Thin cap overhaul goes ‘too far’, warns tax expert
Legitimate business transactions will be collateral damage in the government’s crackdown on multinational tax avoidance.
Reforms to thin capitalisation rules go “too far” and will stifle commercial activity by “exponentially” increasing funding costs for businesses, a tax expert warns.
The government’s proposed changes aimed to restrict the amount of interest deductions that multinational companies could claim, but Andersen Australia national tax director Meng Lee said they “attacked” legitimate transactions.
“Conceptually, the new rules might make sense, but the way they’re drafted basically backs taxpayers into a corner,” he said.
Mr Lee said the most disruptive change would be scrapping the thin capitalisation “safe harbour” test for non-financial institutions. Its replacement, a fixed ratio test that capped interest deductions at 30 per cent of a company’s EBITDA, would cast its net too wide, capturing legitimate transactions and hurting capital inflows.
“Under the old rules, as long as you had maintained a certain debt-to-equity ratio, you could deduct your interest expenses. But the lack of exclusions in the fixed ratio test means that it doesn’t matter whether it’s a legitimate arrangement or an illegitimate arrangement, it will apply.”
“And there’s a lot of plain vanilla commercial arrangements that are going to be negatively impacted by this,” he said. “The cost of funding for companies with Australian operations will go up because all of a sudden, a proportion of the interest that they were paying is now no longer deductible.”
He expected it to severely impact capital-intensive industries in particular.
Infrastructure projects and other early start-up businesses, which often experience a lag between initial funding and profit generation, would be denied interest deductions under the fixed ratio test.
“Because the new rules are based on earnings, if you have no earnings, then you can’t deduct anything,” he said.
“So if you have got a start-up business funded by overseas debt, your cost of funding has just gone up exponentially.”
Mr Lee said this increased cost of funding, coupled with the proposed retrospective application of the laws, would cause many businesses to reassess their plans.
“If you entered into an arrangement before 1 July 2023, based on the old rules and are still paying interest and base all your modelling on those conditions, these new rules would throw all of your modelling out the window. A multimillion-dollar project might not be feasible anymore. It’s got some real-world impacts.”
While there were alternate tests to the fixed ratio test, such as the group ratio and external third-party debt tests, Mr Lee said they applied too narrowly.
“The third-party debt test works by allowing you to deduct interest expenses in relation to debt from a third party such as a bank. But if your foreign parent guarantees the loan, that is not considered third-party debt, and you can’t deduct the interest.
“And this is an illustration of how the rules are not well targeted, because every Australian subsidiary that borrows from the bank, the bank will not lend to that subsidiary unless the foreign parent guarantees it.”
Mr Lee said the regime should include an overarching purpose of transactions through a “tax purpose” test which would take the facts and circumstances of commercial arrangements into account.
“The view by most practitioners is that it’s understandable the government has gone down this route, but there should have been some sort of overarching purpose test place on these rules. Without that, it’s definitely gone too far,” he said.
“It’s like using a sledgehammer to crack a walnut.”
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