The quiet cost of borrowing. By Sharon Grice and Nicholas Mirarchi at William Buck.
The Australian Government has legislated changes that tightened restrictions under the thin capitalisation provisions. In this article, we explore what this could mean for Australian manufacturers.
What is thin capitalisation?
Thin capitalisation rules aim to limit Australian debt deductions, such as loan interest, line fees or other borrowing costs. The overarching policy intends to avoid profit shifting by multinational entities through excess debt deductions in Australia.
For manufacturers, we see that these companies constantly grapple with thin capitalisation:
- Australian manufacturing companies that are expanding and have overseas subsidiaries
- Australian manufacturing companies that are foreign-owned and growing in the Australian market, or
- a combination of the above.
The thin capitalisation provisions are commonly triggered when one of the above entities has total debt deductions exceeding $2m in a tax year. If the total debt deductions of the company and all its associates for that year are below $2m, these rules do not apply.
Before the recent changes, our experience was that many Australian manufacturers relied upon a ‘safe harbour’ ratio test. This broadly allowed debt deductions to be deducted when the debt-to-equity ratio was 1.5:1 (60% of the entity’s Australian assets).
What changes were made to thin capitalisation?
From 1 July 2023, if that entity has debt deductions exceeding $2m, it can choose to apply one of the new threshold tests below to calculate the amount, if any, of the denied debt deduction.
- The Fixed Ratio Test
- The Group Ratio Test
- The Third-Party Test
The changes also include the addition of a new integrity rule, which will apply to income years on or after 1 July 2024 if the debt finance arrangement was in place before 22 June 2023. Broadly, debt deductions must be directly linked to income-producing assets or activities; otherwise, the integrity rule will prevent the deduction of interest on non-income-producing debt.
Fixed Ratio test (the EBITDA test)
The thin capitalisation rules now shift the focus for manufacturers to an earnings-based analysis, intended to replace the previous ‘safe harbour’ test.
For manufacturers using this test, we calculate 30% of their tax earnings (i.e., taxable income) before interest, taxes, depreciation, and amortisation (EBITDA). Any debt deductions exceeding this calculated limit are disallowed, with the option to carry forward denied debt deductions for up to 15 years.
While this new test may be clear and straightforward, we have found that manufacturers with slim margins or loss-makers have had debt deductions denied in full under this test. This is particularly so for manufacturers scaling up or using debt funding to expand new operations.
Group Ratio test
The group ratio test considers a multinational corporation’s worldwide financial position. It limits net debt deductions by calculating a ratio of the worldwide group’s net interest expense and tax EBITDA above, as found in the group’s financial statements.
Unlike the fixed ratio test, denied debt deductions cannot be carried forward as part of this test. However, this test is a viable alternative to the Fixed Ratio Test for Australian manufacturers that are subsidiaries of large and sophisticated global groups. For example, if there is a high reliance on inputs or raw materials from related parties, that could impact margins and EBITDA.
Third-Party Debt test
This final test distinguishes between third-party and related-party debt. Under this test, only debt deductions attributable to external debt are allowed, while deductions associated with related-party debt are denied. For Australian manufacturers that are largely reliant upon external third-party debt finance, as opposed to related party finance, we find that this test would be most applicable if the third-party finance is secured against Australian real property or assets and is exclusively being used to fund the Australian business and ongoing investment. Ordinarily, even if third-party debt gives rise to debt deductions exceeding AU$2 million, the thin capitalisation provisions may still deny a deduction.
Under this test, there is also no provision for carrying forward denied debt deductions in this test. The application of the third-party debt test can become technical and requires expert input, as there are strict conditions to be met when analysing financing arrangements.
What should manufacturers do?
Manufacturing businesses demand a significant level of upfront capital investment in things such as plants, equipment and research and development. Critically, many manufacturers rely on debt finance as opposed to capital raising. For example, foreign-owned manufacturers may depend upon the global financing of their overseas parent, whereas Australian manufacturers expanding overseas may rely upon a mix of third-party or related-party debt finance.
Characteristics of proactive debt funding strategies we see are:
- Constantly reviewing whether it is aligned with the strategies and goals of the entity.
- A sound understanding of how thin capitalisation applies to the optimum level of debt deductions.
- An application of transfer pricing in relation to related party debt (inbound or outbound).
Proactively understanding the impact, if any, of thin capitalisation is also a great example of effective governance within your business.
If you have a manufacturing business that relies on debt funding, consideration of thin capitalisation should be a part of your financial strategy and modelling. William Buck’s advisory team can discuss what thin capitalisation may mean for your business and work with you to add value to your strategic and financial decisions.