On 4 December 2024, the ATO published draft Taxation Ruling TR 2024/D3 (the draft ruling) and published Schedule 3 and 4 of the draft Practical Compliance Guideline PCG 2024/D3, which sets out the Commissioner’s views on aspects of the third party debt test (TPDT) and the Australian Taxation Office’s (ATO’s) compliance approach to restructures carried out in response to the enactment of the new thin capitalisation rules.
The draft ruling provides some clarity on key issues and the ATO’s compliance approach in respect of restructures is welcome. However, there are still unanswered questions relating to the application of the TPDT with some of the ATO’s interpretations of the relevant provisions likely to narrow the availability of the TPDT for many taxpayers.
Overview of the TPDT
The TPDT is one of the three methods to determine the extent to which taxpayers can claim debt deductions such as interest under the new thin capitalisation rules as enacted under Treasury Laws Amendment (Making Multinationals Pay Their Fair Share—Integrity and Transparency) Act 2024 (Act). Broadly, the TPDT denies a borrower’s debt deductions to the extent to which they exceed the borrower’s ‘third party earnings limit’. The third-party earnings limit is calculated by reference to debt from unrelated lenders which satisfies certain conditions.
A fundamental requirement of the TPDT is the lender’s recourse for payment of the debt is limited to Australian assets of the borrower and members of the ‘obligor group’ which are Australian entities and to membership interests in the borrower except where the borrower has a direct or indirect interest in an asset that is not an Australian asset.
Another key requirement is the proceeds of the debt interest must be used to fund commercial activities that have a connection with Australia.
The TPDT also includes conduit financing rules that allow debt deductions which are attributable to on-loans between related parties in certain circumstances.
Key aspects of Taxation Ruling TR 2024/D3
The draft ruling sets out the ATO’s preliminary views on TPDT, primarily on key third party debt conditions. Key points are summarised below.
Commercial activities requirements
One requirement of the TPDT is the debt funding, or substantially all of it, must be used by the borrower to fund its commercial activities in connection with Australia. Furthermore, those activities exclude business carried on by the borrower from a foreign branch or the holding of debt or equity in certain related parties.
The ATO is of the view that the TPDT is designed to cover third party debt that is used to fund investment in Australian operations of trade or business capable of generating profit. In this regard, the ATO considers activities such as the payment of distributions, capital management activities or the indirect purchase of foreign assets through an Australian entity (that is debt funded acquisition of an Australian outbound group) will not satisfy this requirement.
The draft ruling provides an example whereby a trust uses third party debt to acquire Australian real property and to fund trust distributions to foreign investors (example 16). The ATO takes the view that the trust distributions are not commercial activities in connection with Australia.
We query whether such a restrictive interpretation should be adopted. For example, if a borrower uses debt funding to pay a dividend or to return capital, this may allow a borrower to preserve existing funds or working capital in its business which could then be used to generate profits. That is, the debt is effectively funding the operations of the business directed towards generating profits by preserving funds that would otherwise have been used to make the distribution.
If the ATO maintains its view, this will also require borrowers to undertake a tracing exercise for the use of any debt funding. Furthermore, the draft ruling highlights that satisfaction of this requirement must be tested continuously throughout the period the relevant debt interest is on issue.
Recourse to only Australian assets
As noted earlier, a key requirement of the TPDT is that a lender’s recourse for payment of the debt is limited to:
Australian assets of the borrower
membership interests in the borrower (unless the borrower has a legal or equitable interest, directly or indirectly, in an asset that is not an Australian asset)
Australian assets of Australian entities that are members of the obligor group in relation to the debt.
The ATO adopts the ordinary meaning of ‘Australian’ and ‘assets’, noting whether an asset is an Australian asset depends on the facts and circumstances, including the nature of the asset involved and its connection or relationship to Australia. The draft ruling states an asset that only has a tenuous or remote connection to an overseas jurisdiction may still qualify as an Australian asset so long it has a substantial connection to Australia.
The draft ruling provides an example where shares in an Australian subsidiary that has an overseas permanent establishment are not considered Australian assets as the connection with a foreign jurisdiction is more than tenuous or remote (example 13). In this example, the lender (unrelated) has recourse to all the assets in Aus Head Co (borrower) and Aus Sub Co, including the shares in those entities.
The draft ruling also provides an example where shares in a foreign subsidiary are not considered Australian assets (example 14). In this example, the unrelated lender has recourse to all the assets of the Australian parent, its Australian subsidiary and the foreign subsidiary, and the shares in those entities. It is not clear in this example as to whether the shares in the Australian parent are also not Australian assets by virtue of the direct or indirect interest in the foreign subsidiary. As noted earlier, it is permissible for shares in a borrower to be given as security provided the borrower does not have a legal or equitable interest, directly or indirectly, in an asset that is not an Australian asset. The question is whether the Australian parent would be considered to have a direct or indirect interest in foreign (non-Australian) assets by virtue of indirectly holding shares in the foreign subsidiary. Given the application of the thin capitalisation rules to many multinational groups with Australian companies directly or indirectly holding interests in foreign entities, this will be a critical point for the ATO to provide guidance on.
Recourse requirements must also be tested continuously. Notably, example 22 of the draft PCG highlights the need for taxpayers to closely monitor ownership of any foreign assets (for example cash in a foreign bank account).
More generally in relation to recourse, the ATO helpfully states that the TPDT does not require an entity to ‘look-through’ in respect of assets that are rights against another entity and that the concept of ‘recourse’ is not the same as a ‘security interest’.
Minor or insignificant assets carve out
In determining whether a lender only has recourse for payment of a debt to Australian assets, the legislation permits ‘minor or insignificant assets’ to be disregarded.
