CPA flags ‘major deficiencies’ in thin capitalisation changes

CPA Australia has urged the government to defer the commencement date of amendments to the thin capitalisation rules until at least after Royal Assent.

The commencement date of the measures in the bill apply from 1 July 2023, with the bill still yet to be passed as law.

“Many areas require further clarity and resolution and the retrospective application is unfair to taxpayers,” the accounting body sad in a submission to the Senate Economics Legislation Committee.

The submission has also asked the government to consider changing the $2 million de minimus threshold from a gross basis to a net basis given the introduction of the ‘net debt deduction’ concept.

“This would prevent taxpayers being caught where amounts are duplicated within a group and being counted twice,” the submission said.

“As an example, an amount borrowed and on-lent to a related party resulting in $1 million of interest on each leg of the back-to-back loan would result in $2 million total debt deductions in the group. Under a net debt deduction test there would more appropriately be $1 million of net debt deductions as the interest income derived by the interposed entity would reduce the $2 million gross amount to a $1 million net amount.”

Major issues with the third party debt test

CPA Australia said there are currently major deficiencies with the third party debt conditions in section 820-427A(3).

“In particular, the limited recourse rule in s 820-427A(3)(c), which only allows the external lender to have recourse to the assets of the borrowing entity.

“Very few third party lenders will lend having recourse to the assets of the borrowing entity only, instead they will require assets of related entities as security and guarantees. In its present form, most third party lenders will not satisfy the third party debt test.”

The submission also said the test didn’t make sense given the concept of obligor group in s 820-48, which results in entities also being deemed to make a third party debt test choice where they provide a guarantee or security in relation to a debt incurred by an entity that made a third party debt test (TPDT) election.

“This deemed choice only makes sense if a lender can have recourse to the assets of entities other than the borrower in the first place. However, where this borrowing is done via a related conduit that satisfies the conduit financing conditions in s 820-427C, the rules appear to allow the lender to now have recourse to the assets of entities that are members of the obligor group (refer to s 820-427B(4)(b)(i)),” the submission said.

“This is the appropriate outcome and the treatment of borrowing via a related conduit borrowing from an external lender directly should be treated similarly.”

Another issues is the requirement for on-lending by the conduit financer to be on the same arm’s length terms.

“This means where the conduit financer on-lends third party borrowing on non-arm’s length terms, the recipient entity, which could be related group entities, will be denied its debt deductions,” the submission said.

“The other main issue with the third party debt test is that the conditions can only be satisfied by an ‘Australian resident’ as per s 820-427A(3)(e). This term links back to the definition in s 6(1) of the ITAA 1936, which only covers individuals and companies. This means that trusts and partnerships are effectively excluded entirely from accessing this third party debt test.”

Further consultation needed on debt creation rules

CPA Australia said that further consultation was needed on the debt creation rules which were added to the bill and not included in the Exposure draft.

“They were developed without consultation. The proposed rules are extremely broad and go far beyond the stated purpose of attacking debt creation schemes that lack commercial justification,” it said.

“For example, they will apply to deny debt deductions where an entity borrows, including from a bank, to purchase trading stock from a related entity or simply to establish a subsidiary entity.”

The rules also apply to wholly domestic schemes that do not involve payments being transferred offshore despite the EM referring to profit-shifting arrangements.

“The former Division 16G of the Income Tax Assessment Act 1936 (ITAA 1936), which these rules are stated to be modelled on, had sensible exclusions for these exact kinds of ordinary transactions. The current proposed rules have no exclusions at all and have no tax purpose test,” said CPA Australia.

The rules also appear to “attack non-consolidated structures common in small and medium enterprises”, the submission said.

“For example, a group could have an operating entity, a finance entity and a service entity. If the operating entity borrows from the finance entity for working capital and also pays service/management fees to the service entity, these would now appear to result in denied deductions,” it stated.

“By contrast if this was in a tax consolidated group then this would not result in any denials because of the single entity rule.”