Summary of the 2022 October Australian Federal Budget
On 25 October 2022, Labor Treasurer Jim Chalmers delivered the Federal Budget, offering few new incentives or impediments to business and instead focusing on delivering election promises, addressing inflation and setting the stage for more substantial changes in the May 2023 Budget.
The Budget had little structural change for the Australian economy or her tax regimes.
Perhaps signalling economic expectations for the next 18 months, $15 million over two years will be used to extend existing programs to support the financial and mental wellbeing of small business owners. The Budget papers identify inflation peaking at 7.75% in late 2022, taking two years to recede. Economic growth will be significantly curtailed, from 3.25% in the current financial year to 1.5% in 2023-24, accompanied by unemployment rising to 4.5%.
Below is a brief summary of areas most relevant to the clients of global Meritas members.
Financing and Investment
Reform of the thin capitalisation rules
The Federal Government will implement significant reforms to the thin capitalisation rules for non-financial entities from 1 July 2023. The measures will adopt OECD recommendations and apply to entities that are members of multinational groups (both inward and outward investing entities).
A proposed earnings-based test will limit debt deductions for an income year to 30% of an entity’s Earnings Before Interest, Taxes, Depreciation and Amortisation (EBITDA). This will replace the current asset-based safe harbour test which denies deductions where an entity’s average debt exceeds 60% of the average value of its assets for the year.
The alternative arm’s length debt test will be retained but will be limited so that it can only be relied on to support debt deductions on external (unrelated party) debt.
The proposal will also adopt an alternative group ratio rule allowing an entity to claim debt deductions above the 30% EBITDA ratio based on its worldwide group’s net interest expense ratio (as a share of earnings). This will replace the existing asset-based worldwide gearing test.
Unlike the current thin capitalisation rules which operate to permanently deny excessive debt deductions, the earnings-based rule will allow denied interest deductions to be carried forward up to 15 years.
While the measures are targeted at large multinational groups, the thin capitalisation rules apply to many entities in the middle market which are majority foreign-owned or have foreign operations.
The earnings-based test will particularly affect property developers, property funds and miners which may incur debt deductions in the early years of a project prior to generating income. In these projects, any change to the debt/equity mix may affect investor returns on equity and performance fees earned by fund managers.
The Federal Government is silent on any grandfathering or transitional relief such that the measures will apply from 1 July 2023 to entities with pre-existing arrangements. Such entities may therefore be significantly affected where long-term borrowings have been committed and may not be easily renegotiated.
Entities who were funded to ensure that they complied with the current 60% safe harbour may now find that the deductibility of a significant portion of their interest costs will be deferred affecting projected returns.
Many aspects of the measures are still unknown including what adjustments are required to the EBITDA (such as for tax losses and intra-group distributions), whether the measures will apply to net interest expenses (as per BEPS Action 4) or gross interest expenses, whether capital gains will form part of EBITDA and if and how the excess debt capacity of related entities will be factored into the calculations.
The de minimis rule, which permits entities to deduct up to $2 million of annual interest expense prior to application of the thin capitalisation rules remains unchanged.
The Government will introduce legislation to clarify that digital currencies will not be treated as foreign currency for Australian tax purposes.
This maintains the current tax treatment of digital currencies, including the capital gains tax treatment where they are held as an investment.
This measure removes uncertainty following the decision of El Salvador to adopt Bitcoin as legal tender and will be backdated to income years that include 1 July 2021.
Digital currencies issued by, or under the authority of, a government agency will continue to be taxed as foreign currency.
Restricting royalty deductions for Significant Global Entities
In keeping with the commitment to multinational tax integrity, the Federal Government announced that it will introduce an anti-avoidance rule to prevent Significant Global Entities (SGEs) from claiming tax deductions for payments made directly or indirectly to related parties concerning intangibles held in tax havens (i.e. jurisdictions with a tax rate of less than 15% or a tax preferential patent box regime without sufficient economic substance).
This measure complements the ATO’s recent focus on the treatment of payments relating to intangibles and royalties.
The proposed integrity rule will apply to payments made on or after 1 July 2023, which is consistent with other proposed multinational integrity changes.
While this provided some clarity around the entities and types of payments that will be subject to the provision, there are still some uncertainties. Of particular interest will be what is included within the definition of ‘intangibles’.
There is also no mention of a purpose test, unlike many other anti-avoidance provisions in the tax law. This may result in many more payments being caught by the new anti-avoidance rule.
The Budget confirms that the measure previously announced in the 2021-22 Budget to relax residency requirements for self-managed superannuation funds (SMSFs) and small APRA-regulated funds (SAFs) by extending the safe harbour for the central control and management test from two to five years for SMSFs and removing the active member test for both fund types is still proposed. Failing the ‘residency’ requirement can render SMSFs and SAFs non-complying, which can have serious financial consequences.
