Australia's earnings-based thin capitalisation rules from 1 July 2024
How the 2024 thin capitalisation reforms replaced safe harbour gearing tests with an EBITDA-based fixed ratio test for general class investors.
Why the rules changed
The thin capitalisation rules have undergone significant changes as a result of the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share — Integrity and Transparency) Act 2024. This Act was passed by Parliament on 27 March 2024 and received Royal Assent on 8 April 2024.
The reform aims to align Australia’s thin capitalisation regime more closely with the OECD’s Base Erosion and Profit Shifting (BEPS) Action 4 recommendations. These recommendations focus on limiting the ability of multinational companies to reduce their tax liabilities through excessive debt.
The amendments have different application dates. The main thin capitalisation rules apply to income years commencing on or after 1 July 2023. The rules relating to the creation of debt deductions take effect from 1 July 2024.
The fixed ratio test (FRT)
The Fixed Ratio Test is the default method for determining compliance with Australia’s thin capitalisation rules for general class investors. This test assesses the ratio of a company’s net debt to its tax EBITDA.
Under the FRT, a company’s net debt deductions are restricted to 30% of its tax EBITDA. Any net debt deductions that exceed this 30% limit are disallowed.
Deductions denied under the FRT can be carried forward. These carry-forward deductions can be used in subsequent years, provided the carry-forward criteria are met and remain unexpired after 15 years.
Group ratio and third-party debt tests
The group ratio test replaces the previous worldwide gearing test. This test determines compliance with the thin capitalisation rules and is based on the worldwide group’s net third-party interest expense to EBITDA ratio.
A third-party debt test is available as an alternative election. If eligibility requirements are met, this election allows 100% of certain third-party debt deductions.
Financial entities and ADIs remain subject to bespoke rules and are not considered ‘general class investors’ for the purposes of these rules.
Debt deduction creation rules (DDCR)
The debt deduction creation rules (DDCR) restrict the ability to claim deductions for interest expenses on related-party loans. These rules specifically target loans used to fund asset acquisitions or prescribed payments.
The DDCR take effect for income years commencing on or after 1 July 2024. A de minimis threshold of $2 million in associate-inclusive debt deductions remains in place.
The DDCR operate in conjunction with the existing thin capitalisation rules; compliance with both sets of rules is required. The 90% Australian assets exemption for outward investing entities is also retained.
Frequently asked
Are small businesses caught by thin cap?
No. The de minimis threshold means entities with associate-inclusive debt deductions of $2 million or less are exempt from the thin capitalisation rules. Most small businesses are below this threshold.
Do the new rules apply to trusts?
Yes. Thin capitalisation applies to companies and trusts that are 'general class investors' and have foreign-related party or foreign-controlled financing.