Assume there are two taxpayers in the Group (A and B) and that Taxpayer A borrows $30m from a financier and incurs an interest cost of $1.5m (at 5% interest). Assume that Taxpayer A on-lends $20m to Taxpayer B and receives $1m in interest income. Assume both taxpayers are general class investors and would be able to apply the FRT method. In this example, Taxpayer A would have net debt deductions of $0.5m and Taxpayer B would have net debt deductions of $1m. On a group basis, the total net debt deductions would be $1.5m (i.e. $0.5m + $1m) and would be under the current

3 The conduit financing rules in the Bill (i.e. proposed section 820-427C) recognise that many non-tax consolidated groups have a ‘group treasury’ entity to streamline and simplify borrowing processes for the group. Many groups also use the entity with the best access to funding to borrow money and on-lend to other group members as required.

limit of $2m. We believe that this is the correct result on a group basis. Without an amendment, gross deductions would be $2.5m and both these taxpayers would be subject to the thin capitalisation provisions.

21.2. Example 2: Assume the same facts, however Taxpayer A borrows $30m from a financier and incurs an interest cost of $2.1m (at 7% interest). Assume that Taxpayer A on-lends $20m to Taxpayer B and receives $1.4m in interest income. Assume both taxpayers are general class investors and are able to apply the FRT method. In this example, Taxpayer A would have net debt deductions of $0.7m and Taxpayer B would have net debt deductions of $1.4m. On a group basis, the taxpayers would have net debt deductions of $2.1m ($0.7 + $1.4m) and would be over the current limit of $2.0m. Again, we believe that the provision (using an associate entity grouping concept) provides appropriate integrity and the correct result on a group basis.

22. We believe that our proposed amendment would be relatively simple to implement and would retain the status quo for middle market taxpayers under the new methods, would provide integrity to the provisions on a group basis, and would appropriately reduce unwarranted significant compliance costs as a result of changing to the new methods.

Recommendation 2 – Modification to the de minimis exclusion

Section 820-35 should be amended to include a new subsection (subsection (2)) that modifies the reference from ‘total debt deduction’ to ‘net debt deductions’, (as defined), where the relevant entity and/or the associate entity is a ‘general class investor’ (as defined).

Allocation of excess interest capacity to associate entities

23. The Bill contains rules (in proposed section 820-52) which remove certain distributions from an entity’s tax EBITDA. These rules address concerns regarding double gearing benefits (i.e. from counting the same underlying income in tax EBITDA at multiple levels to support excessive debt deductions incurred as a result of holding debt at multiple levels). We understand the rational for this principle and support an integrity provision that addresses this situation.

24. However, the current drafting goes beyond this integrity concern and effectively eliminates single gearing arrangements, where gearing is only at a holding entity level (i.e., at the parent or investor level). In such a circumstance, there is no integrity concern, and the current drafting would result in an unwarranted denial in deductions

24.1. For example, it is not uncommon for property structures to have a holding entity with multiple subsidiary entities, where all the debt is held in the parent entity Under the current drafting, all the debt deductions incurred by the parent will be denied under the FRT (or group ratio test) as the provisions exclude distributions of income from its subsidiary entities.

24.2. Under the current provisions (pre 1 July 2023), this issue does not arise as the provisions allow the head entity to use the ‘excess’ capacity of its subsidiary member. This has been a feature of the thin capitalisation provisions since its inception.

25. We also note that anomalous outcomes will arise under the current drafting of the provisions. For example, while distributions from a subsidiary will be ignored, the sale of interests in a subsidiary may generate a capital (profit) gain that reflects those undistributed profits of the subsidiary. These capital gains would be included in the owner’s tax EBITDA, while alternatively distributions of those same underlying profits to the owner would not. Such outcomes result in arbitrary outcomes depending on the legal structure or transaction chosen rather than on the underlying economic substance. This could result in taxpayers simply seeking to minimise distributions and maximise returns from a sale transaction to overcome the anomalous outcome.

26. We believe that the removal of distributions should have been accompanied by an ‘associate entity excess’ calculation. As highlighted above, the current thin capitalisation provisions contain an appropriate associate entity ‘excess’ calculation in section 820-920 to address this exact issue under the current provisions

27. The adoption of an associate entity excess rule to complement the removal of distributions from tax EBITDA is absolutely critical for the rules to operate in a coherent manner and to remain neutral between consolidated and non-consolidated structures, as well as neutral between the outcome of receiving a distribution and disposing of the interests in the subsidiary entity

28. The explanatory memorandum (“EM”) to the Bill (at page 93) states that the decision not to adopt an excess capacity allocation rule was done for simplicity and integrity. However, we believe that a rule could easily be adopted that is both simple and that does not pose a risk from an integrity perspective. Again, we highlight that the ‘excess’ rule has been contained in the thin capitalisation provisions contained in Division 820 since its inception and thus we do not agree with the reasons stated in the EM for not providing such a rule.

