BDO Global Tax Alert

Budget 2022-23 includes measures affecting MNEs, including changes to the thin cap rules

27 October 2022

Australia’s Federal Budget was presented on 25 October 2022 against a backdrop of uncontrollable global turmoil—from a pandemic to natural disasters, war, an energy crisis and inflationary pressures. While the primary focus of the budget targets the pressures on the population—cost of living, childcare, paid parental leave, costs of medicine, housing affordability and wage growth, it includes measures affecting multinational enterprises (MNEs), including proposals to revise the rules on the deductibility of interest expense and payments for intangibles made to low or no-tax jurisdictions, introduce new reporting requirements and adopt a tax position on the tax treatment of digital currencies.

BDO Australia has prepared a comprehensive analysis of the full budget 2022-23 proposals, which can be accessed here.

Multinational tax integrity: limiting interest deductions

Thin capitalisation rules

The budget includes proposed changes to Australia’s thin capitalisation rules (that apply to taxpayers with overseas operations) for years starting on or after 1 July 2023 to bring Australia in line with the OECD’s recommended approach. Under the current thin capitalisation rules, the deduction of interest on the debt of MNE taxpayers is limited by the following tests:

  • The safe harbour debt amount (an asset-to-debt ratio);
  • The worldwide gearing debt amount (based on the debt ratio of the worldwide group); and
  • The arm’s length debt test.

The proposed changes would replace the safe harbour and worldwide gearings tests with an earnings-based test. Specifically, the measures would:

  • Limit an entity’s debt deductions to 30% of EBITDA (earnings before interest, taxes, depreciation and amortisation). This test would replace the existing safe harbour rules and would allow taxpayers to carry forward disallowed deductions to subsequent income years;
  • Replace the worldwide gearing test to allow an entity in an MNE group to claim debt deductions up to the level of the worldwide group’s net interest expense as a share of earnings; and
  • Retain an arm’s length debt test as a substitute test that would apply only to an entity’s external (third-party) debt, disallowing deductions for related party debt.

New arm’s length debt test

The arm’s length debt test follows the market approach that considers the amount of debt a stand-alone Australian business would reasonably be expected to borrow from independent commercial lenders operating at arm’s length. This often places a higher reliance on debt-to-asset and debt-to-equity ratios that are less likely to be volatile than earnings tests. It should be noted that although the arm’s length debt test would remain as a substitute test, the test would now only apply to an entity’s external (third-party) debt. All related party debt deductions would be disallowed under this test. Under this change, it is evident the Australian Taxation Office (ATO) would place a greater focus on the use of related party debt to fund an Australian taxpayer's business, which would require taxpayers to consider this matter further when determining the best way to finance their Australian operations.

BDO comment

If enacted, the proposed measures are likely to significantly increase the compliance burden for a wide range of taxpayers, adding to an already complex compliance landscape. Whilst these changes may give a certain competitive advantage to Australian taxpayers with local operations, they would ultimately lead to greater uncertainty for MNEs. This potentially could negatively impact the level of investment into Australia by MNEs in the long run. Overall, it is disappointing to see the government implementing these changes without considering more targeted measures for taxpayers that have limited capacity to manage the complexity, cost and time required to deal with these new measures. There is one silver lining, however: under the proposed legislation, debt deductions denied in one year could be carried forward for use in future years, whereas currently interest deductions disallowed under the thin capitalisation rules are permanently lost.

Disallowing deductions for payments relating to intangibles held in low or no-tax jurisdictions

The government announced an anti-avoidance provision to prevent significant global entities (SGEs, typically defined as members of a global group with gross revenue of at least AUD 1 billion) from claiming tax deductions for payments made directly or indirectly to related parties in relation to intangibles held in low or no-tax jurisdictions. A low or no-tax jurisdiction is defined as a jurisdiction with a tax rate of less than 15% or a tax preferential patent box regime without sufficient economic substance. The measure would apply to payments made on or after 1 July 2023 and is estimated to increase tax receipts by AUD 250 million up to 2025-26.

Currently, payments to related parties in relation to intangibles are deductible for income tax purposes subject to the taxpayer complying with:

  • Withholding tax obligations;
  • Hybrid mismatch provisions;
  • Transfer pricing provisions; and
  • Published ATO guidance, such as Practical Compliance Guidelines.

The deductions may be disallowed if any of the requirements in the above rules are not met, regardless of the tax rate applicable to the recipient entity.

