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Australia’s new thin capitalisation regime: ATO releases draft guidance on restructures
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  • 12 minute read
  • 10 Oct 2024

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The ATO has released its first public guidance on Australia’s new thin capitalisation rules. In a much-anticipated Draft Practical Compliance Guideline, the ATO considers the potential application of anti-avoidance rules to restructures undertaken in response to the new debt deduction creation rules.

10 October 2024

In brief

Significant changes to Australia’s thin capitalisation regime were enacted earlier this year. The move from an asset-based test to an earnings-based test, along with a highly restricted third party debt test and the introduction of new debt deduction creation rules (DDCR), means that many taxpayers will be facing debt deduction denials for the first time. As a result, some may be considering restructuring their financing arrangements.

The Australian Taxation Office (ATO) issued its first formal public guidance in relation to the new thin capitalisation rules on 9 October 2024 in the form of draft Practical Compliance Guideline PCG 2024/D3 Restructures and the new thin capitalisation and debt deduction creation rules (the draft PCG). This draft PCG 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. It currently only covers compliance risks arising from restructures in response to the DDCR and will be updated to include a new schedule on restructures arising from the other changes to the thin capitalisation rules at a later date.

In detail

The new thin capitalisation rules apply to general class investors for income years commencing on or after 1 July 2023. These rules broadly introduce the following tests:

  • a “fixed ratio test” that permits net debt deductions up to 30% of tax EBITDA
  • a “group ratio test” that allows net debt deductions up to the ratio of the worldwide group’s net interest expense to its earnings; and
  • a “third party debt test” that permits debt deductions attributable to genuine third party debt that meets certain third party debt conditions.

In addition, for income years commencing on or after 1 July 2024, the new DDCR will apply, which is intended to disallow related party debt deductions to the extent that they are incurred in relation to certain debt creation schemes that typically lack genuine commercial justification and regardless of when the arrangement was entered into. There are broadly two types of arrangements that may fall within scope of the DDCR:

  • related party debt deductions in relation to the acquisition of a capital gains tax (CGT) asset or a legal or equitable obligation from an associate, subject to certain exemptions (Type 1); and
  • related party debt deductions in relation to a financial arrangement used to fund certain payments to associates including dividends, distributions, returns of capital, and royalties (Type 2).

To read more about the new thin capitalisation rules, refer to our earlier Tax Alert.

In restructuring arrangements in response to these recent amendments, there are broadly two sets of anti-avoidance provisions that taxpayers should be aware of:

  1. the general anti-avoidance rules in Part IVA of the Income Tax Assessment Act 1936, which could potentially apply to any restructure in response to these amendments; and
  2. the new specific anti-avoidance provision for the DDCR, which can only apply to schemes that are, broadly, entered into for the principal purpose of preventing the DDCR from applying to deny a debt deduction.

Key insights from the draft PCG

The draft PCG released on 9 October 2024 contains an outline of the ATO compliance approach and risk assessment framework for assessing risks relating to thin capitalisation restructures, and two schedules. Schedule 1 contains examples where the DDCR may or may not need to be considered, whilst Schedule 2 covers the compliance risks arising from restructures in response to the DDCR. The ATO has flagged that Schedule 3, which will be added later, will cover risks relating to restructures in response to the other thin capitalisation changes. This is intended to be published concurrently with a draft ruling on the third party debt test that is currently under development.

Consistent with the approach adopted in some other PCGs, this draft PCG contains a risk assessment framework based on coloured zones, which are outlined below:

Risk zone and level Description Expected ATO compliance approach

White

Further risk assessment not required

Restructures in the following categories:

  • There is a settlement agreement between the taxpayer and the ATO entered into after 8 April 2024, and the terms of that settlement cover tax outcomes under the DDCR; or
  • There is a court decision in relation to the tax outcomes of the arrangement including under the DDCS, and the taxpayer was a party to the proceeding.

At this point in time, it is unlikely that many restructures will fall within the white zone.

 The ATO will not have cause to apply compliance resources beyond verifying that taxpayers can substantiate that the conditions for white zone have been met.