29. Given the significant impact of the proposed rules on taxpayers, it is not appropriate that an excess interest capacity rule merely be ignored, and it is essential that these impacts are addressed by appropriate rules that achieve a balance between fairness and integrity.

30. Providing for an associate entity excess rule to complement the removal of distributions from tax EBITDA is consistent with the OECD’s BEPS Action 4 recommendations on grouping issues under the FRT. We believe it would be relatively simple to draft an excess rule to complement the provisions. Such as a rule would work as follows:

30.1. It would require one to determine an entity’s excess of its FRT limit over its net debt deductions for the year (being the amount in proposed paragraph 82056(1)(b)). This would already be calculated for an entity subject to the FRT and thus would be readily available;

30.2. Increase the FRT limit of associate entities who would be required to exclude distributions from the entity from its tax EBITDA. That is, entities that hold an associate entity interest of 10% or greater would be entitled to apply this rule; and

30.3. The allocation of excess amounts should be based on ownership interests held in a company, partnership or trust that confer entitlements to distributions of income. This would alleviate integrity concerns by ensuring excess amounts cannot be allocated merely to optimise tax outcomes (e.g. by way of discretionary trust distributions).

31. Such an amendment is absolutely critical to ensure the provisions do not harshly and unfairly impact non-consolidated group structures where debt interests are held by the holding entity (which is a common structure adopted in the middle market)

32. While the explanatory memorandum (“EM”) to the Bill suggests (at page 86) that “nonconsolidated groups may opt to simplify their structures in absence of specific excess capacity rules”, we do not believe that this is possible in the majority of cases. Furthermore, due to the debt creation rules proposed to be contained in Subdivision 820-EAA, we believe that the EM comment is materially incorrect in respect of this statement That is:

32.1. Under the proposed debt creation rules), any restructure is likely to result in a permanent denial of deductions at the subsidiary level. For example, where the parent on-lends money to the subsidiary (which is used to return capital to the parent entity), this refinancing transaction would likely trigger the application of the debt creation provisions. The combination of the lack of an associate entity excess rule and the debt creation rules appears to have the effect of trapping non-consolidated groups into structures that will substantially increase their tax liabilities despite the overall level of gearing and debt deductions throughout the group not being excessive.

32.2. Even if the debt creation rules were removed or significantly reduced in terms of scope, we note that in a parent / subsidiary structure ( where debt is borrowed at the parent level), the financial lending institution may restrict the debt (or additional debt) that can be borrowed at the subsidiary level (even associate debt) where the financial institution has taken security over the underlying assets of the subsidiary entity. Accordingly, it may not be commercially possible to restructure the debt in such arrangements. We note in this circumstance, the third party debt test is also unlikely to be available

32.2.1. This is consistent with the EM, paragraph 2.92 stating that 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.”

32.3. Many structures contain favourable borrowing terms that were established prior to the increase in interest rates. Renegotiating arrangements today may result in a significantly higher cost of funding which could jeopardise the viability of many existing projects.

33. Given that the existing provisions already contain an ‘excess’ rule and have always contained an ‘excess’ rule (in section 820-920), we believe that the existing concepts contained in Division 820 could be used to create a very simple ‘excess’ FRT rule that would be both fair and equitable The Appendix contains some further details and examples about how an excess interest capacity would work to achieve appropriate outcomes and the potential drafting of such a provision

Recommendation 3 – Inclusion of an ‘associate entity’ excess provision

A general class investor should have an ability to include the excess of an associate entity’s FRT limit over its net debt deductions for the year. The amount of the excess included should be based on the direct ownership interest that is held by an associate entity (that is above the relevant 10% threshold as required by subsection 820-52(9))

Tax EBITDA should only exclude dividends and franked distributions from associate entities

34. We also believe that it is critical that the rule in respect of dividends and franked distributions in proposed subsections 820-52(2) and (3) be restricted to dividends or franked distributions received from associate entities, using the same 10% threshold as for partnership and trust distributions. It is unduly harsh to exclude all dividends from smaller portfolio investments in non-associate entities from being included in tax EBITDA

35. An investment entity holding a portfolio of listed shares (Australian or foreign) would effectively be prevented from using any leverage to fund dividend returns. Allowing such an entity to include distributions from, for example, non-associate entity listed trusts in their tax EBITDA but not dividends from non-associate entity listed companies is incoherent and has the potential to improperly distort investment decisions.

36. In our view, portfolio distributions do not give rise to an integrity risk (as outlined in the rule contained for trust distributions) and accordingly the rule excluding dividends needs to be amended to ensure that it only applies to non-portfolio dividends.

