What Are the New Rules and Why They Matter
Australia has overhauled its interest limitation and thin capitalisation framework to align with OECD BEPS Action 4. Key changes effective for income years from 1 July 2023, with the Debt Deduction Creation Rules (DDCR) coming into force from 1 July 2024. (ato.gov.au)
Entities (company, trust, etc.) subject to these rules are those that are foreign controlled, or are privately owned with outbound operations and cross-border interest payments or debt to related parties. The de minimis threshold still exempt where associate-inclusive debt deductions don’t exceed AUD 2 million in a year. (ato.gov.au)
Key Tests Under Thin Capitalisation
Each entity must apply one of three tests to ascertain allowable net interest deductions:
- Fixed ratio test: Net debt deductions capped at 30% of EBITDA; excess may be carried forward up to 15 years under certain conditions. Exchange with associate debt included. (ato.gov.au)
- Group ratio test: Uses worldwide group’s debt ratios to determine allowable net deductions—no carry forward. (ato.gov.au)
- Third-party debt test: Only external (third party) debt allowed; related party debt deductions denied; no carry forward. (ato.gov.au)
The classic arm’s length debt test has been removed. For DDCR: deductions related to related party loans that fund acquisitions or distributions may now be denied. (ato.gov.au)
Action Steps for Entity Owners and Trustees
- Review existing debt arrangements: Identify all related party loans, internal financing and associated terms.
- Assess preferred test: Depending on your structure, one of the three tests may offer optimal deductions.
- Ensure systems capture EBITDA accurately and support forecasting – to compare against fixed ratio.
- Monitor restructure risks: Changes in group structure, ownership, or financing arrangements can trigger tougher treatment under these rules.
- Prepare for auditing and reporting: Entities may need to provide disclosures or schedules in the tax return regarding thin capitalisation and DDCR compliance.
Example Scenario
Suppose a private Australian entity has total net debt deductions of AUD 3 million, including related party debt, and its calculated EBITDA is AUD 10 million. Under the fixed ratio test, deductions are capped at $3 million × ratio limit = $3 million actually allowable (that is 30% of EBITDA). If net debt deductions are $4 million, deductions above $3 million are denied—but may be carried forward if fixed ratio chosen.
If same entity picks third-party debt test, it must exclude all related party debt, regardless of amount, but may allow full third-party debt if unrelated. No carry forward.
Compliance Penalties & Timing
- Legislation is already law. (ato.gov.au)
- For income years starting 1 July 2024, entities must ensure debt deduction creation rules are observed. Non-complying deductions can be denied altogether.
- Violations may also lead to adjustments, audits, and Senior Executive penalties.
Takeaway
Entity-based structuring demands careful alignment with laws effective since 2023-24 and fully in force by 2024-25. Whether choosing fixed ratio, group ratio, or third-party test, each comes with its documentation, disclosure, and compliance burden—but also potential tax savings. Get advice, model scenarios, adjust financing as needed to retain more deductions legally.