Fixed ratio test

How the fixed ratio test applies for general class investors.

Published 23 July 2024

How the fixed ratio test works

The fixed ratio test is the default test that applies for general class investors that do not make a choice to use either the group ratio test or the third party debt test.

If the fixed ratio test applies, the amount of debt deductions of an entity for an income year that is disallowed is the amount by which the entity’s net debt deductions exceed the entity’s fixed ratio earnings limit for the income year.

An entity’s fixed ratio earnings limit for an income year is 30% of its tax EBITDA for that income year.

Net debt deductions

An entity’s ‘net debt deductions’ for an income year are worked out according to the following steps:

Step 1: Work out the sum of the entity’s debt deductions for the income year, less any debt deductions denied under the debt deduction creation rules in Subdivision 820-EAA of the ITAA 1997.

Step 2: Work out the sum of each amount included in the entity’s assessable income for that year that is one of the following:

either interest, an amount in the nature of interest, or any other amount economically equivalent to interest
any amount directly incurred by another entity in obtaining or maintaining the financial benefits received by the other entity under a scheme giving rise to a debt interest
any other expense that is incurred by another entity and that is specified in the regulations for the purposes of calculating net debt deductions under this step.

Step 3: Subtract the result of step 2 from the result of step 1.

The result of step 3 is the entity’s net debt deductions for an income year. The entity’s net debt deductions may be a negative amount.

Tax EBITDA

An entity’s tax EBITDA for an income year is worked out according to the following steps:

Step 1: Work out the entity’s taxable income or tax loss for the income year. In doing so disregard the operation of the thin capitalisation rules, except for the debt deduction creation rules in Subdivision 820-EAA of the ITAA 1997. Treat a tax loss for the income year as a negative amount. Certain adjustments are required to step 1.

Step 2: Add the entity’s net debt deductions for the income year.

Step 3: Add the sum of the entity’s deductions that are:

decline in value and capital works deductions (if any) for the income year under Division 40 and Division 43 of the ITAA 1997. Do not include deductions available under these provisions if they represent the entire amount of an expense incurred by the entity (i.e. immediately deductible amounts).
general deductions that relate to forestry establishment and preparation costs unless those costs relate to the clearing of native forests
deductions for the capital costs of acquiring trees under section 70-120 of the ITAA 1997.

Step 4: Add the excess tax EBITDA amount for the income year (if any) (refer below for further information).

Step 5: Make adjustments in accordance with regulations (if any) made for the purposes of calculating the entity’s tax EBITDA.

The result of step 5 is the entity’s tax EBITDA for the income year. If the result of step 5 is less than zero, treat it as being zero.

Adjustments required for step 1

Amounts to be disregarded in calculating step 1

In calculating step 1 of an entity’s tax EBITDA, the following amounts must be disregarded:

Amounts that are included in the entity’s assessable income under Division 207 of the ITAA 1997 (concerning franked distributions) to the extent that Division results in an amount of, or a share of, a franking credit being included in the entity’s assessable income for the income year.
Any dividend or non-share dividend paid to the entity by an associate entity and included in the entity’s assessable income under section 44 of the ITAA 1936. For this purpose, a modified definition of associate entity is set out in subsection 820-52(9) of the ITAA 1997.
If the entity is a beneficiary of a trust other than an AMIT, and is an associate entity of the trust as defined in subsection 820-52(9) of the ITAA 1997, disregard
- amounts included in the beneficiary’s assessable income under Division 6 of Part III of the ITAA 1936, which deals with the net income of a trust
- amounts included in the beneficiary’s assessable income under Subdivision 115-C of the ITAA 1997, which deals with the grossing up of capital gains distributed by a trust to a beneficiary
- distributions from the trust to the beneficiary.
If the entity is a member of an AMIT, and is an associate entity of the AMIT as defined in subsection 820-52(9) of the ITAA 1997, disregard
- amounts included in the member’s assessable income under Division 276 of the ITAA 1997, which deals with the attribution of an AMIT’s income and tax offsets to members of an AMIT
- distributions from the AMIT.
If the entity is a partner in a partnership and is an associate entity of the partnership (under subsection 820-52(9) of the ITAA 1997), disregard the entity’s share of the net income of the partnership as determined under Division 5 of Part III of the ITAA 1936.

Application of step 1 to corporate tax entities

For the purposes of calculating step 1 of a corporate tax entity's tax EBITDA for an income year, assume that both the following apply:

The entity chooses to deduct, under subsection 36-17(2) or (3), all of the entity's tax losses for loss years occurring before the income year.
Subsection 36-17(5) of the ITAA 1997 does not apply to that choice.

Application of step 1 to trusts other than AMITs

In working out the tax EBITDA for an income year of a trust other than an AMIT, the reference to taxable income at step 1 is treated as being a reference to the net income of the trust as determined under Division 6 of Part III of the ITAA 1936.