Recommendation 4 – Amendment to the dividend exclusion in tax EBITDA

Subsection 820-52(3) should be modified so that it only applies where “the entity is a shareholder of the company and is an *associate entity of the company”. This recommendation is consistent with the rule contained in subsection (6) [for trusts] and subsection (8) [for partnerships]

Remove the debt creation rules in Subdivision 820- EAA pending proper public consultation

37. Proposed Subdivision 820-EAA was not included in the exposure draft and was instead included in the Bill without any prior public consultation. As drafted, the provisions have scope to apply to ordinary commercial arrangements resulting in a significant and unfair impact on taxpayers through the denial debt deductions. Similar to the lack of an associate entity excess rule, referred to above, these rules would impact nonconsolidated groups such as those in the middle market where trust structures are common.

38. While the EM states that this Subdivision is targeted at schemes that allow for profits to be shifted out of Australia in the form of tax-deductible interest payments, the provisions are not drafted in a way that actually targets cross-border profit-shifting arrangements and instead applies to wholly domestic arrangements in circumstances where the arrangement would not be one that has a ‘tax mischief’

39. We believe that the Subdivision must be removed from the Bill and only re-introduced after a proper consultation process is undertaken. The consultation process needs to ensure that there are appropriate limitations in place on the measure to ensure it does not apply to ordinary commercial arrangements, retrospective arrangements or arrangements that do not actually involve the creation of additional debt in Australia.

40. The Appendix contains further detail about some of the key concerns with the current drafting of the debt creation rules and the lack of any common-sense exclusions which were a feature of the previous debt creation rules in former Division 16G.

Recommendation 4 – Removal of the debt creation rules pending consultation

Due to the significant unintended implications that will arise due to Subdivision 820EAA, we recommend the Subdivision be removed in its entirety until appropriate consultation has occurred on the proposed provisions.

Ensure that the third party debt test operates appropriately

41. The third party debt test (“TPDT”) is an important alternative to the FRT. This is particularly so for highly leveraged groups in the property and construction sector who would otherwise face substantial denial of debt deductions under the FRT. The group ratio test does not provide a viable alternative for most such groups that consist of investment entities that do not fully consolidate their subsidiaries on a line-by-line basis in their financial statements

42. The TPDT needs to allow for entities to deduct interest expenses incurred under ordinary arm’s length arrangements with third parties where excessive debt is not allocated to Australia. Otherwise, many large projects that deliver critical housing and infrastructure may become unviable if the after-tax returns are substantially impacted by denials of debt deductions.

43. We understand and acknowledge that the TPDT is not intended to cater for all arrangements. Our proposals included in this submission do not request an expansion of the provisions. We are simply highlighting technical issues and (what we believe to be) errors that will impede the practical application of the provisions to circumstances which we believe are intended to be within the policy of the provisions.

44. There are currently numerous issues with the provision in the Bill, which appear to be unintended errors, that should be able to be rectified easily, with the following being the most critical:

44.1. The third party debt conditions should be refined to ensure that the external lender is able to have recourse to the assets of the borrower as well as the assets of members of the obligor group in respect of that borrowing. Currently, certain obligor group members are deemed to make a TPDT election, but the provision then results in failure of the third party debt conditions due to the presence (and deemed inclusion) of such obligor group entities. An amendment is required to ensure that the two concepts work together properly and provide meaningful effect to the deemed choice rule for obligor group members

44.2. Currently, the provisions allow for this to occur where a conduit financer borrows amounts and on-lends these to associate entities. It is critical that this

same outcome occurs for a direct borrowing from an external lender not done via a conduit (otherwise taxpayers will simply seek to interpose a conduit financier to obtain a practical outcome)

44.3. The rules should allow for Australian trusts and partnerships to satisfy the third party debt conditions. As currently drafted, only individuals and companies are able to satisfy these requirements as the provisions use the term Australian resident. This can easily be rectified by changing the term “Australian resident” to “Australian entity”. We believe that this is a simple drafting error. It should not be the case that trusts and partnerships are excluded from the TPDT in a wholesale manner, particularly given the common use of trusts as highly leveraged property-holding vehicles that would be seeking access to the test

44.4. The rules should also allow conduit financers to satisfy the third party debt conditions. As currently drafted, the provisions cannot be applied where the conduit entity uses third party borrowed funds to acquire associate entity debt (i.e., on-lends the amounts to a related entity) This is because the conduit financing rule requires the third party debt test to be satisfied (paragraph 820427C(1)(f)), which in turn requires the conduit financier not to hold any ‘associate entity debt’ (subparagraph 820-427A(3)(d)(ii)). As a conduit financier will be used for these purposes (i.e. to borrow from third parties to lend to associates of the conduit financier), we do not believe that it will be possible to satisfy the conduit financing rule without amendment

44.5. Further consequential amendments must also be made to section 820- 910 so that ‘associate entity debt’ is able to be held by general class investors. Based on the current drafting, this does not appear possible and therefore the intended impermissible use of funds under the third party debt conditions would not actually be prevented unless the definition of ‘associate entity debt’ is appropriately modified.

