Australia’s new thin capitalisation regime: ATO draft guidance on third party debt test and restructures

In brief

On 4 December 2024, the Australian Taxation Office (ATO) released its next tranche of guidance on the new thin capitalisation rules comprising:

Draft Taxation Ruling TR 2024/D3 Income tax: aspects of the third party debt test in Subdivision 820-EAB of the Income Tax Assessment Act 1997 (the draft Ruling)
Two additional schedules to Draft Practical Compliance Guideline PCG 2024/D3 Restructures and the thin capitalisation and debt deduction creation rules – ATO compliance approach (the draft PCG).

Since the enactment of the new thin capitalisation rules, taxpayers have identified various circumstances that may present an issue if they wish to use the third party debt test (TPDT). These include holding of foreign assets, back-to-back swap arrangements, borrowing to pay dividends or distributions to investors, and the circumstances in which an otherwise ineligible asset can satisfy the ‘minor or insignificant’ exception. TR 2024/D3 provides a first look at the ATO’s views on these issues, and based on these preliminary views, it seems that, in the ATO's opinion, many of these circumstances will result in the TPDT being unavailable.

In contrast, many taxpayers will welcome the ATO’s TPDT compliance approach set out in the new Schedule 3 of PCG 2024/D3. Acknowledging the late enactment of the new thin capitalisation rules and that taxpayers require time to restructure their arrangements, this Schedule sets specific types of restructures that can be undertaken to comply with certain TPDT conditions and prescribes time limits for undertaking those restructures in order to benefit from the ATO’s compliance approach. This effectively enables taxpayers that follow this Schedule to claim pre-restructure debt deductions using the TPDT without the ATO challenging that position, notwithstanding that those deductions would not otherwise satisfy the conditions of the test. However, given these time limits and the amount of time it may take to amend third party and related party transaction documents, it is critical for taxpayers seeking to rely on this compliance approach to take action quickly.

The ATO’s commentary in TR 2024/D3 clearly favours a narrow interpretation of the TPDT conditions. Taxpayers that adopt alternative interpretations of these conditions to allow the TPDT to be available for third party debt arising from genuine commercial arrangements may expect to receive greater levels of scrutiny. As a result, many taxpayers may need to fundamentally reconsider their financing structures and capital management policies, which may include complete renegotiations of external financing arrangements as well as material group restructures.

This Tax Alert analyses the ATO’s latest draft guidance, including the issues described above, and highlights our key takeaways.

Stakeholders have the opportunity to make comments on both TR 2024/D3 and PCG 2024/D3 by 7 February 2025.

For an overview of the new thin capitalisation rules in Australia, refer to our earlier Tax Alert.

In detail

Third Party Debt Test (TR 2024/D3)

The new TPDT broadly allows an entity to deduct all of its “debt deductions” attributable to a debt interest that satisfies the third party debt conditions. It replaced the arm’s length debt test for general class investors and financial entities.

Third party debt conditions

The ATO draft guidance is detailed and considers various aspects of each condition of the new test, including the relevant test time, how the condition applies to debt that is on issue for only part of the year, and the interpretation of key terms. In many cases it also provides examples to illustrate the ATO’s position. The draft Ruling does not, at this stage, specifically address the conduit financing rules associated with the TPDT.

In the table below, we have highlighted key points from the ATO’s draft Ruling relevant to two key TPDT conditions – the recourse condition and the use of proceeds condition. It is also important to read the draft Ruling in conjunction with the ATO’s proposed compliance approach in Schedule 3 of the draft PCG (which is discussed below).

