The ATO has released much awaited draft guidance on Australia’s new thin capitalisation regime and the debt deduction creation rules. The draft guidance will be seen by some as the equivalent of a lump of coal for Christmas, with the theme of the new guidance being a narrow interpretation of the provisions. The draft guidance is unfortunately of limited utility on the more uncertain areas of the legislation (of which there are many). In this alert, we examine the Commissioner’s guidance and highlight key areas of interest and uncertainty for taxpayers.
Introduction
On 4 December 2024, the Australian Taxation Office (ATO) released its guidance on Australia’s new thin capitalisation regime (see our previous alert here) in the form of TR 2024/D3 “Income tax: aspects of the third party debt test in Subdivision 820-EAB of the Income Tax Assessment Act 1997” (TR 2024/D3) and Schedules 3 and 4 of PCG 2024/D3 “Restructures and the thin capitalisation and debt deduction creation rules - ATO compliance approach” (PCG 2024/D3).
In this alert we consider:
- the ATO’s guidance on the third party debt test (TPDT) and the conduit financing rules; and
- the ATO’s compliance approach to restructures in response to the new rules.
At a glance
Technical guidance: in a number of respects, the draft guidance comprises very narrow interpretations of the new legislation – for example, the meanings of “minor or insignificant” and “commercial activities” which are discussed below. Concerns regarding the ambiguity of these concepts were raised during consultation on the new laws and the hope was that the ATO guidance would adopt a pragmatic approach to these concepts which unfortunately does not seem to be the case. Time may tell as to whether Courts will have the same views as the ATO on these matters.
Restructures: some themes coming out of the draft guidance on restructures are:
- there appears to be a working assumption in underlying the guidance that entities can simply repay their related party debt with equity or retained earnings – however, there is no acknowledgement or indication of an understanding that, in economic terms, equity is generally a more expensive source of funds than debt;
- the replacement of related party debt provided by an offshore parent entity with third party debt is considered to be “debt dumping” in Australia (and therefore, a “high-risk restructure”) – why this is “debt dumping” where third parties are willing to independently lend to the Australian group with security limited to Australian assets as required by the new rules is unclear. This is possibly the most counter-intuitive conclusion in the draft guidance;
- Australian entities which may have historically borrowed from third parties at higher interest rates will have an advantage over those entities for which a global parent has ‘pushed down’ lower cost funds because, according to the ATO, the only option for the latter entities is to find sources of equity funding to repay their related party debt i.e. there is an expectation that taxpayers should have taken the more expensive option of borrowing directly from third parties in the first place because to do so now is “high-risk”; and
- the majority of restructures will fall somewhere between the “low-risk” and “high-risk” restructure examples in PCG 2024/D3 and could therefore attract engagement with the ATO – this sits in stark contrast to the ATO’s view expressed to the Senate Economics Legislation Committee during consultation on the new laws that ‘as a general principle, the ATO would not be looking to apply integrity rules in the proposed new law or elsewhere where taxpayers are restructuring their arrangements as a means of seeking to comply with the underlying intent of the new law’.
Guidance on key TPDT concepts
Although the new thin capitalisation rules took effect from 1 July 2023, taxpayers have been waiting for clarification of a number of key concepts used in the TPDT, some of which are considered in the draft guidance.
KEY TPDT CONCEPTS
It is a requirement of the TPDT that, disregarding recourse to minor or insignificant assets, the lender has recourse for repayment of the debt only to certain “covered” Australian assets.
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Guidance on “recourse”
The ATO has helpfully confirmed that the requirement that a third party lender only has recourse to Australian assets does not require borrowers to “look-through” obligations owed to, or rights of, an obligor e.g. a lender is not considered to have “recourse” to the assets of an investor that is party to an equity commitment deed in respect of a borrower. |
Observations
One of the carve outs from the general prohibition on credit support rights is a right that provides recourse, directly or indirectly, only to one or more Australian assets. However, no guidance has been provided on the meaning of “indirectly” in this context. |
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Guidance on “minor or insignificant” assets
The ATO has confirmed that the expression “minor or insignificant” is limited to investments of a “minimal or nominal value” (an example provided is $2 of foreign share capital) and is not to be measured by reference to the relative value of foreign assets against all assets to which the lender can have recourse. The stated basis for this narrow interpretation is that the TPDT is a concession. However, PCG 2024/D3 includes a temporary concessionary compliance approach to be taken by the Commissioner from 1 July 2023 to 1 January 2027 which permits the market value of identified non-Australian assets to be less than 1% of all assets to which the lender has recourse, subject to a cap of $1M for each asset or bundle of identical assets. This concessionary approach does not extend to credit support rights. |
Observations
An alternative view is that “insignificant” contemplates the testing of the relative values of foreign assets to Australian assets to which a lender has recourse. The ATO approach departs from the 10% threshold that appears in other contexts, such as:
We understand that this condition is aimed at preventing excessive “dumping” of third-party debt which is supported by recourse to non-Australian assets into Australian. A relative value test (i.e. 10% of non-Australian assets making up the security net) would to our mind entail a low risk of mischief, reduce compliance costs, and prevent technical non-compliance by the many Australian entities relying on the TPDT as intended across the real estate, infrastructure, and energy sectors. |
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Guidance on “Australian assets”
Unfortunately for taxpayers, TR 2024/D3 provides no definitive guidance on what “Australian” means in this context in terms of nature or connection to Australia and the examples provided do not resolve uncertainties with respect to intangible assets connected to Australia and other jurisdictions. However, the following are not considered to be “Australian Assets”:
Fortunately, PCG 2024/D3 broadly states that amending an arrangement to exclude recourse to non-Australian assets, transferring non-Australian assets to an associate entity, and closing a foreign bank account are examples of low-risk restructures to comply with this requirement. |
Observations
No guidance has been provided in respect of a foreign subsidiary that is not a CFC in which a less than 10% “portfolio interest” is held, nor in respect of shares in an Australian company that owns a CFC. There is also no consideration of the relative value of an overseas PE of an Australian resident subsidiary to its Australian activities. We would expect this to be highly relevant in determining whether the shares in a subsidiary have a requisite connection to Australia. |
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Another requirement of the TPDT is that the entity uses all, or substantially all, of the proceeds of issuing the debt interest to fund its commercial activities in connection with Australia.