To avoid doubt, subsection 102UX(3) of the ITAA 1936 is disregarded in determining the net income of the trust for the purposes of calculating its tax EBITDA.

Application of step 1 to AMITs

In working out the tax EBITDA for an income year of an entity that is an AMIT, treat the reference to taxable income at step 1 as a reference to the net income of the entity as determined by reference to the AMIT’s total assessable income for the income year reduced by all the deductions of the AMIT for the income year.

Application of step 1 to partnerships

In working out the tax EBITDA for an income year of a partnership, treat the reference to taxable income at step 1 as being a reference to the net income of the partnership as determined under Division 5 of Part III of the ITAA 1936.

Application of step 1 to R&D entities

In working out the taxable income or tax loss of an entity under step 1 of the tax EBITDA calculation, if the entity is an R&D entity that is entitled to a notional deduction for an income year under Division 355 of the ITAA 1997 in relation to R&D activities of the R&D entity, subtract an amount equivalent to the amount of the notional deduction.

Excess tax EBITDA amount

The tax EBITDA of a 'controlling entity' includes the 'excess' tax EBITDA of a 'controlled entity'.

Broadly, excess tax EBITDA amounts of a controlled entity are transferred to the controlling entity according to the controlling entity’s average ‘TC direct control interest’ in the controlled entity for the income year. This requires a consideration of the direct control interest for each day of the income year. For a day to count towards the calculation of the average direct control interest, the direct control interest for that day must be 50% or greater.

An entity will be a controlling entity if it satisfies all the following conditions:

It is one of the following entities for a period that is all or part of an income year
- a company that is an 'Australian entity'
- a unit trust that is a resident trust for CGT purposes
- a managed investment trust that satisfies the residency requirement in subsection 275-10(3) of the ITAA 1997
- a partnership that is an 'Australian entity'.
The entity is a general class investor for all or part of the income year.
The entity has not made a choice to apply the group ratio test or the third party debt test in relation to the income year.
One or more other entities are a controlled entity in relation to the entity for the income year.

An entity (the 'test entity') will be a controlled entity in relation to a controlling entity if it satisfies all the following conditions:

The controlling entity has a TC direct control interest of 50% or more in the test entity at any time during the income year.
The test entity is one of the following entities for a period that is all or part of the income year
- a company that is an Australian entity
- a unit trust that is a resident trust for CGT purposes
- a managed investment trust that satisfies the residency requirement in subsection 275-10(3) of the ITAA 1997
- a partnership that is an 'Australian entity'.
The test entity is a general class investor for all or part of the income year.
The entity has not made a choice to apply the group ratio test or the third party debt test in relation to the income year.

The definition of Australian entity is contained in section 336 of the ITAA 1936. This definition is modified for partnerships under subsection 820-60(7) of the ITAA 1997. The modification ensures that for the purposes of determining an excess tax EBITDA amount, a partnership will be an Australian entity where Australian residents and/or Australian trusts together hold at least a 50% direct participation interest in the partnership.

The following steps set out the calculation of the excess tax EBITDA amount that can be included in a controlling entity’s tax EBITDA:

Step 1: For each controlled entity, work out the amount (if any) by which the fixed ratio earnings limit of the controlled entity for the income year exceeds the sum of the following:

The controlled entity’s net debt deductions for the income year (for this purpose, treat a negative amount of net debt deductions as nil).
The total of the controlled entity’s FRT disallowed amounts for the 15 income years ending immediately before the income year (to the extent those amounts have not been applied under section 820-56).

Step 2: For each controlled entity, you must apply all the following:

Work out the controlling entity’s TC direct control interest in the controlled entity for each day in the income year under the following provisions
- subsection 820-60(4) of the ITAA 1997 for controlled entities that are companies
- subsection 820-60(5) of the ITAA 1997 for controlled entities that are trusts
- subsection 820-60(6) of the ITAA 1997 for controlled entities that are partnerships
For each day on which the amount was 50% or greater, add the amounts calculated above.
Divide the result above by the number of days in the income year during which the controlled entity was in existence. Express the result as a percentage.

Step 3: For each controlled entity, multiply the result of step 1 by the percentage worked out under step 2. If the amount worked out under step 1 for a controlled entity is nil, the result for that controlled entity under this step will be nil.

Step 4: Add up the amounts worked out under step 3.

Step 5: Divide the result of step 4 by 0.3. The result of this step is the excess tax EBITDA amount.

An excess tax EBITDA amount transferred to a controlling entity is taken into account when considering whether that controlling entity has an excess amount itself, which it can, in turn, transfer to another controlling entity.

Special deduction for fixed ratio test disallowed amounts

A special deduction allows general class investors to claim debt deductions that have been previously disallowed within the past 15 years under the fixed ratio test in a later income year.

For the special deduction to apply, the entity must be using the fixed ratio test for the income year and its fixed ratio earnings limit for the income year must exceed its net debt deductions. An amount of those previously disallowed debt deductions up to the excess amount may be able to be deducted, subject to satisfying further criteria. If net debt deductions are equal to or higher than the fixed ratio earnings limit, then no previously disallowed debt deductions can be deducted.

