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Australia’s new thin capitalisation regime: Reviewing debt documents for the third party debt test
Australia’s new thin capitalisation regime: Reviewing debt documents for the third party debt test
  • 7 minute read
  • July 15, 2024

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As many taxpayers subject to the new thin capitalisation rules have already found, not all third party borrowings are eligible to meet the new ‘third party debt test’. In this Tax Alert, we discuss some of the key things that taxpayers seeking to rely on this test should look for when reviewing their third party agreements.

15 July 2024

In Brief

The thin capitalisation rules now include a third party debt test (TPDT) as one option taxpayers may elect to use. Broadly, the TPDT allows debt deductions attributable to genuine third party debt only (that is, debt that satisfies the third party debt conditions) while entirely disallowing debt deductions that do not meet the requisite conditions (including all related party debt deductions). 

However, not all third party debt arrangements are eligible for this TPDT. Many of the features that may cause a debt arrangement to be ineligible are commonly found in commercial third party debt arrangements. Therefore, taxpayers that are seeking to rely on the TPDT should first conduct a thorough review of their transaction agreements to ensure that the test is available. 

This Tax Alert discusses the things to look out for when conducting this review, including some of the more common issues that arise from ordinary commercial dealings. The comments are based on the thin capitalisation rules and available guidance as at the date of this Tax Alert. 

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

In Detail

First, a quick refresher 

The TPDT is available for debt deductions that are attributable to debt interests that satisfy the third party debt conditions. Broadly, these conditions require that: 

  • The issuer (borrower) of the debt must be an Australian entity. 
  • The holder (lender) of the debt must not be an associate entity of the issuer. 
  • The holder (lender) must only have recourse for payment of the debt to certain types of Australian assets held by either the issuer (lender) or an Australian entity that is in the obligor group (subject to certain narrow exceptions). 
  • Substantially all of the proceeds of the debt are used to fund the issuer's Australian commercial activities, which does not include any business carried on by an overseas permanent establishment nor the holding of any associate entity debt, controlled foreign entity debt or controlled foreign entity equity. 

Notably, the definitions of Australian entity and associate entity are modified for the purposes of the TPDT. There is also a special rule that makes the TPDT available for third party hedging costs for managing the interest rate risk for third party debt that is itself eligible for the TPDT, as well as a 'conduit' test that modifies the third party debt conditions where third party debt proceeds are on-lent by the issuer to an associate entity. 

When reviewing your third party agreements 

The TPDT works on an 'all or nothing' basis for each debt interest. In other words, the TPDT fully disallows each debt deduction that is attributable to a debt interest that does not satisfy the test, while leaving untouched each debt deduction that is attributable to a debt interest that does satisfy the test. Given the binary outcome, taxpayers should conduct a thorough review of their third party debt agreements to be reasonably confident that their debt deductions are eligible for the TPDT.

When you are reviewing your third party debt agreements, it will be important to ask: 

Who are the parties involved? 
  • Is the borrower an ‘Australian entity’? 
  • Are there any foreign entity guarantors or security providers? 

(see 'Australian entity requirement') 
Which assets does the lender have recourse to? 
  • Does the lender have recourse against non-Australian assets? 
  • Does the lender have recourse against assets that are held by a non-Australian entity? 
  • Does the lender have recourse against assets that are rights in relation to a guarantee, security or credit support? 

(see ‘Recourse assets’) 
What were the third party debt proceeds actually used for? 
  • Were the debt proceeds used for anything that might not be considered to be an Australian commercial activity? 
  • How can we practically identify the actual use of those proceeds? 
(see ‘Use of debt proceeds’) 
Was some or all of the third party debt proceeds on-lent to an associate entity? 
  • Are the terms relating to costs (including interest rate and fees) the same between the third party loan and the related party on-loan? 
  • Were the proceeds of the related party on-loan entirely sourced from a single third party debt interest? 

(see ‘Related party on-lending') 
Are there any hedging arrangements for managing the interest rate risk of the third party debt? 
  • Are there any interest rate hedging arrangements, including related party swaps executed on back-to-back terms with a market facing swap? 

(see ‘Hedging arrangements’)

‘Australian entity’ requirement

It is important to check if the borrower, each guarantor or each security provider is an 'Australian entity'. This is because the TPDT is not available for a third party debt interest if the borrower is not an ‘Australian entity’ or if the lender has recourse to assets (other than membership interests in the borrower) that are held by an entity that is not an ‘Australian entity’. 

For the purposes of the TPDT, an ‘Australian entity’ must either be an Australian resident, an Australian trust or a partnership where Australian residents or Australian trusts together hold at least a 50% direct participation interest. Therefore, a foreign resident entity, including a foreign resident carrying on a business through an Australian permanent establishment, is not able to benefit from the TPDT. Similarly, a partnership formed in Australia that does not have at least 50% of the partnership interests held by Australian partners will also not be eligible for the TPDT. 