BDO comment

By adding a new measure to address the perceived risk of integrity issues associated with payments related to intangibles and royalties over and above the existing provisions, it is likely compliance costs for both taxpayers and the ATO would increase. Given the brevity of the budget papers, it is unclear as to how “payments for intangibles” would be defined, and in particular whether embedded royalties (i.e., royalties embedded into the product price) are intended to be included by the measure. The recent consultation paper issued by the Australian Treasury implies this is being strongly considered. If this outcome eventuates, additional guidance would be required from the ATO, and compliance costs for affected taxpayers would further increase again, as it would generally be a complex and subjective exercise to analyse payments into discrete components and evidence the process under which portion of a charge would be deemed to be an embedded royalty.

Australia’s existing integrity rules, including the transfer pricing rules and general anti-avoidance provisions, already seek to address several of the perceived issues targeted by the proposed rule (such as the low tax rate in the case of the hybrid mismatch rules or the requirement for substance in the case of the transfer pricing rules). Australian groups with relationships to low-tax jurisdictions, such as Hong Kong, Ireland and Singapore, used as centralised hubs for intangibles would need to reconsider these arrangements due to the risk of double taxation. There also remains a risk of a denial of deductions even where substantial activity (resulting in intangibles) is carried on in a country with a low tax rate. The rules could result in an economically appropriate and arm’s length payment being denied deductibility, which could decrease Australia’s competitiveness in attracting foreign investment.

Improved tax transparency

The government has proposed measures intended to enhance reporting requirements for large multinationals, Australian public companies and tenderers for Australian government contracts worth more than AUD 200,000 by requiring the public release of certain tax-related information. This reflects an expansion of the current approach in Australia, under which the amount of tax-related information currently made public by the ATO is limited in nature. This improved level of tax transparency is intended to increase scrutiny of large MNEs’ tax affairs and thereby improve public trust in the Australian tax system.

Under the proposals, the government would require:

  • SGEs (i.e., large MNEs with worldwide turnover of more than AUD 1 billion) to disclose certain tax information on a country-by-country (CbC) basis, together with a statement on their approach to taxation for disclosure by the ATO;
  • Australian public companies (listed and unlisted) to disclose information on the number of subsidiaries and their country of tax domicile; and
  • For tenderers for Australian government contracts that are worth more than AUD 200,000 to disclose their country of tax domicile.

BDO comment

Noting that the EU recently announced similar requirements, a question remains as to how these measures would impact foreign investments from non-European countries, as well as Australia’s existing commitment to keep the information that is disclosed as part of the CbC reporting private (under Action 13 of the OECD BEPS Action Plan). It is also debateable whether the announced measures target companies proportionately, as several large Australian taxpayers (with global income less than AUD 1 billion) would not be impacted to the same degree as Australian subsidiaries of overseas SGEs, which can have relatively small operations in Australia, compared with their global footprint.

What is clear is that this measure would increase the compliance burden for impacted taxpayers and increase the chance of reputational damage due to tax-related disclosures being put in the public domain without sufficient context or explanation. The public needs greater understanding of the contribution large taxpayers make to the community in terms of tax paid, but the information needs to be presented in a format that is easy for the public to digest and understand. It is uncertain whether publishing information on a CbC basis would achieve this goal, as existing CbC disclosures are not straightforward. It is also unclear whether this measure applies to all SGEs, many of which do not currently need to prepare CbC information. More guidance is needed.

Taxation of digital currencies

The government has committed to treating digital currencies not issued by or under the authority of sovereign governments as a capital asset, rather than as foreign currency. Currently, there is an argument that digital currencies could be treated the same as foreign currencies, where the gain or loss on their use is assessable or deductible. This change provides some clarity to taxpayers on their reporting obligations by vocalising a consistent “bright line” going forward. Taxpayers would be entitled to the 50% capital gains tax discount on any profits realised but would no longer be entitled to claim a deduction for any losses against ordinary income, unless they could show they hold the cryptocurrency on revenue account.

BDO comment

The government’s decision to exclude digital currencies from being treated as foreign currency is understandable but doing so leaves taxpayers to navigate the difficult question of whether a particular transaction is on revenue or capital account each time they trade. We hope the Board of Taxation’s current inquiry into the tax treatment of digital assets produces a coherent set of principles for their taxation. Until then, taxpayers transacting in cryptocurrency must make difficult technical tax distinctions.

Neil Billyard