Yellow

Compliance risk not assessed

 Restructures that do not fall within the green or red zones. The ATO may engage with the taxpayer to understand the compliance risks of their restructure.

Green

Low risk

Restructures in the following categories:

  • Covered by the low-risk examples in Schedule 2 of the draft PCG and exhibit the features set out in paragraph 166 of the draft PCG (see further below); or
  • The ATO has reviewed the restructure and provided a low-risk rating or high assurance under a Justified Trust review.
 The ATO will generally only have cause to devote compliance resources to obtain comfort and verify a taxpayer's self-assessment.

Red

High risk

Restructures in the following categories:

  • Covered by the high-risk examples in Schedule 2 of the draft PCG (see further below); or
  • The ATO has reviewed the restructure and provided a high-risk rating or low assurance under a Justified Trust review.

The ATO will prioritise its resources to review these arrangements. This may involve commencing a review or audit.

The ATO has noted that whilst the red zone reflects features that are considered to indicate greater risk, it is not a presumption that Part IVA of the ITAA 1936 or the DDCR specific anti-avoidance rule will necessarily apply.

The ATO is seeking submissions on the draft PCG until 8 November 2024.

DDCR examples

In Schedule 1 of the draft PCG, the ATO sets out a number of examples involving general class investors and indicates whether the DDCR will need to be considered in each scenario. Whilst some of these are straightforward, there are some important insights which we have drawn out below:

  • Timing and the associate pair condition - Example 1 is a taxpayer that uses related party debt to finance the acquisition of a CGT asset from a third party that later becomes an associate pair. The ATO states that in this case, the taxpayer does not need to consider the application of the DDCR as the taxpayer and the third party were not associate pairs at the time the taxpayer acquired the CGT asset. This is a helpful example as it clarifies that the associate pair condition is to be tested at the time of the acquisition for a Type 1 arrangement, and later changes that establish an associate pair relationship should not create a DDCR issue.
  • Cash pooling - Example 4 is a taxpayer which is part of a multinational group that has a global cash pooling arrangement. The ATO states that the taxpayer will need to consider the application of the DDCR where the account balance attached to the cash pool goes into negative such that the taxpayer will pay interest on the negative balance to the cash pool leader. Although the example does not explicitly state whether the cash pool leader is an associate pair of the taxpayer, we expect that this should be the case and therefore the scope of this example does not include cash pooling arrangements in which interest is only payable directly or indirectly to an unrelated financial institution. Notably, in this example, the entity used its cash pool to undertake transactions with associate pairs and therefore does not cover cash pools that are used to fund commercial transactions with external parties. Nonetheless, this example provides acknowledgment from the ATO that the DDCR can apply to cash pooling arrangements in a similar manner to other forms of related party debt.
  • Interaction with Division 7A loans - The draft PCG contains two examples (Examples 9 and 10) highlighting the potential application of the DDC to a complying Division 7A loan which is relevant to private companies. Example 9 features a taxpayer that uses a complying Division 7A loan to fund the acquisition of a CGT asset from an associate paid, which is a Type 1 DDCR arrangement. Example 10 features a trust that uses a complying Division 7A loan to settle a beneficiary’s unpaid present entitlement (UPE) to trust income, which is a Type 2 DDCR arrangement. These are very common arrangements within privately held groups and can present challenges if a trust requires cash to be retained (rather than paid out as a trust distribution) for reinvestment or working capital purposes.

Evidence, tracing and apportionment

The draft PCG provides some limited guidance on the records and evidence that a taxpayer will require to determine whether the DDCR has application to arrangements, noting that many stakeholders have raised concerns about the lack of documentation available for historical transactions. Whilst acknowledging the challenges of obtaining documents to evidence use of related party debt funding for historical transactions, the draft PCG confirms that the onus is on the taxpayer to prove that the DDCR does not apply, and the ATO does not consider it appropriate to limit its compliance activities to more recent transactions. The following documents and information are mentioned in the draft PCG as being able to assist in determining whether the DDCR applies to historical transactions:

  • copies of loan documentation prepared when the related party debt was entered into or dealt with (for example, intercompany loan agreements or other documents setting out the purpose of the loan and key terms)
  • copies of the taxpayer's and relevant associate pair's financial accounts for the relevant years, prepared in accordance with accounting principles, and any records or working papers prepared by the taxpayer or their professional advisers, for example, accounting or tax working papers
  • copies of cash flow statements, general ledger, journals or other records or working papers with identifiable entries relating to historical transactions and related party debt
  • copies of bank statements or payment records; and
  • copies of board minutes, resolutions and papers, or any other contemporaneous documentation relating to the decisions to undertake historical transactions or enter into related party debt.