Recourse assets 

Given that the TPDT permits lender recourse only to Australian assets that are held by Australian entities (subject to certain narrow exceptions), the application of the test requires an examination of the potential pool of assets to which the lender may have recourse. The following forms of lender recourse are commonly present in commercial third party debt arrangements, but may give rise to an issue when seeking to rely on the TPDT: 

  • The borrower or a guarantor holds non-Australian assets, and the security terms do not 'ringfence' the available lender recourse only to Australian assets. This will often be the case where the borrower or a guarantor is an Australian entity that owns shares in foreign subsidiaries that are not minor or insignificant. 
  • One or more of the guarantors is not an Australian entity (for example, a foreign parent guarantor). 
  • Security is provided over shares or units in an obligor entity, and those shares or units are directly held by a foreign entity (for example, the debt is secured over shares in an Australian guarantor, which is directly owned by a foreign holding company). 

Multinational Australian groups will therefore need to consider how foreign assets are held within their group, and how banking security arrangements are structured to ensure that lenders do not have recourse to any foreign assets if the TPDT is to be relied upon. 

Use of debt proceeds

The TPDT is available only if “all, or substantially all” of the debt proceeds are used by the borrower to fund its commercial activities in connection with Australia that do not include any business carried on at or through its overseas permanent establishments and the holding of associate entity debt, controlled foreign entity debt or controlled foreign entity equity. 

Taxpayers considering the TPDT will therefore need to consider the actual use of the debt proceeds. Where a permitted use or uses of the proceeds are stipulated in the loan agreement, the actual use may be simple to identify. If the external loan agreement covers multiple tranches, it will be important to consider if a different permitted use is specified for each tranche, and whether each tranche is a separate debt interest for purposes of this test. 

If the loan agreement does not specify the permitted use of debt proceeds, the identification of the actual use of the proceeds will likely require a tracing exercise. Subject to future guidance from the ATO or case law, the use might be identifiable from internal records, including accounting entries or bank statements. Such an exercise may be practically challenging if the records do not clearly indicate a one to one flow through of funds from drawdown to eventual use, or if the proceeds from various debt interests (which may occur if multiple drawdowns are made, the loan agreement covers multiple tranches, or if there are multiple loans) are pooled into a bank account prior to being used.

A complicated scenario that may be encountered is where an Australian group borrows third party debt to acquire shares in a target group which has non-Australian operations. A question arises as to whether the use of those proceeds to acquire the target shares could be considered to relate to both Australian and non-Australia activities (or the holding of controlled foreign entity equity).

Related party on-lending

Special rules apply to modify the TPDT where the proceeds of the third party debt interest are on-lent to another Australian entity that is an associate entity through a conduit arrangement. Of particular relevance, the ‘conduit test’ requires that:

  • The terms relating to costs of the third party debt interest are the same as those of the related party on-loan (subject to narrow exceptions allowing for the recovery of administrative and hedging costs). 
  • The related party on-loan is financed only with proceeds from the third party loan. 

The conduit test therefore covers arrangements where the proceeds of a particular third party debt interest are on-lent on the same cost terms. Taxpayers will therefore need to look out for features such as: 

  • Related party on-loan with an interest rate based on a ‘group cost of funds’, ‘blended cost of funds’ or ‘all-in third party cost of funds’ instead of the interest rate stipulated in the third party debt agreement which was used to fund the related party on-loan. 
  • Third party debt that includes fees (including establishment fees and commitment fees) that are not present in the related party on-loan and there is no clear mechanism allowing for the borrower of the third party debt to recover costs arising from these fees. 
  • Related party debt that is financed from the proceeds of multiple third party debt interests, which may occur where a group finance company has sourced debt from multiple third party lenders or from multiple drawdowns, and on-lent the proceeds to a related party via a single intercompany loan.
  • Related party debt that is financed from the proceeds of a combination of third party debt and other sources (including available cash from operations or intercompany debt). 

Hedging arrangements 

The TPDT is applicable for debt deductions that a borrower incurs for hedging or managing interest rate risk for an eligible third party debt interest if that hedging cost is not referable to an amount paid or payable to an associate entity of the borrower. 

It follows that debt deductions associated with hedging costs payable to a related party are disallowed under the TPDT. This may give rise to issues where debt deductions arise under a ‘back to back’ related party swap depending on how the arrangement is structured. 

It is also not uncommon for corporate groups to pool the interest rate risk associated with third party debt by entering into internal swaps with a group finance company, which in turn hedges the net exposure via a third party swap. Unfortunately, debt deductions associated with these internal swaps will also likely be disallowed under the TPDT. 

The Takeaway

A third party debt arrangement may not be eligible for the TPDT if one or more of the following are present: 

  • A borrower, guarantor or security provider is a not an 'Australian entity'. 
  • The lender has recourse for payment of the debt to certain assets, guarantees or security that are not eligible for the TPDT (i.e. non-Australian assets or assets that are held by non-Australian entities). 
  • Some of the debt proceeds are used to fund non-Australian activities.
  • The debt proceeds are on-lent to an associate entity in a manner that does not pass the 'conduit' test.

In addition, the TPDT disallows debt deductions associated with related party interest rate hedging arrangements, which may mean that related party swaps executed on back-to-back terms with a market facing swap face difficulties falling within the TPDT. 

Given that many of these features are common within commercial third party debt arrangements, taxpayers that are seeking to rely on the TPDT should first conduct a thorough review of their transaction agreements to ensure that their third party debt arrangements are eligible. It is expected that the ATO will release guidance which should assist taxpayers in reviewing their arrangements for compliance with the TPDT. 

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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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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