These changes will make it easier for members to retain and contribute to such funds whilst they are temporarily overseas for work or education.
Public reporting requirements for SGEs
The Budget has extended current tax transparency requirements to now include new public tax disclosure requirements. Specifically, for income years commencing from 1 July 2023:
- SGEs will be required to publicly release certain tax information as well as a statement on their approach to taxation;
- Australian public companies (both listed and unlisted) will be required to disclose information on the number of subsidiaries and their country of tax domicile; and
- Entities which tender for Australian Government contracts worth more than $200,000 will be required to disclose their country of tax domicile (by supplying their ultimate head entity’s country of tax residence).
The details concerning what information will require disclosure and how the information will be disclosed (i.e. through ATO publications or within existing financial accounts) is unclear.
Increase in penalty unit amount
The Federal Government will increase the amount of the Commonwealth penalty unit from $222 to $275, from 1 January 2023. These penalty units generally apply to offences ranging from making false or misleading statements to late lodgements.
SGEs will be most impacted as their administrative penalties are calculated based on double penalty units while late lodgements are multiplied by 500. This means that the current maximum failure to lodge penalty for any missed statement will increase from $555,000 to $687,500 for SGEs.
Change in treatment of off-market share buy-backs
The Federal Government will target investors of listed companies who undertake off-market share buy-backs. Currently, the tax law distinguishes between a share buy-back made in the ordinary course of trading on an official exchange (on-market buy-backs), and all other share buy-backs (off-market buy-backs).
Under existing rules, a company that undertakes an off-market share buy-back is required to allocate the buy-back proceeds received by the shareholder between two components, a dividend component (which can be franked), and a capital component; the proportion split often based on the relative composition of the company’s retained earnings and paid-up share capital.
However, where a buy-back occurs on-market, the whole of the buy-bck proceeds is treated as capital and no franking credit attaches to the distribution. .
Off-market share buy-backs have been used as a strategy by listed companies to better utilise their excess franking account balances and to provide increased returns to shareholders on low rates of tax such as superannuation funds and individuals on low marginal rates of tax. Such shareholders are able to receive a tax refund to the extent the company’s tax rate exceeds their own tax rate.
The tax treatment of off-market buy-backs by listed companies will now align with on-market buy-backs; no part of the consideration for the off-market share buy-back will be taken to be a dividend.
Whilst the effective tax rate for an individual on the top marginal tax rate deriving a discount capital gain is similar to that when receiving a fully franked dividend the changes would be expected to impact the investment returns of superannuation funds.
If enacted, the measures will apply from 7:30pm on 25 October 2022 (Budget Night) and may result in the discontinuation of a number of off-market share buy-backs currently being contemplated by listed companies.
Announced but not enacted
Leading into the most recent Budget there were approximately 70 previously announced measures that had not yet been enacted. The Federal Government has provided clarity in respect to only 12 of these measures, leaving taxpayers uncertain as to the Federal Government’s position on the remaining measures.
Taxation of financial arrangements
The Federal Government will not proceed with previously announced measures to amend the Taxation of Financial Arrangements (TOFA) rules.
The original announcement primarily concerned the re-write of the TOFA provisions to allow financial institutions to better align with accounting principles, and to provide simplified rules for non-financial institutions.
The Federal Government instead has confirmed that it intends to proceed with minor technical amendments to facilitate access to hedging on a portfolio basis.
The integrity rule on back-to-back equity and debt financing
The Federal Government announced that it does not intend to proceed with reforms to the integrity rule (section 974-80) that sought to recharacterise debt interests in a company as equity interests where debt is funded by related party equity.
The ATO has historically taken a very broad view of this integrity provision, which led to an announcement in the 2011-12 Budget that the law would be amended to remove unintended consequences.
By not proceeding with the measure, there is a risk that the ATO may return to their original views expressed on section 974-80. It will therefore be critical for the ATO to clarify how they will seek to apply this integrity rule going forward.
Limited partnership collective investment vehicles
The Federal Government has chosen not to proceed with previous announcements to introduce a Limited Partnership Collective Investment Vehicle (LPCIV).
LPCIVs are a globally recognised investment vehicle and, in addition to Collective Investment Vehicles that were introduced from 1 July 2022, would have completed a suite of collective investment vehicle structures available in Australia.
The Federal Government has stated that it will not proceed with the proposal to allow taxpayers to self-assess the effective life of intangible depreciating assets.
This means that effective lives of intangible depreciating assets (such as in-house software, copyrights and patents) will continue to be set by statute.
Other measures not confirmed in the Budget
There are a significant number of other measures that were previously announced but not yet legislated, including proposed changes to Division 7A, corporate and individual tax residency measures.
The above has been prepared using a number of sources from trusted outlets and organisations.
Should you wish to discuss any of these matters or any other tax issues please contact Meritas Australia and New Zealand Tax Partner Philip Diviny.