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Guidance on “Commercial activities”
Again, this phrase has been interpretated narrowly. The ATO’s view is that the relevant borrowed funds must be used in “Australian operations of trade or business capable of generating profit” and not “distributions, capital management activities, or the indirect purchase of foreign assets through an Australian entity”. Further, only a “minimal” or “nominal” amount of the relevant proceeds may be used for something other than such operations of trade or business. |
Observations
This interpretation adds a condition that is not in the legislation. An entity’s commercial activities should include its capital management activities. Many organisations have dedicated capital management teams. Further, distributions are returns on investors’ capital contributions and should therefore be viewed as a necessary part of an entity’s ordinary commercial activities. A practical question arises as to how entities might manage this “condition”. The debt deduction creation rules (DDCR) require the tracing of the use of debt funding. The draft ruling appears to be applying concepts from DDCR to entities electing to apply the TPDT despite the DDCR expressly not applying to such entities. |
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CONDUIT FINANCING RULES
For the purposes of the TPDT, a “debt deduction” is “attributable to a debt interest” to the extent it is “directly associated with hedging or managing the interest rate risk in respect of the debt interest” and not referable to an amount paid to an associate entity.
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Guidance on interest rate hedging costs
The conduit financing rules modify the TPDT for certain arrangements in which funds borrowed from third parties by an SPV finance entity are on-lent to associate entities. Example 1 of TR 2024/D3 confirms that payments under a back-to-back interest rate swap entered into by a conduit financier and an associate entity borrower in respect of an on-loan, which mirrors a swap entered into by the conduit financier and an external swap provider, will not be deductible to the borrower under the TPDT. |
Observations
However, PCG Example 26 indicates that a restructure which entails closing out a back-to-back swap in such circumstances and amending the terms of the on-loan to effectively embed the commercial effect of the external swap is a low-risk restructure. While the above example is helpful, it was hoped that the Commissioner would adopt a more pragmatic approach to back-to-back swap arrangements given that they arise in the context of many existing projects and there is no discernible logic for the condition in the legislation. It is a pity that taxpayers are having to incur costs to restructure their current arrangements particularly in circumstances where there is no tax mischief and no cross-border aspect. |
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Under the conduit financing arrangements, the terms of the on-loan, to the extent that those terms relate to costs incurred by the borrower in relation to the on-loan, must be on the same terms as the external, third party loan.
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Guidance on “on the same terms”
PCG 2024/D3 provides the following examples of low-risk restructures to comply with the conduit financing rules:
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Observations
These examples demonstrate a narrow, technical reading of the conduit financing rules and, in particular, that the rules do not permit multiple external loans which fund a single on-loan (even if entered into on the same terms). This will give rise to a number of practical issues in practice that will need to be addressed. |
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Restructures
There are a number of overarching requirements in Schedule 3 to draft PCG 2024/D3 which are to apply to restructures undertaken to comply with the TPDT, including that the “quantum and rate of the financing arrangement do not materially change”. Practically, this may prevent many taxpayers from achieving a low-risk compliance approach, as it is generally expected that the quantum and/or rate of a financing arrangement will change by reason of a restructure to comply with the TPDT (i.e., if recourse is limited to Australian assets and/or credit support arrangements are changed, interest rates are also likely to change).
Schedule 4 to draft PCG 2024/D3 sets out some limited examples of restructures in response to the thin capitalisation rules more generally:
- only one low-risk “restructure” example is provided which does not really entail any actual restructuring – electing to a form a tax consolidated group without any other restructure steps, where one subsidiary’s debt deductions are denied for exceeding the fixed ratio limit (with the effect that greater debt deductions are allowed on a group basis).
- the following two high-risk restructure examples are provided:
- an entity with excess debt capacity under the FRT introduces further debt for the purpose of maximising debt deduction capacity under the FRT without a commercial purpose (Example 28); and
- a finance company has existing third party debt with varying interest rates and maturity dates which is on-lent via intercompany loans that do not have the same rate or tenor as the external loans and the intercompany loans are amended to the highest interest rate of all the external loans (Example 29).
Schedule 4 effectively provides that any restructuring (aside from an election to form a tax consolidated group without any other steps) will not be considered low-risk and could therefore attract engagement with the ATO. Moreover, the high-risk examples appear to be uncontroversial breaches of law (Part IVA for Example 28 and the “on-loan on same terms” requirement for Example 29). Further examples of restructuring arrangements (including by refinancing or amendments) would be welcomed by taxpayers.
Historical transactions
In a move which is sure to undermine taxpayers’ confidence in their ability to comply with the tax laws at any particular point in time, the ATO has not made any allowance for a concessional or transitional approach to record-keeping, despite many affected financing arrangements having been entered into long before the announcement of the new rules. Draft PCG 2024/D3 makes it clear that the onus is on taxpayers to provide “evidence of relevant tracing” of the use of funds, notwithstanding that there was no requirement for taxpayers to keep such evidence at the time of the use of the funds. Taxpayers will simply have to attempt to piece together the past with the documents they still have.
Both the TR 2024/D3 and Schedule 3 and 4 of PCG 2024/D3 are open for public comment until 7 February 2025.
Please reach out if you have any questions about the changes to the thin capitalisation rules.
