Property development and thin cap changes

The Treasury Laws Amendment (Measures for Future Bills) Bill 2023: Thin capitalisation interest limitation is an important piece of legislation that is designed to limit the amount of interest expenses that entities can claim as tax deductions.

This legislation is aimed at preventing entities from using excessive debt financing and interest deductions to reduce their taxable income.

The thin capitalisation rules have been in place in Australia for many years, however the new legislation seeks to make the rules more effective in limiting the amount of interest (and payments economically equivalent to interest) that entities can claim as deductions.

This legislation is expected to have a significant impact on the property development sector in Australia. This article will explore the potential impact of the draft 2023 thin capitalisation legislation on the property development sector in Australia.

Background      

Thin capitalisation is a tax strategy used by entities to reduce their overall tax liabilities.

It involves entities financing their assets and business operations with a higher proportion of debt than entity and using the interest payments on that debt as a tax deduction. Notwithstanding the current asset based thin capitalisation rules, transfer pricing rules, hybrid mismatch targeted financing integrity rules, as well as a raft of other integrity provisions addressing debt deductions, the Government perceives a risk to the domestic tax base and has sought to further reform the thin capitalisation rules in line with OECD best practices.

Broadly, the current thin capitalisation rules require entities to maintain a certain level of equity in proportion to their debt. If an entity’s debt level exceeds the allowable limit, then the interest payments on the excess debt cannot be claimed as tax deductions. The new legislation aims to make these rules more effective by introducing the Thin Capitalisation Interest Limitation (“TCIL”) provisions.

What are the changes?

The TCIL provisions will rewrite the way in which the thin capitalisation rules operate in Australia.

The existing rules are designed to limit the debt deductions that an entity can claim for tax purposes based on the amount of debt used to finance its operations compared with its level of equity, by restricting the amount of interest deductions an entity can have based on its level of assets.

This approach historically indirectly limits the amount of debt an entity can use to generate allowable interest deduction. However, OECD BEPS Action Item 4 sets out a more direct approach to limit the interest expenses an entity can claim.

The proposed draft legislation seeks to follow OECD best practice guidance, which recommends linking an entity’s net interest deductions (and payments economically equivalent to interest) to its level of economic activity within Australia, measured using an entity’s earnings before interest, taxes, depreciation and amortisation (i.e., a “tax EBITDA”).

Under the draft legislation the default earnings-based tests for ‘general class investors’ will apply, being a fixed ratio test that replaces the existing safe harbour test. An entity may elect to apply a group ratio test to apply that replaces the existing worldwide gearing test. In addition, the draft legislation introduces an external third-party debt test for general class investors and financial entities that are not ADIs.

Under the draft legislation:

• The ‘general class investor’ definition is proposed to be introduced. The definition is a consolidation of the previous general classes of entities which included ‘outward investor (general)’, ‘inward investment vehicle (general)’ or ‘inward investor (general)’.
• Two earnings-based tests (being the fixed ratio test and the group ratio test) have been proposed that will disallow an amount of an entity’s debt deductions based on the entity’s earnings or profits.

Fixed ratio test (default)

• The fixed ratio test allows an entity to claim net debt deductions up to 30 per cent of its ‘tax EBITDA’, which is broadly, the entity’s taxable income or tax loss adding back deductions for interest, decline in value, capital works and prior year tax losses (if the amount is less than or equal to zero the entity cannot claim any debt deductions in that year).
• Under the fixed ratio test, a special deduction is allowed for debt deductions that were previously disallowed under the fixed ratio test if an entity has excess capacity under the fixed ratio test in a subsequent year (i.e., the entity’s net debt deductions are less than 30 per cent of its ‘tax EBITDA’ for an income year). Debt deductions disallowed over the previous 15 years can be claimed under this special deduction rule. However, currently under the proposed draft rules, if an entity does not use the fixed ratio test in a subsequent income year, the entity loses the ability to carry forward any existing fixed ratio test disallowed amounts for income years going forward (that is, entities must continue to use the fixed ratio test every year to maintain access to the special deduction allowance).
• The special deduction is included as part of the fixed ratio test to address year on year earnings volatility concerns for businesses which limit their ability to claim debt deductions depending on their economic performance for an income year, although can only be carried-forward (not backwards).