Outside of the temporary ‘safe harbour’ rules (see below commentary), the ATO has adopted a narrow view on the minor or insignificant asset carve out by limiting the scope to ‘assets of minimal or nominal value’. The draft ruling provides an example of shares in a foreign company with share capital of $2 and no other assets, with the ATO taking the view that such shares would be considered a minor or insignificant asset (example 8).
In contrast, in another example (example 9), the ATO considers that shares in a foreign subsidiary are not minor or insignificant assets where the value of those shares is $10 million even, in relative terms, this only represents 2% of the market value of all assets of the group. The ATO reasons that the shares in the Foreign Co are not of minimal or nominal value and that relative values are not determinative as to whether the ineligible assets are minor or insignificant assets (contrary to some suggestions raised in consultation for a 5% or 10% benchmark to be applied).
Restructuring to satisfy the TPDT
As covered in our previous article, draft Practical Compliance Guideline PCG 2024/D3 (Restructures and the thin capitalisation and debt deduction creation rules – ATO compliance approach) sets out the Commissioner’s compliance approach in relation to the application of the anti-avoidance rules to certain restructures in relation to the debt deduction creation rules. PCG 2024/D3 was reissued on 4 December 2024 to include Schedule 3 and 4, which set out the ATO’s compliance approach in respect of restructures relating to the TPDT (Schedule 3) and the thin capitalisation changes more generally (Schedule 4).
Schedule 3 provides examples of restructures that can be undertaken (that is ‘green zone’ restructures) by taxpayers to facilitate compliance with the TPDT, with the ATO undertaking not to apply compliance resources other than to verify that the compliance approach applies. It also allows taxpayers to claim pre-restructure debt deductions under the TPDT notwithstanding the conditions for the TPDT would not have otherwise been satisfied. This is a welcome move given the delay in the enactment of the Act (and with no grandfathering rules).
Key points to note are set out below.
Restructures to comply with the recourse to Australian assets requirement
The examples of restructures where the ATO will not apply compliance resources are:
Amending the terms of a loan to remove a lender’s recourse to foreign assets (example 20).
Transfer of shares in a foreign entity to a related party that is not in the obligor group in relation to the debt (example 21).
Closure of a borrower’s foreign bank account and requiring all customer payments to be made to the borrower’s Australian bank account (example 22).
This compliance approach is limited to restructures undertaken between 22 June 2023 (the date the Act was enacted) and the end of the income year in which the draft PCG is finalised.
Safe harbour test in relation to minor or insignificant assets
The draft PCG provides a temporary safe harbour test in relation to minor or insignificant assets if certain criteria are satisfied, this being:
the market value of the minor or insignificant assets (that are not Australian assets) is less than 1% of all assets to which there is recourse (proportionate test)
the market value of each such asset does not exceed $1m (quantitative test)
such assets are not credit support rights.
This compliance approach is limited to income years starting on or after 1 July 2023 and ending on or before 1 January 2027.
Restructures to comply with conduit financing conditions
The draft ruling does not provide guidance in relation to the ATO’s interpretation of the conduit financing provisions (although the ATO have noted this may be provided following completion of the high priority public advice and guidance).
However, the draft PCG provides certain examples of restructures allowed to be undertaken by taxpayers to comply with the conduit financing conditions. These examples generally involve removing margin on project finance, creating separate intercompany loans and back-to-back lending facilities.
This compliance approach is limited to restructures undertaken between 22 June 2023 and the end of the income year in which the draft PCG 2024/D3 is finalised (or income years ended on or before 1 January 2027 for examples 25 and 26, this being creating intercompany loans and amending back-to-back arrangements).
Other restructures
Schedule 4 of the draft PCG provides the ATO’s views on compliance risks associated with certain restructures in response to the new thin capitalisation rules. It provides examples of restructures which the ATO considers are low risk and those that are considered high risk.
For example, forming a tax consolidated group to account for differing individual tax EBITDA’s of entities within a group is considered a low-risk restructure. In contrast, introducing debt to maximise debt deductions under the fixed ratio test (with no commercial purpose) or amending conduit financing interest rates to maximise debt deductions, are considered high risk restructures.
Key takeaways
It is important to note that the current guidance is in draft and subject to consultation and further change. While the guidance provides much needed clarity in relation to several key areas of the TPDT, it also raises some questions that will no doubt be flagged in the consultation process. Although the TPDT is designed to be narrow (as stated in the explanatory memorandum to the Act), the ATO’s proposed interpretation of various aspects of the test will mean that it is not viable for many taxpayers.
The ATO is seeking public feedback on the draft ruling and draft PCG until 7 February 2025. As flagged in our earlier articles, the ATO has also committed to providing guidance on the interaction of the transfer pricing rules to the Act (expected to be completed in January 2025).
As we await the finalisation of the ATO guidance and given the time limits in relation to the transitional compliance approaches provided for in the draft PCG, it is crucial for taxpayers to actively review and adjust their existing and future arrangements, including:
Whether to undertake any restructures, noting this is likely to be a key area of focus by the ATO and that the transitional compliance approaches are intended to be temporary.
Reviewing security package arrangements, noting that lenders will often require security over the shares in the borrower in addition to security over the assets and that lenders will generally not accept recourse to just Australian assets.
Documenting the use of any debt funding (for the purposes of the commercial activities test) and reviewing ownership of any foreign assets (for example cash in a foreign bank account).
Reviewing capital management policies given the ATO’s proposed restrictive approach to the commercial activities requirement under the TPDT and the recent raft of integrity rules relevant to the funding of distributions (for example the integrity rule relating to franking credits for distributions funded by equity raisings and the debt deduction creation rules limiting debt deductions in the context of related party transactions).
Please contact one of our tax experts if you would like to discuss how the changes to the thin capitalisation rules (including the debt deduction creation rules) may impact you.