Condition	Key points from the draft ATO guidance
Disregarding recourse to minor or insignificant assets, the holder of the debt interest has recourse for payment of the debt only to certain Australian assets held by the entity or an Australian member of the obligor group, or to membership interests in the entity (the recourse condition)	This condition looks at the potential pool of assets that are available in satisfaction or recovery of amounts owed to the holder of the debt by the issuer and is not the same as the concept of security. Where assets include rights against another entity, it does not require a 'look-through' approach to the underlying assets held by another entity. For example, if the borrower has rights against another entity under a guarantee that does not relate to the borrower’s obligations under the loan, the ATO’s position is that the lender is not considered to have recourse to the assets of the guarantor even though these assets may be used to satisfy its obligations under the guarantee (example 6). It is not clear if this approach would also apply to a guarantee that directly relates to the borrower’s obligations under the relevant debt. Notwithstanding the above, a 'look-through' approach may be required in determining whether assets are 'Australian assets' for the purposes of this test. Whilst TR 2024/D3 indicates that whether an asset is an Australian asset depends on the relevant facts and circumstances, it includes an example where shares in an Australian subsidiary are not considered to be Australian assets as the subsidiary has an overseas permanent establishment (PE) because the connection with a foreign jurisdiction is more than tenuous or remote (example 13). It is not clear how far this approach might extend. TR 2024/D3 appears to suggest that an asset may not be treated as an Australian asset if it has more than a tenuous or remote connection to another jurisdiction, even if that asset is also substantially connected with Australia. For example, if the Australian subsidiary held shares in a foreign subsidiary (as opposed to an overseas PE), would this result in the shares in the Australian subsidiary being treated as not Australian assets? This will be a critical point to gain clarity on for those groups looking to amend security arrangements in order to satisfy the test. With regards to the exclusion for minor or insignificant assets, the ATO considers that this covers assets of minimal or nominal value only. The ATO’s preliminary view is that this is not intended to be a measure of relative values, and the actual or hypothetical impact of any ineligible assets on the quantum or terms of the debt interest is not determinative of whether those assets are minor or insignificant. Schedule 3 of PCG 2024/D3 provides a compliance approach to help taxpayers restructure their arrangements to satisfy this condition. This is discussed further below. TR 2024/D3 also provides guidance on the general prohibition against rights in relation to guarantees, security or credit support, and each of the types of permitted credit support. Key takeaway: The ATO’s approach to recourse helpfully confirms that ‘look-through’ is generally not required. However, many will need to rely on the ATO’s compliance approach in PCG 2024/D3 to restructure arrangements that would otherwise fail this condition (see further below). The ATO’s positions on ‘minor or insignificant’ and ‘Australian assets’ are very narrow and likely to catch out some taxpayers who will now need to restructure if they are to satisfy the test.
The entity uses all, or substantially all, of the proceeds of issuing the debt interest to fund its commercial activities in connection with Australia (the use of proceeds condition)	This is a factual inquiry and is not a 'once-off' test as the use of the proceeds of debt can change over time. The concept of 'substantially all' is only intended to accommodate a minimal or nominal amount of the relevant proceeds being used other than to fund the entity’s commercial activities in connection with Australia (e.g. borrowing costs on its external financing arrangements). The context and purpose of the TPDT indicates that this condition is designed to cover third party debt that is used to fund investment in the Australian operations of trade or business capable of generating profit. It will be satisfied where it can be demonstrated that the proceeds of issuing the debt interest are used to invest in activities of that description. The use of the proceeds of issuing the debt interest to fund activities that do not meet that description (for example, the payment of distributions, capital management activities, or the indirect purchase of foreign assets through an Australian entity) will not satisfy this condition. Key takeaway: The ATO’s position that using the proceeds of issuing debt to fund payment of distributions and returns of capital is not a commercial activity in connection with Australia is likely to significantly impact many existing structures that typically use third party debt in this way. This is very common within the infrastructure and real estate sectors and will likely cause many groups to fail the test, as well as having a material impact on investment returns.

Condition

Key points from the draft ATO guidance

Disregarding recourse to minor or insignificant assets, the holder of the debt interest has recourse for payment of the debt only to certain Australian assets held by the entity or an Australian member of the obligor group, or to membership interests in the entity (the recourse condition)

This condition looks at the potential pool of assets that are available in satisfaction or recovery of amounts owed to the holder of the debt by the issuer and is not the same as the concept of security.
Where assets include rights against another entity, it does not require a 'look-through' approach to the underlying assets held by another entity. For example, if the borrower has rights against another entity under a guarantee that does not relate to the borrower’s obligations under the loan, the ATO’s position is that the lender is not considered to have recourse to the assets of the guarantor even though these assets may be used to satisfy its obligations under the guarantee (example 6). It is not clear if this approach would also apply to a guarantee that directly relates to the borrower’s obligations under the relevant debt.
Notwithstanding the above, a 'look-through' approach may be required in determining whether assets are 'Australian assets' for the purposes of this test. Whilst TR 2024/D3 indicates that whether an asset is an Australian asset depends on the relevant facts and circumstances, it includes an example where shares in an Australian subsidiary are not considered to be Australian assets as the subsidiary has an overseas permanent establishment (PE) because the connection with a foreign jurisdiction is more than tenuous or remote (example 13). It is not clear how far this approach might extend. TR 2024/D3 appears to suggest that an asset may not be treated as an Australian asset if it has more than a tenuous or remote connection to another jurisdiction, even if that asset is also substantially connected with Australia. For example, if the Australian subsidiary held shares in a foreign subsidiary (as opposed to an overseas PE), would this result in the shares in the Australian subsidiary being treated as not Australian assets? This will be a critical point to gain clarity on for those groups looking to amend security arrangements in order to satisfy the test.
With regards to the exclusion for minor or insignificant assets, the ATO considers that this covers assets of minimal or nominal value only. The ATO’s preliminary view is that this is not intended to be a measure of relative values, and the actual or hypothetical impact of any ineligible assets on the quantum or terms of the debt interest is not determinative of whether those assets are minor or insignificant.
Schedule 3 of PCG 2024/D3 provides a compliance approach to help taxpayers restructure their arrangements to satisfy this condition. This is discussed further below.
TR 2024/D3 also provides guidance on the general prohibition against rights in relation to guarantees, security or credit support, and each of the types of permitted credit support.