The amount of the deduction for an income year is worked out according to the following steps:

Step 1: Work out the amount by which the entity’s fixed ratio earnings limit exceeds its net debt deductions for the current income year.

Step 2: Apply against that excess each of the entity’s fixed ratio test disallowed amounts that arose in any of the previous 15 income years (to the extent that they have not already been applied under this step in a previous income year).

Step 3: The amount of the deduction is the total amount applied under step 2.

An entity has a ‘fixed ratio test disallowed amount’ for an income year equal to the debt deductions of the entity for the income year that are disallowed under the fixed ratio test for that income year.

Entities must have continually applied the fixed ratio test every income year to allow access to their balance of carried forward fixed ratio test disallowed amounts. However, the mere fact that Division 820 does not apply to an entity in a subsequent income year will not result in fixed ratio test disallowed amounts being lost.

Fixed ratio test disallowed amounts must be applied in sequence, such that fixed ratio test disallowed amounts attributable to the earliest income year, subject to the 15-year limit, are applied first.

Loss rules for fixed ratio test disallowed amounts

If an entity is a company or trust, it must pass the company or trust loss rules in relation to its fixed ratio test disallowed amounts, otherwise the entity cannot apply the amount under step 2.

If an entity is a company, it must pass a modified version of the Continuity of Ownership Test (COT) or Business Continuity Test (BCT) in relation to each of its fixed ratio test disallowed amounts it wishes to apply under step 2.

Where the entity is a trust, it must pass a modified version of the trust loss rules in Schedule 2F to the ITAA 1936 in relation to each of its fixed ratio test disallowed amounts they are seeking to apply under step 2.

The special deduction and consolidated groups

Transferring a fixed ratio test disallowed amount

When an entity with a fixed ratio test disallowed amount joins a tax consolidated group, that fixed ratio test disallowed amount can be transferred to the head company of that group at the joining time, subject to certain conditions. This transfer occurs even where the joining entity becomes the head company of the tax consolidated group at the joining time.

The fixed ratio test disallowed amount is transferred only to the extent that the fixed ratio test disallowed amount could have been applied by the joining entity in respect of an income year (the trial year). The trial year is generally the period commencing 12 months before the joining time to just after the joining time.

Specifically, the fixed ratio test disallowed amount is transferred at the joining time from the joining entity to the head company if both:

at the joining time, the joining entity had not become a member of the joined group (but had been a wholly owned subsidiary of the head company if the joining entity is not the head company)
the amount applied by the joining entity under step 2 for calculating the special deduction for fixed ratio test disallowed amounts in respect of the trial year were not limited by the joining entity’s excess amount under the preceding step 1.

If a fixed ratio test disallowed amount cannot be transferred, then the amount is effectively lost and cannot be applied under step 2 by any entity.

If a fixed ratio test disallowed amount is successfully transferred, then the head company is treated as having that amount for the same income year in which the joining entity had the amount. This preserves the effect of the 15-year limit for fixed ratio test disallowed amounts.

For the purposes of applying the modified COT, the head company is treated as acquiring fixed ratio test disallowed amounts at the joining time. This is necessary to ensure the modified COT is not automatically failed for income years occurring after consolidation. This is not a refresh of the 15-year utilisation period.

A head company may choose to cancel the transfer of fixed ratio test disallowed amounts that would otherwise be transferred by the joining entity. If the transfer is cancelled, the income tax law operates for the purposes of income years ending after the transfer as if the transfer had not occurred. That is, the loss cannot be utilised by any entity for those income years.

Impact on allocable cost amounts

When a tax consolidated group forms, or one or more entities join a tax consolidated group, tax costs for the assets of each joining entity are calculated by reference to the allocable cost amount (ACA) for the joining entity. On exit from the group, the process is reversed and the group’s cost base of the equity in the leaving entity is derived from the net assets of the leaving entity at the designated time.

Step 6A of the ACA calculation requires taxpayers to subtract an amount in relation to fixed ratio test disallowed amounts transferred to the head company. The step 6A amount is generally worked out by multiplying the sum of the transferred fixed ratio test disallowed amounts by the corporate tax rate.

In more limited circumstances, Step 5A of the ACA calculation requires taxpayers to subtract fixed ratio test disallowed amounts accruing to the joined group before the joining time, except to the extent that such an amount reduced the undistributed profits comprising the step 3 ACA amount.

Note: Where an entity’s ACA includes a step 5A adjustment and it becomes a subsidiary member of a group at the same time as an interposed subsidiary member, the group will need to consider whether an adjustment is necessary to the market value of membership interests held by the interposed subsidiary member in other group members to determine the tax cost setting amount of the interposed subsidiary member’s assets. Refer to section 705-160 of the ITAA 1997 for further information.

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