44.6. Amendments should also be made in the conduit financer rule to correct what appear to be critical errors. The rules in subsection 820-427B(4) modify the application of the third party debt conditions by replacing the reference to Australian assets held by the borrower to assets held by certain entities “not mentioned in subparagraphs 820-427C(1)(c)(i) and (ii)”. This appears to exclude recourse to the assets of borrower itself under subparagraph 820427C(1)(c)(i). Further, no entities at all are mentioned in subparagraph 820427C(1)(c)(ii). As a result, these provisions do not appear to operate properly.

Recommendation 5 – Modify the TPDT to ensure that it operates as intended

Amendments are required to the TPDT provisions to ensure that they operate as intended in very basic cases as outlined above.

• Subparagraph 820-427A(3)(c)(i) should be amended to include assets held by members of the obligor group. This would coincide with the deemed TPDT election required by the obligor group in section 820-48 and would be consistent with the rule contained in subsection 820-427B(4) for conduit financing arrangements.

45. The Appendix contains further detail about key corrections that are required regarding the TPDT.

• The reference to Australian resident in sections 820-427A and 820-427B should be changed to “Australian entity” consistent with the current thin capitalisation provisions.

• The conduit financing rule should be modified to ensure that the reference to ‘associate entity debt’ in subparagraph 820-427A(3)(d)(ii) is not required to be applied by a conduit financer.

• The proposed change to the definition of ‘associate entity debt’ in section 820910 needs to be modified so that, for the purposes of the TPDT, it can apply to debt held by general class investors;

• The reference in the conduit financing rule to ‘assets held by each entity not mentioned’ in subparagraphs 820-427C(1)(c)(i) and (ii) appears to be a drafting error and should be corrected

If you would like to discuss any aspect of this submission, please contact either Leo Gouzenfiter on (03) 8612 9674 or me on (03) 8610 5170

Yours sincerely

A M KOKKINOS Executive Director

APPENDIX – DETAILED COMMENTS

Allocation of associate entity excess capacity to complement removal of distributions

46. It is critical that a rule be included to allow the for the allocation of excess interest capacity if taxable distributions are to be excluded from an entity’s tax EBITDA under proposed subsections 820-52(2), (3), (6), (8) and (9).

47. We understand these rules were included to prevent ‘double counting’ of tax EBITDA (i.e. taxable income at the subsidiary level as well as distributions sourced from that same taxable income at the investor level). We note that double gearing structures were identified as an integrity risk to the balance sheet safe harbour rules 4

48. Under the existing safe harbour rules, the prevention of double gearing by grouping associate entities is achieved by a combination of two complementary rules in the safe harbour calculations:

48.1. The exclusion of associate entity equity from an entity’s average assets; and

48.2. A mechanism by which the amount of assets held in excess of the safe harbour debt amount can increase the safe harbour amount for certain associate entities.

49. These rules prevent excessive debt being introduced into structures while ensuring that it does not unfairly punish group structures where the debt is incurred at the parent or investor level.

50. By way of example, a group that invests $40m of equity and borrows $60m of debt to fund a $100m investment should generally not breach the safe harbour rules, regardless of how that debt is allocated between a parent entity and subsidiary. This is demonstrated by the following examples:

4 Refer to paragraph 2.5 of the revised EM to the Treasury Laws Amendment (Making Sure Foreign Investors Pay Their Fair Share of Tax in Australia and Other Measures) Bill 2019

Investors from Sub $60m debt

Parent Trust

$100m equity

Sub Trust

Thin capitalisation outcome under the current rules:

Sub Trust

o $60m safe harbour debt amount ($100m assets x 60%)

o $nil debt

o $60m excess safe harbour debt amount ($60m - $nil)

Parent Trust

o $nil standalone safe harbour amount (due to exclusion of associate entity equity)

o $60m associate entity excess amount (from Sub Trust)

o $60m debt

o No excess debt ($60m - $60m)

Investors $60m debt

equity $40m equity

Thin capitalisation outcome under the current rules:

Sub Trust

o $60m safe harbour debt amount ($100m assets x 60%)

o $60m debt

o No excess debt ($60m - $60m)

Parent Trust

o $nil standalone safe harbour amount (due to exclusion of associate entity equity)

o $nil associate entity excess amount (from Sub Trust)

o $nil debt

o No excess debt ($0m - $0m)

Thin capitalisation outcome under the current rules:

Sub Trust

o $60m safe harbour debt amount ($100m assets x 60%)

o $30m debt

o $30m excess safe harbour debt amount ($60m - $30m)

Parent Trust

o $nil standalone safe harbour amount (due to exclusion of associate entity equity)

o $30m associate entity excess amount (from Sub Trust)

o $30m debt

o No excess debt ($30m - $30m)

51. These examples demonstrate that for non-consolidated structures, appropriate outcomes are achieved where a parent/investor entity both:

51.1. excludes its investment (debt or equity) in the associate entity subsidiary; and

51.2. picks up any excess capacity from the associate entity subsidiary.