Key takeaway: The ATO’s approach to recourse helpfully confirms that ‘look-through’ is generally not required. However, many will need to rely on the ATO’s compliance approach in PCG 2024/D3 to restructure arrangements that would otherwise fail this condition (see further below). The ATO’s positions on ‘minor or insignificant’ and ‘Australian assets’ are very narrow and likely to catch out some taxpayers who will now need to restructure if they are to satisfy the test.

The entity uses all, or substantially all, of the proceeds of issuing the debt interest to fund its commercial activities in connection with Australia (the use of proceeds condition)

This is a factual inquiry and is not a 'once-off' test as the use of the proceeds of debt can change over time.
The concept of 'substantially all' is only intended to accommodate a minimal or nominal amount of the relevant proceeds being used other than to fund the entity’s commercial activities in connection with Australia (e.g. borrowing costs on its external financing arrangements).
The context and purpose of the TPDT indicates that this condition is designed to cover third party debt that is used to fund investment in the Australian operations of trade or business capable of generating profit. It will be satisfied where it can be demonstrated that the proceeds of issuing the debt interest are used to invest in activities of that description.
The use of the proceeds of issuing the debt interest to fund activities that do not meet that description (for example, the payment of distributions, capital management activities, or the indirect purchase of foreign assets through an Australian entity) will not satisfy this condition.

Key takeaway: The ATO’s position that using the proceeds of issuing debt to fund payment of distributions and returns of capital is not a commercial activity in connection with Australia is likely to significantly impact many existing structures that typically use third party debt in this way. This is very common within the infrastructure and real estate sectors and will likely cause many groups to fail the test, as well as having a material impact on investment returns.

Debt deductions related to hedging

Where a taxpayer chooses the TPDT for an income year, they are broadly permitted to claim debt deductions up to the 'third party earnings limit', which is the sum of each debt deduction for the income year that is attributable to a debt interest that satisfies the third party debt conditions.

For these purposes, certain debt deductions associated with hedging or managing interest rate risk are taken to be attributable to a debt interest. This includes debt deductions that are:

directly associated with hedging or managing the interest rate risk in respect of the debt interest; and
not referrable to an amount paid, directly or indirectly, to an associate entity.

Example 1 of the draft Ruling depicts a conduit financing scenario where a financing entity (‘FinCo’) has borrowed funds from a bank and on-lent the funds to an associate entity ('Project Trust'). FinCo has also obtained a swap from an external party and passed this on to the Project Trust on a back-to-back basis via a separate swap arrangement between FinCo and Project Trust ('on-swap'). TR 2024/D3 indicates that the requirement that costs associated with hedging are not referrable to amounts paid to an associate entity is not satisfied in this case in respect of debt deductions paid under the on-swap between FinCo and the Project Trust. This appears to include circumstances where the external swap is ‘in the money’ and FinCo is required to make payments in relation to the on-swap to the Project Trust. If the FinCo’s payments in relation to the on-swap are considered to be ‘debt deductions’, TR 2024/D3 indicates that these debt deductions will be disallowed under the TPDT.

This is likely to cause significant issues for funding structures that are intending to rely on the conduit financing rules, have hedging in place and pass these through to the ultimate borrower using separate back-to-back swaps. It is noted, however, that the ATO provides a compliance approach in Schedule 3 of PCG 2024/D3 in relation to a restructure that is undertaken to remove back-to-back swaps in a conduit financing scenario and instead embed the cost of hedging into the intercompany lending. This is discussed further below.

Restructures and thin capitalisation (PCG 2024/D3)

PCG 2024/D3 was first released by the ATO on 9 October 2024. It is intended to provide a framework for assessing the risk of anti-avoidance provisions applying to restructures in response to the changes to the thin capitalisation rules, and highlights areas the ATO is likely to apply resources to review arrangements.

