APPENDIX – DETAILED COMMENTS

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

6 Subdivision 122-A.

7 Subdivision 124-N.

8 Division 615.

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.

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.

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