52. Under the proposed FRT, which is based on earnings rather than assets, similarly appropriate outcomes can only be achieved if a parent/investor entity both:

52.1. excludes distributions received from the associate entity subsidiary; and

52.2. picks up any excess capacity from that associate entity subsidiary.

53. Excess capacity in this context refers to the excess mentioned in proposed paragraph 820-56(1)(b), being the excess (or unused amount) of an entity’s fixed ratio earnings limit for the income year over its net deduct deductions for that income year. We do not believe additional drafting is needed to identify this amount (as the concept is already included in the Bill).

54. Such a policy would be consistent with OECD best practice. Paragraph 197 of the OECD BEPS Action 4 Report states (as one of the three ways a fixed ratio rule could be applied):

The country may treat entities within a tax group as a single entity for the purposes of applying the fixed ratio rule and group ratio rule. For example, the benchmark fixed ratio would be applied to the tax group’s total tax EBITDA. Interest capacity would then be allocated within the tax group in accordance with rules developed by the country, which may include allowing a group to determine the allocation of interest capacity between entities. To prevent abuse, transactions within the tax group which do not net off may be stripped out of the tax group’s “entity EBITDA”. Under this option, entities which are in the same financial reporting group, but which are not part of the same tax group, would continue to be treated as separate entities and would apply the fixed ratio rule and group ratio rule independently.

55. This paragraph succinctly highlights the two key issues that emerge from applying the FRT on a standalone basis:

55.1. Interest capacity is not allocated between group members; and

55.2. Intra-group transactions have the potential to exploit the rules

56. The OECD Report does not attempt to prescribe a method of allocation of interest capacity and leaves this up to countries to develop.

57. Example 4 to Part I of the OECD Report illustrates the different outcomes under a fixed ratio rule applied on an entity-by-entity basis as opposed to a grouped basis.

58. In summary, the group taxation basis results in the $5m excess capacity of A1 Co being used to increase the maximum allowable deduction to A2 Co as per paragraph 243 of the report:

This is because A1 Co is not fully utilising its capacity to absorb interest deductions and it is assumed that there are no rules in place to permit the surrender of interest capacity from A1 Co to A2 Co. The example illustrates the potential advantage of applying the rule at the level of the local group (although this may also be achieved if rules did allow the surrender of interest capacity within the group).

59. As noted in the OECD Report, the outcome in the “group taxation” column above can be achieved by “rules to allow the surrender of interest capacity within the group” or by “applying the rule at the level of the local group”.

60. A limited rule that allocates excess capacity based on an entity’s interest in the associate entity appropriately achieves a balance between fairness an integrity. This could be based on the existing concepts in the thin capitalisation rules, being the “TC direct control interests” held by the entity in the underlying company, trust or partnership at the relevant testing time, with any adjustments necessary to ensure the integrity of the provisions (e.g. to ensure discretionary entitlement holders or any shortterm holdings of TC control interests for the relevant income year do not obtain an inappropriate allocation of any excess capacity).

61. Given that the FRT and tax EBITDA is concerned with amounts of assessable income, we believe it is therefore also appropriate in this context to only consider rights to receive income from the associate entity rather than voting rights, rights to capital distributions or rights to acquire interests in the subsidiary. Modifications to the concept of TC direct control interests can be made to ensure it only considers income rights.

62. We note the current associate entity excess rules in section 820-920 are complex as they seek to ensure appropriate outcomes for both the parent and subsidiary entities under a balance sheet approach. We do not believe that complexity is required in order to allocate excess interest capacity to an entity’s associate entity owners under the new rules. For example:

62.1. The concept of associate entity’s premium excess amount should not be relevant in the context of tax EBITDA. This concept ensured that entities were not unfairly penalised where the holding value an investment in an associate was greater than the book value 5 and is only relevant where a balance sheet method is adopted. The tax EBITDA method would simply only need to use a percentage of ownership without any need for a premium calculation.