The original draft PCG included two schedules relating to the debt deduction creation rules (DDCR):

Schedule 1 contains background to the DDCR and examples where the DDCR may or may not need to be considered.
Schedule 2 addresses the ATO preliminary views in relation to restructures in response to the new debt deduction creation rules.

The revised draft PCG released on 4 December 2024 contains two new schedules dealing with restructures in relation to the TPDT (Schedule 3) and restructures in response to the thin capitalisation changes more generally (Schedule 4). The risk assessment framework set out in the draft PCG remains the same with four zones – white, yellow, green and red. Restructures will broadly fall into the green zone if covered by a low risk example in Schedule 2 or 4 of the draft PCG, and into the red zone if covered by high risk examples in Schedule 2 or 4 of the draft PCG.

Refer to our earlier Tax Alert for further details of the risk assessment framework, and in relation to Schedules 1 and 2 which are largely unchanged at this time.

ATO’s proposed compliance approach in relation to the third party debt test

New Schedule 3 of draft PCG 2024/D3 deals with restructures relating to the TPDT. Specifically, it provides targeted compliance approaches that can be applied to:

restructures that remove recourse for payment of a debt to assets that are not Australian assets, including with regard to the minor or insignificant exemption, or
restructures undertaken to comply with the requirement in the conduit financing conditions that on-lending arrangements are broadly on back-to-back terms.

Schedule 3 takes a different approach to Schedules 2 and 4 in that it does not focus on whether restructures are high or low risk of attracting the operation of anti-avoidance provisions. Instead, it provides a set of criteria which, if applicable to a restructure, will reduce the likelihood of the ATO applying compliance resources to verify outcomes under the TPDT both before and after the restructure. This is a welcome approach as many taxpayers are seeking to amend their third party debt arrangements to ensure satisfaction of the third party debt conditions.

To benefit from the compliance approaches outlined in Schedule 3, the following requirements must be met:

Any restructure is undertaken in a straightforward manner having regard to the circumstances, without any associated contrivance or artificiality and is on arm’s length terms.
The restructure will not attract the application of the general anti-avoidance rules.
Prior to and following any restructure, the original arrangement satisfies the third party debt conditions (other than the condition to which the compliance approach applies).
The use of the financial arrangement does not change.
The quantum and rate of the financing arrangement do not materially change.

Schedule 3 of the draft PCG, which should be read in conjunction with TR 2024/D3, broadly outlines three compliance approaches, summarised in the table below. These are intended to facilitate taxpayers determining whether to restructure their affairs to comply with the TPDT.

Condition	Compliance approach
Recourse to Australian assets	This compliance approach is limited to restructures undertaken between 22 June 2023 and the end of the income year in which the PCG is finalised. It applies only for the purpose of considering whether the recourse condition is satisfied in the period prior to the restructure. Where restructures are consistent with examples provided and the requirements set out above are also met, the ATO will only allocate compliance resources to verify that this compliance approach applies. Examples involve removing recourse to foreign assets from the obligor group by amending loan terms (example 20), disposing of foreign assets (example 21) and rearranging business transactions (example 22).
Disregard recourse to minor or insignificant assets	This compliance approach is limited to income years starting on or after 1 July 2023 and ending on or before 1 January 2027. It applies only for the purpose of considering whether the recourse condition is satisfied in the period prior to the restructure. Where taxpayers satisfy the following criteria, the ATO will only apply compliance resources to verify that this compliance approach applies. The criteria are: You make reasonable efforts to identify minor or insignificant assets of the obligor group that are not Australian assets and both of the following apply: The market value of those assets identified is less than 1% of all of the assets to which the holder of the debt interest has recourse for the payment of the debt. The market value of each asset (or bundle of identical assets, such as a shareholding) does not exceed $1m. None of those assets are credit support rights.
Conduit financing – requirement for lending arrangements to be on back-to-back terms	This compliance approach is limited to restructures undertaken between 22 June 2023 and the end of the income year in which the PCG is finalised. It applies only for the purpose of considering whether the conduit financing condition relating to back-to-back terms is satisfied in the period prior to the restructure. For examples 25 and 26 of the draft PCG (creating multiple intercompany loans and amending hedging arrangements), the compliance approach also applies when considering whether this condition is satisfied following the restructure for income years ending on or before 1 January 2027. Where restructures are consistent with examples provided and the requirements set out above are also met, the ATO will only allocate compliance resources to verify that this compliance approach applies. Examples involve removing the margin on project finance (example 24), creating separate intercompany loans where previously only one intercompany loan existed (example 25), and removing back-to-back swaps and embedding the hedging costs into the intercompany loan (example 26). Given that this compliance approach applies only for the purpose of considering whether the ‘back-to-back terms’ conduit financing condition is met, it is unclear whether the compliance approach provides protection for pre-restructure debt deductions from back-to-back swap costs arising in example 26. This is because payments made under the back-to-back swap do not satisfy the requirement that amounts are not paid directly or indirectly to an associate entity, which is not explicitly covered by this compliance approach.

