Restructures in response to the debt deduction creation rules – draft ATO guidance | Gilbert + Tobin Lawyers: Law Firm in Sydney, Melbourne & Perth

18/10/2022

The Treasury Laws Amendment (Making Multinationals Pay Their Fair Share—Integrity and Transparency) Act 2024 (Act) was enacted earlier this year, which introduced significant changes to the thin capitalisation rules and introduced the debt deduction creation rules (DDCR). Both may operate to limit the amount of debt deductions that taxpayers can claim in an income year.

As the new thin capitalisation rules and the DDCR can potentially affect the availability of debt deductions, taxpayers may restructure to preserve those deductions going forward. As part of the consultation process following the enactment of the Act, the ATO undertook to provide guidance on when it would seek to apply anti-avoidance rules to any restructures in response to the introduction of the DDCR and the thin capitalisation rules. This led to the issue of draft Practical Compliance Guideline PCG 2024/D3 on 9 October 2024.

At this stage, the draft PCG only sets out the ATO’s proposed compliance approach in relation to restructures in response to the DDCR, but it will eventually be updated to also cover the ATO’s views on risks arising from restructures in response to the thin capitalisation rules. A draft ruling on the third-party debt test is also expected to be issued by the ATO later this year.

Overview of the DDCR

To recap, the DDCR operates to deny debt deductions arising under certain related party arrangements. Although it only applies to income years commencing on or after 1 July 2024, it can apply to arrangements entered into before or after that date.

Unless an exemption applies, the DDCR generally applies to two types of arrangements:

Acquisition case: Where an entity borrows from related parties to acquire a CGT asset or a legal or equitable obligation from related parties known as ‘associate pairs’, the entity’s debt deductions on the borrowing are disallowed.
Payment or distribution case: Where an entity borrows from a related party to fund, or facilitate the funding of, specified payments or distributions (for example dividends, returns of capital, royalties) to related parties, the entity’s debt deductions on the borrowing are disallowed.

The DDCR generally applies to taxpayers who are subject to the thin capitalisation rules.

Although the focus of the draft PCG is on restructures to avoid the application of the DDCR, it usefully sets out 11 examples of when the DCCR rules may or may not need to be considered and guidance on how to practically apply the DDCR. Key points to note are:

Timing: In order for the DDCR to apply in an acquisition case, a taxpayer must generally acquire an asset from a related party known as an associate pair. Example 1 confirms the time to test this associate pair relationship is when the asset is acquired.
Tracing: Example 3 involves an Australian company borrowing from a related party into fund its commercial operations and to pay dividends to its foreign resident parent. The ATO is of the view the Australian company will need to consider the application of the DDCR to the extent to which the borrowing funded or facilitated the funding of the dividends, which highlights the importance of tracing and tracking the use of funds. The ATO states that they expect taxpayers to keep contemporaneous documentation and associated analysis on the operation of the DDCR (including evidentiary support for tracing the use of funds).
Historical transactions: As noted earlier, the DDCR can apply to transactions entered into before its commencement date of 1 July 2024. Taxpayers may not have records about historical transactions and/or related party debt in order to determine whether or not the DDCR applies. Notwithstanding this, the ATO will be reviewing historical transactions and states the onus will be on taxpayers to prove DDCR does not apply.

Proposed compliance approach to restructures

The draft PCG sets out the Commissioner’s compliance approach in relation to the application of the general anti-avoidance rule and a specific anti-avoidance rule in section 820-423D of the Income Tax Assessment Act 1997 to certain restructures. The draft PCG sets out the following risk assessment framework:

Risk zone	Risk level and ATO’s compliance approach	Criteria
White	Further risk assessment not required. The ATO will not apply compliance resources beyond verifying that the taxpayer can substantiate conditions for the white zone.	All restructures are covered by an eligible settlement agreement with the ATO or the taxpayer is party to a court decision relating to the tax outcome of the arrangement including under the DCCR.
Yellow	Compliance risk not assessed. The ATO may engage with the taxpayer to understand compliance risks.	One or more restructures are not in the green or red zones.
Green	Low risk. The ATO will generally only devote compliance resources to verify a taxpayer’s self-assessment.	All restructures are covered by the low-risk examples in the draft PCG and exhibit certain features in the draft PCG; or The ATO has provided a low-risk rating (or high assurance under a Justified Trust review) and there has been no material change to the arrangement.
Red	High risk. The ATO will prioritise resources to review these arrangements (for example a review or audit). However, it is not a presumption the anti-avoidance rules necessarily apply to these arrangements.	Any restructures are covered by the high-risk examples in the draft PCG; or The ATO has provided a high-risk rating (or low assurance under a Justified Trust review).

Some key points to note:

The ATO states that low risk restructures will involve the repayment of all related party debt that could be subject to the DDCR without any additional debt being issued or acquired. Example 12 involves an Australian company repaying borrowings which would have been subject to the DDCR using retained earnings. Since there are no debt deductions under the restructured arrangements, this is perceived by the ATO as a low risk restructure. Similarly, example 16 involves an Australian company repaying borrowings subject to the DDCR with funds from the issue of equity, which is also considered to be low risk.
The highest risk restructures would involve arrangements where debt deductions are expected to be disallowed under the DDCR and these arrangements are restructured or recharacterized so that a similar level of debt deductions continues to be available. Example 19 involves an Australian company refinancing borrowings that would be subject to the DCCR with third party debt, which is considered to be a high risk restructure.
Once finalised, the guideline will apply to restructures entered into on or after 22 June 2023 (this being the date the Act was introduced into parliament).

Key takeaways

The DDCR (along with the new thin capitalisation rules) are expected to significantly impact multinational groups. Taxpayers that are undertaking or considering undertaking restructures in response to the Act should carefully review the draft PCG against their own specific circumstances.

Notably, the 2024 International Dealings Schedule (IDS) to be lodged as part of the company tax return requires taxpayers to disclose whether a restructure or replacement of an arrangement was undertaken during the 2024 income year in which DDCR would have applied if the arrangement was still in place on or after 1 July 2024. Taxpayers may also be required to report the risk rating through the reportable tax position (RTP) schedule (if a RTP schedule is required to be lodged with the company tax return).

The ATO is seeking public feedback to the draft PCG until 8 November 2024. Separately, the ATO has also committed to providing guidance on the interaction of the transfer pricing rules to the Act.

Please contact one of our tax experts if you would like to discuss how the recent changes to the thin capitalisation rules and the debt deduction creation rules may impact you.