62.2. The concept of equity capital, cost-free debt capital and the treatment of interest-free loans as associate entity equity are also only relevant where applying a balance sheet safe harbour method and are also not required under an excess calculation method for EBITDA

63. To demonstrate how such a rule would work, take the example of a group that makes $10m of net operating income (i.e. excluding interest and depreciation) for an income year. Such a group should therefore be able to deduct $3m of debt deductions that year under the FRT Under a rule that both excludes distributions as well as picks up

5 Refer to paragraph 1.101 of the EM to the Taxation Laws Amendment Bill (No. 5) 2003

excess amounts, the same outcome should arise regardless of at what level the debt deductions are incurred. This is illustrated as follows:

FRT outcome under suggested rule:

Sub Trust

o $10m tax EBITDA

o $3m FRT limit (30% x tax EBITDA)

o $3m net debt deductions

o $nil deductions denied

o $nil excess interest capacity

Parent Trust

o $nil tax EBITDA (distributions from Sub Trust excluded)

o $nil excess capacity from Sub Trust

o $nil FRT limit

o $nil net debt deductions

o $nil deductions denied

o $nil excess interest capacity

$3m debt deductions

$10m distribution from Sub Trust

Sub Trust

FRT outcome under suggested rule:

Sub Trust

o $10m tax EBITDA

o $3m FRT limit (30% x tax EBITDA)

o $nil net debt deductions

o $nil deductions denied

o $3m excess interest capacity

Parent Trust

$10m income

o $nil tax EBITDA (distributions from Sub Trust excluded)

o $3m excess capacity from Sub Trust

o $3m FRT limit

o $3m net debt deductions

o $nil deductions denied

o $nil excess interest capacity

$1m debt deductions

$8m distribution from Sub Trust

$2m debt deductions

FRT outcome under suggested rule:

Sub Trust

o $10m tax EBITDA

o $3m FRT limit (30% x tax EBITDA)

o $2m net debt deductions

o $nil deductions denied

o $1m excess interest capacity

Parent Trust

$10m income

o $nil tax EBITDA (distributions from Sub Trust excluded)

o $1m excess capacity from Sub Trust

o $1m FRT limit

o $1m net debt deductions

o $nil deductions denied

o $nil excess interest capacity

64. We believe the above amendments are critical as the provisions in the Bill otherwise unfairly and inappropriately discriminate against non-consolidated groups and attack legacy structures that were entered into in good faith. It will often be practically difficult

or impossible for such groups to simply “push debt” down (e.g. by borrowing at the subsidiary level to return capital to the parent entity in order to repay the debt at the parent level). Such restructures may also trigger the application of anti-avoidance rules in Part IVA or the debt creation rules proposed to be contained in Subdivision 820-EAA, with no ATO guidance available with respect to this issue.

Debt creation rule in new Subdivision 820-EAA needs to be appropriately targeted

65. The proposed debt creation rules will have a significant and disproportionate impact on non-consolidated structures commonly adopted by middle market taxpayers where there is no risk of profit shifting outside Australia.

66. Of particular concern is that the 90% Australian asset exemption from the thin capitalisation rules, contained in section 820-37, is not proposed to apply to prevent the application Subdivision 820-EAA. This means that Australian-headquartered outbound groups with an immaterial foreign investment, which may be as insignificant as the holding of a dormant foreign subsidiary with no assets, are brought within the scope of the rules where there is little potential scope of profit-shifting outside Australia.

67. We note that former Division 16G of the ITAA 1936, which Subdivision 820- EAA is modelled on, contained a series of sensible exceptions in former section 159GZZF to ensure the rules did not apply in inappropriate situations including:

67.1. Acquisitions of cash and trading stock (other than as part of a purchase of a business);

67.2. Acquisitions of new shares (i.e. share issues/subscriptions)

67.3. Acquisitions of assets not previously used for a taxable purpose;

67.4. Arrangements that did not increase the overall indebtedness of the relevant group; and

67.5. Arrangements that did not increase the ability of the group to make payments to related foreign entities (other than taxable dividends).

68. Without the development of sensible exclusions, following proper public consultation, the current provisions will impact ordinary arrangements such as the use of borrowed funds by a retailer to purchase trading stock from an associated wholesaler or an entity using borrowed funds to establish a subsidiary company or unit trust. The rules would also appear to disallow all debt deductions of a conduit financier which incurs debt deductions in relation to holding debt in an associate. This overly broad application of the rules would make the overall operation of the rules non-sensical.

69. In particular, many non-consolidated structures involve entities that serve separate functions where, under ordinary commercial arrangements, those entities make intragroup payments. These structures may also commonly include a central finance entity which provides finance to group entities. This is recognised in the conduit financing rules in proposed Subdivision 820-EAB. Such arrangements will result in debt deductions paid between associates that we believe would trigger the operation of section 820-423A(5).