Group ratio test (election)

• The group ratio test can be used as an alternative to the fixed ratio test for more highly leveraged groups. The group ratio test allows an entity in a highly leveraged group to potentially deduct net debt deductions in excess of the amount permitted under the fixed ratio rule, based on a relevant financial ratio of the worldwide group.
• If the group ratio test applies, the amount of debt deductions of an entity for an income year that are disallowed is the amount by which the entity’s net debt deductions exceed the entity’s group ratio earnings limit for the income year.

External third-party debt test (election)

• The external third-party debt test allows all debt deductions which are attributable to third party debt and that satisfy certain other conditions. This test replaces the arm’s length debt test for all entities previously subject to the arm’s length debt test.

Impact on the property development sector

The impact of the TCIL provisions on the property development sector in Australia will largely depend on the financing structure of individual businesses (and the groups that they form part of) within the sector.

The property development sector often relies heavily on debt financing, which makes it particularly vulnerable to the new legislation.

The new legislation may result in higher economic costs for property developers, as they will no longer be able to claim as much interest as tax deductions. This could make it more difficult for some developers to obtain financing, particularly if they have a high level of debt. It may also result in a shift towards equity financing, which could be more expensive for some businesses.

Another potential impact of the TCIL provisions on the property development sector is a decrease in the overall level of investment in the sector. This could occur if the new legislation makes it less attractive for foreign investors to invest in Australian property development projects. To the extent investors are further limited to the amount of interest expenses that can be claimed tax deductions, they may be less likely to invest in the sector.

On the other hand, the new legislation may also result in more stable investment in the property development sector. By limiting the amount of interest that entities can claim as tax deductions, the proposed draft legislation may encourage developers to use more equity financing. This could result in a more stable financial structure for businesses in the sector, which may be less vulnerable to market fluctuations in interest rates and reduce their overall risk exposure.

Furthermore, the new legislation could lead to increased competition within the property development sector. Developers that are less reliant on debt financing may have a competitive advantage over those that rely heavily on debt financing. This could lead to a more efficient and competitive property development sector in the long run.

Potential strategies for property developers

In light of the draft thin capitalisation legislation, property developers may need to consider new strategies to maintain profitability and competitiveness.

One potential strategy is to focus on equity financing rather than debt financing. This could involve seeking out new equity partners or issuing new shares to raise capital for projects.

Foreign owned Australian property developers should consider its current funding arrangements and whether they need to restructure or refinance these in anticipation of the proposed rules. It will also be prudent to assess the viability of electing to use the group ratio test and the impact that using this may have on any carry-forward deduction under the fixed ratio test.

Another strategy is to reduce overall borrowing costs by negotiating better loan terms with lenders. This could involve negotiating lower interest rates or longer repayment periods to reduce the impact of the new legislation on tax liabilities. Developers may consider refinancing strategies to retain completed developments for the longer term to ensure that disallowed interest deductions that are carried forward are ultimately utilised in future years.

Property developers will need to focus on reducing overall costs to maintain profitability in the face of rising interest rates and reduced tax deductions. This could involve finding ways to streamline processes, reducing overheads, and adopting new technologies.

Conclusion

Overall, the impact of the TCIL provisions on the property development sector in Australia is likely to be significant.

The sector is particularly vulnerable to the new legislation due to its reliance on debt financing, which may result in higher financing costs and a decrease in investment. However, it is also possible that the legislation could result in a more stable financial structure for businesses in the sector.

The impact of the new legislation will ultimately depend on the individual financing structures of businesses within the sector, and how they adapt to the new rules. While the draft rules are under consultation, property developers that will be impacted by these changes should be taking proactive steps to restructure, refinance, or otherwise minimise its impact.

For more information

To learn more about the new legislation and how it can affect you and/or your business, please reach out to your local RSM adviser today.

Related Articles & Insights