The draft PCG also notes that the ATO expects best practice recording keeping practices have changed since the enactment of the DDCR, such that taxpayers now would keep contemporaneous documentation and associated analysis on the operation of the DDCR. Importantly, the ATO’s expectation is that a taxpayer should not claim a debt deduction unless sufficient information is available to support a conclusion that the DDCR does not apply.

With respect to tracing and apportionment, the draft PCG notes that tracing is a factual exercise and, while apportionment does not replace tracing, it may be appropriate to apportion where it is not possible to trace. Whether an apportionment methodology is fair and reasonable depends on the facts and circumstances. As such, the ATO has not provided much in the way of guidance on these two matters.

Low and high-risk restructures

Schedule 2 of the draft PCG contains examples of restructures in response to the DDCR that the ATO consider to be low-risk or high-risk restructures, and a list of features that must be present for a restructure to be low risk. These features are:

  • debt deductions disallowed by the DDCR prior to the restructure have been accurately calculated
  • prior to the restructure, the arrangements would not have attracted the application of Part IVA of the ITAA 1936
  • the restructure occurs in a straightforward manner having regard to the circumstances without any associated contrivance or artificiality and is on arm’s length terms; and
  • the arrangement following the restructure will not attract the application of Part IVA of the ITAA 1936.

A restructure will not be considered low risk unless all of these features are present.

The low-risk restructures identified in the draft PCG can be summarised as follows:

  • repaying debt from retained earnings with no new debt arrangements entered into (example 12)
  • repaying temporary bridging finance obtained from shareholders with external finance that was always anticipated (example 13)
  • liquidating a dormant foreign subsidiary such that the taxpayer is no longer a general class investor subject to the DDCR (example 14)
  • repaying debt from the issue of new equity (examples 15, 16 and 17); and
  • utilising separate non-interest bearing accounts or borrowings for transactions with associate pairs (example 17).

High risk restructures identified in the draft PCG include:

  • contending to change the character of costs incurred or the use of debt (example 18); and
  • replacing related party debt with third party debt where the original associate lender repays a similar amount to the third-party lender (example 19).

There will be many restructures that do not fall within the low-risk or high-risk examples highlighted by the ATO. For example, taxpayers may replace related party debt with third party debt in genuine commercial circumstances that do not align with example 19 (i.e. where the original associate lender does not repay a similar amount to the third-party lender or a domestic refinancing in line with the maturity of foreign debts). Therefore, the draft PCG offers taxpayers limited clarity on whether the ATO will seek to apply the anti-avoidance provisions to this type of simple restructure even where it is undertaken on a commercial, arm’s length basis without any contrivance, artificiality or other circumstances indicative of debt ‘dumping’.

The takeaway

Taxpayers that have already undertaken or are considering undertaking restructures or refinances in response to the new thin capitalisation rules, should review the PCG against their own facts and circumstances to identify the risk that the ATO will seek to apply the anti-avoidance provisions. This is particularly important given that all restructures undertaken in anticipation of the debt deduction creation rules must be disclosed in the 2024 International Dealings Schedule to be lodged with the income tax return. In addition, taxpayers may be required in future to report any self-assessed risk ratings based on the PCG in a Reportable Tax Position Schedule to be lodged with the ATO. It is clear that where high risk restructures are identified, taxpayers should consider engaging with the ATO early, as this issue is likely to be a key feature of ATO compliance action over the next year.

Contact us

If you would like to further discuss this Alert, reach out to our team or your PwC adviser.

James Nickless

Partner, Tax, Sydney, PwC Australia

+61 411 135 363

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Angela Danieletto

Partner, Tax, Sydney, PwC Australia

+61 410 510 089

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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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