69.1. For example, a group may be structured to have a finance company, an operating company and a service trust, all of which are associates. The finance company provides working capital loans to the operating company, part of the proceeds of which are used to pay a service fee to the service trust (e.g. to

manage its payroll function or for the provision of staff employed by the service trust). The group has a minimal investment (<1% of its overall business) in a foreign subsidiary or permanent establishment but otherwise its operations are wholly domestic. Such arrangements could now result in substantial denials of debt deductions.

70. Further, former 159GZZD ensured that the rules only applied in respect of acquisitions of assets made on or after the commencement date of the provisions (1 July 1987). In the absence of a similar application or transition rule, taxpayer will be required to review all prior arrangements for an indefinite period of time backwards to consider whether any debt currently held relates to an asset that was originally acquired from an associate.

70.1. For example, a taxpayer may have transferred an asset out of an operating entity into special purpose vehicle in 1998 for asset protection reasons as part of a genuine restructure and may have paid tax on the associated capital gain in order to do so. The owner of the asset may have general borrowings which may be considered to relate to the holding of the asset acquired 25 years ago. Consequently, Subdivision 820-EAA can now apply to deny those debt deductions.

70.2. Acquisitions of assets from related parties may have also occurred pursuant to an ordinary commercial transaction pursuant to a CGT roll-over such as the transfer of a business from a trust to a wholly-owned company, 6 the transfer of assets from a unit trust to a company, 7 or the interposition of a holding company which involves that interposed holding company acquiring shares from an associate. 8 These restructures are provided for under the current tax system and may be purely domestic transactions but nevertheless result in an entity having acquired an asset from an associate, the holding of which may be related to any debt deductions incurred in the future.

70.3. Further, such a related-party acquisition may have occurred previously between two members of a tax consolidated group, which was ignored at that under the single entity rule. Those entities may still be associates but no longer part of a tax consolidated group (e.g. exit of one entity due a 5% acquisition by a third party). These entities would now be required to consider transactions that occurred during that period when they were both members of the same group.

70.4. In addition to the unfair retrospective nature of the provisions, taxpayers will be required to incur significant costs to retrospectively analyse whether any asset currently held was previously acquired from a related-party in order to comply with the new rules.

71. We also believe the “scheme” rule in proposed section 820-423D is not necessary as Part IVA of the ITAA 1936 already applies to cancel tax benefits where schemes are entered into for the sole or dominant purpose of obtaining those tax benefits. A separate Part IVA type rule, albeit with a “principal purpose” rather than “dominant purpose” test, would appear to add unnecessary complexity to the operation of the tax system. Given the breadth of Part IVA and the fact it applies to benefits that result in the obtaining of deductions, it is not clear why such an additional rule is required.

72. Our comments only highlight some of the most immediate issues of concern with proposed Subdivision 820-EAA and we reiterate that it is critical that the development

6 Subdivision 122-A.

7 Subdivision 124-N.

8 Division 615.

of these rules is considered as part of a thorough public consultation process rather than rushed through in its current state.

Third party debt conditions – recourse to assets held by the borrower

73. We highlight that for entities electing to use the TPDT, the third party debt conditions in proposed subparagraph 820-427A(3)(c)(i) require that the holder of the debt interest have recourse for payment of the debt only to Australian assets held by the entity that issued the debt (i.e. the borrower). A further restriction is included in subparagraph 820-427A(3)(c)(ii) so that recourse cannot be had assets of the borrower that are certain rights in relation to guarantees or credit support, subject to an exception mentioned in subsection 820-427A(4).

74. The exception in subsection 820-427A(4) provides that the third party debt conditions can still be satisfied where the holder of the debt has recourse to rights held by the borrower in respect of guarantees or other forms of credit support where these relate to the creation or development of Australian real property so long as that would not allow for recourse against an foreign associate of the borrower.

75. However, the exception in subsection 820-427A(4) does not provide for any exception to the requirement in subparagraph 820-427A(3)(c)(i) that recourse can only be had to assets held by the borrower, regardless of whether or not they relate to Australian property development activities.

76. This appears inconsistent to the concept of ‘obligor group’ in proposed section 820-49 which states that a member of an obligor group in relation to a debt interest includes (in addition to the borrower) any entity the assets of which the creditor has recourse to for payment of the debt

77. If an entity is a member of an obligor group (and is required to lodge a tax return), the effect of proposed subsection 820-46(5) and section 820-48 is that the obligor entity is deemed to make a choice to use the TPDT for the income year if the borrower has also made that choice. This ensures that entities in the same group cannot use a combination of different methods where the third party debt test is chosen.

78. However, if a lender has recourse to the assets of an entity other than the borrower (i.e. the obligor entity), then the borrower’s debt interest would fail the third party debt conditions and would never elect into the third party debt test so that the obligor group and deemed choice rule would never have practical effect.