Practically, the compliance approach set out in the draft PCG appears to indicate that arrangements that would otherwise fail the TPDT will be treated by the ATO as if they satisfy the third party debt conditions for a period before the restructure, if the restructure is undertaken within the required time frames and in line with the requirements of the compliance approach. This approach will be welcomed by taxpayers. As taxpayers may need to negotiate changes to their financing arrangements in place prior the end of the income year when the PCG is finalised (potentially 30 June 2025), discussions may need to begin early in respect of potential changes that are required.

ATO’s proposed compliance approach in relation to restructures in response to the thin capitalisation changes more generally

Draft PCG 2024/D3 now includes a Schedule 4 which considers the ATO’s views on compliance risks associated with certain restructures in response to the new thin capitalisation rules. This is in the context of the potential for the general anti-avoidance provisions (Part IVA) to apply to cancel all or part of any tax benefits that arise following a restructure in response to the new thin capitalisation rules.

Following the same risk framework in the previously issued draft PCG, the ATO now includes the following examples of a low risk and high risk restructures:

Forming a tax consolidated group which results in no debt deductions denied – considered to be low risk because the group availed itself of a choice open to it and did not otherwise restructure its affairs to produce a result that no debt deductions were denied using the consolidated group’s tax EBITDA (example 27).
Introducing debt in Australia to maximise debt deductions under the fixed ratio test (FRT) – considered to be high risk because under the facts, the additional debt appears to have been introduced for the purpose of maximising debt deduction ‘capacity’ under the FRT and with no apparent commercial purpose (i.e. there was no change to the taxpayer’s business operations, nor did it result in a material change in the group’s global leverage) (example 28).
Amending conduit financing interest rates – considered to be high risk where intercompany loans are amended to reflect the highest interest rate of all the external loans (example 29).

The takeaway

Restructures undertaken in response to the introduction of the new thin capitalisation rules are likely to be a key focus of the ATO’s compliance programs in 2025. The 2024 International Dealings Schedule already contains a new question (question 39a) requiring taxpayers to indicate if they restructured or replaced an arrangement that would have attracted the operation of the debt deduction creation rules. To supplement this, it is possible that taxpayers will be required to disclose other restructures in future ATO compliance reviews and/or future Reportable Tax Position (RTP) Schedules (although noting this is not required in the 2024 RTP Schedule).

Any taxpayer seeking to rely on the TPDT test for the 2024 and/or current income year should waste no time in re-assessing their positions adopted against the views set out in the draft Ruling and the draft PCG. For those taxpayers that currently might not be looking to use the TPDT, but may in the future, it will be imperative to review the ATO’s views on the TPDT conditions as set out in the draft Ruling. Some key issues to look out for:

Use of back-to-back swaps with a conduit financier. This is likely to be highly relevant in the infrastructure and real estate sectors.
Whether the lender has recourse to any foreign assets, including potentially on a 'look-through' basis for shares.
The use of debt for non-commercial purposes including payment of distributions and returns of capital.
The potential application of the ATO’s compliance approaches where arrangements need to be restructured to comply with the certain third party debt conditions.

This latest draft guidance from the ATO no doubt raises many questions for affected taxpayers. In this respect, the opportunity to provide feedback to the ATO on both TR 2024/D3 and PCG 2024/D3 by 7 February 2025 should be noted.

James Nickless

Partner, Tax, Sydney, PwC Australia

+61 411 135 363

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Christina Sahyoun

Infrastructure, Partner, Sydney, PwC Australia

+61 403 658 464

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Clement Lui

Director, Tax, Sydney, PwC Australia

+61 414 821 023

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Patricia Muscat

Director, Tax, Sydney, PwC Australia

+61 282 667 119

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Australia’s new thin capitalisation regime: ATO draft guidance on third party debt test and restructures

In brief

In detail

Third Party Debt Test (TR 2024/D3)

Third party debt conditions

Debt deductions related to hedging

Restructures and thin capitalisation (PCG 2024/D3)

ATO’s proposed compliance approach in relation to the third party debt test

ATO’s proposed compliance approach in relation to restructures in response to the thin capitalisation changes more generally

The takeaway

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