79. In order for the third party debt conditions to be consistent with the obligor group concept, the exception in s ubsection 820-427A(4) regarding Australian real property development should also provide an exception to subparagraph 820-427A(3)(c)(i) to allow the holder of the debt interest to have recourse to Australian assets held by all members of the obligor group in relation to the debt interest (which includes the borrower and all obligor entities).

80. We understand that credit support from related parties (e.g. guarantees, security over property, etc) are not necessarily rights held and exercisable by the primary borrower against those entities but rather provide the creditor with direct recourse for payment to the other entity and their assets.

81. Such assets are simply not held by the entity that is the borrower Accordingly, the exception contained subsection 820-427A(4) needs to be broad enough to provide an exception to both subparagraphs 820-427A(3)(c)(i) as well as (ii), in a way that gives meaningful effect to the obligor group and deemed choice rules.

Conduit financing conditions allow recourse to assets of obligor group members

82. We note that the conduit financing rules, in particular subparagraph 820-427B(4)(b)(i) allow the external creditor to have recourse to the assets of members of the obligor group. It appears incoherent to allow for this extended recourse in situations where amounts are borrowed by a conduit financer (and then on-lent to associate entities), but not to allow for the same extended recourse in direct borrowing situations (i.e. not via a conduit financer). Therefore, it is important that the general third party debt conditions be consistent with the conduit financing conditions so that entities are not required to interpose a conduit entity in order to obtain external financing for which security can be provided by related entities

83. We also note what appears to be a drafting error in paragraph 820-427B(4)(b) which states, where the conduit financing conditions are satisfied, that recourse can be had to the Australian assets held by each entity not mentioned in subparagraphs 820427C(1)(c)(i) and (ii).

83.1. We note that the entity mentioned in subparagraph 820-427C(1)(c)(i) is the entity that issued the debt interest. It is not apparent why recourse cannot be had to the assets of the actual borrower.

83.2. We note further that there are no entities mentioned in subparagraph 820427C(1)(c)(ii). While there are entities mentioned in subsection 820-427C(4) (i.e. foreign associate entities) these are not mentioned in subparagraph 820427C(1)(c)(ii) itself.

83.3. We believe that these references in section 820-427B need correcting to ensure they work coherently with the other provisions.

Third party debt conditions – entity must be an Australian resident

84. The third party debt conditions in proposed subsection 820-427A(3) include, in paragraph (e), a requirement that the entity that issued the debt interest (i.e. the borrower) is an Australian resident.

85. This is a defined term 9 that only covers individuals and companies and does not cover trusts and partnerships. This has the consequence that trusts (including public trading trusts and complying superannuation entities) and partnerships can never satisfy the third party debt conditions in relation to any debt interests that they issue.

86. We believe this is unintended drafting error rather than an intentional policy choice to exclude all trusts (e.g. the majority of Australian managed funds) and partnerships from effective access to the third party debt test. The EM does not comment on this aspect of the “Australian resident” requirement so as to indicate that it should exclude all trusts and partnership.

87. We therefore suggest that “Australian resident” be amended to “*Australian entity” which is a term that is adopted throughout Division 820 and covers Australian trusts and Australian partnerships.

9 This is via section 2-15 (which does not require “Australian resident” to be asterisked), section 995-1 and subsection 6(1) of the ITAA 1936

88. The reference to “Australian resident” in proposed subparagraph 820-427B(4)(b)(ii) should also be amended to “*Australian entity” for the purposes of the conduit financing rules.

Third party debt conditions – borrower not to use funds to hold associate entity debt

89. The third party debt conditions do not permit the entity that issued the debt interest (i.e. the borrower) to use proceeds of issuing the debt interest to hold any associate entity debt pursuant to proposed subparagraph 820-427A(3)(d)(ii).

90. However, this would appear to prevent a conduit financer from satisfying the third party debt conditions in its own right in relation to any “ultimate debt interest” it issues in accordance with paragraph 820-427C(1)(a) as it will have used the proceeds from that issue to make loans to associate entities (i.e. hold associate entity debt).

91. Therefore, section 820-427B should be modified to allow conduit financers to use the proceeds of the ultimate debt interest to hold associate entity debt.

91.1. We note further that items 101 and 102 modify section 820-910 which contains the definition of “associate entity debt” in what the EM describes as consequential amendments to remove references to general investors. However, by not inserting the term “general class investor” in section 820-910, there appears to be an unintended consequence that “associate entity debt” can now only be held by financial entities.

91.2. While this might be appropriate in the context of applying the balance sheet safe harbour method from 1 July 2023 ( as the concept is no longer relevant for general investors), the adoption of the term “associate entity debt” in the new third party debt conditions would likely require associate entity debt to be that which can be held by general class investors for the restriction in subparagraph 820-427A(3)(d)(ii) to have a meaningful application.