Third party debt test: Draft ATO guidance

On 4 December 2024, the ATO released further guidance in relation to the new thin capitalisation rules in Division 820 of the Income Tax Assessment Act 1997 (Cth) (ITAA97) in the form of a Draft Taxation Ruling [TR 2024/D3](Draft Ruling) and an updated Draft Practical Compliance Guideline [:PCG 2024/D3] (Draft PCG), in each case dealing with aspects of the third party debt test (TPDT).

The TPDT, which replaces the previous arm’s length debt test, limits an entity’s gross debt deductions for an income year to an amount equal to the sum of its debt deductions for that year that are ‘attributable to’ debt interests:

• which are issued to non-associated entities;
• which are used to fund the entity’s Australian operations; and
• where lenders have recourse only to Australian assets of the borrower and the obligor group.

The draft ruling addresses each of these key aspects, but does not include guidance on the ‘conduit financing’ rules.

While the provision of guidance on these rules is welcome, and a number of the compliance approaches are helpful (if only for the short term), there are a number of additional issues which should be considered and some areas where more clarity is needed. Submissions on the draft guidance are open until 7 February 2025.

The Draft Ruling provides limited and, in some cases, problematic guidance on the operation of important elements of the TPDT which in some cases is addressed by short term ‘compliance approaches’ outlined in the Draft PCG:

• When swap costs are ‘attributable to’ the relevant debt interest: The Draft PCG spends little time considering the meaning of ‘attributable to’ and instead focusses on s 820-427A(2), which deems certain swaps costs to be attributable to complying debt interests in some circumstances. As a result, it is unclear whether the Commissioner considers that swap costs can be attributable to complying debt interests where s 820-427A(2) doesn’t apply – specifically in conduit financing structures.
• ‘Recourse’ to ‘Australian assets’: The Commissioner considers that lenders will have ‘recourse’ to all assets of a borrower unless the terms of the debt interest specifically limit the lender’s recourse, meaning that taxpayers with non-Australian assets will either need to transfer those assets or amend the terms of their debt to rely on the TPDT. The Commissioner’s description of non‑Australian assets is vague and creates uncertainty.

When are debt costs are ‘attributable to’ the relevant debt interest?

A debt cost will be deductible under the TPDT if it is ‘attributable to’ a debt interest issued by the entity that satisfies the third party debt conditions.¹ The phrase ‘attributable to’ is not defined in the ITAA97. In the Draft Ruling, the Commissioner expresses the view that the phrase expresses a similar nexus enquiry as the phrase ‘in relation to’ as it appears in s 820-40 (prior to the recent changes) and denotes something like ‘belonging to’ or ‘caused by’, and, like the phrase ‘in relation to’, requires a nexus between the cost and the interest.² The Commissioner considers this appropriate in the context of the TPDT but has said elsewhere: “[c]onsistent with judicial consideration of the phrase 'attributable to' in other contexts, its use in the NCMI provisions should also be interpreted broadly”.³

The Draft Ruling notes that ‘[a]n entity will generally be able to claim its debt deductions in full if all the debt interests it issues satisfy the TPDT’,⁴ but this conflicts with subsequent statements in the Draft Ruling that not all debt costs will be ‘attributable to’ debt interests.

For example, in the Commissioner’s view, interest rate swap costs are seemingly not (aside from the operation of a deeming provision which doesn’t apply in conduit financing situations)⁵ ‘attributable to’ a debt interest⁶ – at least where there is a separate swap agreement and loan agreement.

This view seems to conflict with the language previously included in s 820-40(3)(a), which expressly contemplated swap costs being ‘in relation to’ debt interests. That legislative history is relevant to the interpretation of the current rules.

‘Recourse’ to ‘Australian assets’

For the TPDT to operate, the lender must have recourse only to the Australian assets of the borrower or another Australian member of the borrower’s ‘obligor group’.⁷ ‘Minor or insignificant’ assets are disregarded when assessing whether this requirement is met.

In the Commissioner’s view:

• The meaning of ‘recourse’: ‘Recourse’ is broader than traditional security,⁸ and ‘refers to the [debt interest] holder’s ability to recover amounts owed to it by the issuer in respect of the debt to which the debt interest relates’.⁹
• The exclusion of non-Australian assets: An agreement which ‘ring fences’ or excludes from recourse any potential or future non-Australian assets held by a borrower or obligor group is not strictly necessary where neither the borrower nor the obligor group hold non-Australian assets.¹⁰

However, this requirement is tested continuously throughout the period the relevant debt interest is on issue. Therefore, a borrower or an obligor group could fall foul of the requirement where a not insignificant non-Australian asset is acquired during the life of a debt interest. In the draft PCG, the Commissioner suggests that a foreign bank account into which sales proceeds from foreign customers are deposited before the funds are repatriated to Australia would be a non-Australian asset that is not minor or insignificant if the balance is material at some point during the year, i.e. during the period between sales proceeds being deposited and repatriated. Taxpayers relying on the TPDT will need to closely monitor their ownership of any non-Australian assets as it may be difficult in practice to limit a lender’s recourse to non-Australian assets since cash could then be moved outside a lender’s reach by being transferred into a foreign account.

In the Draft PCG, the Commissioner outlines three types of restructures which he considers appropriate to meet this element of the TPDT: removing recourse to foreign assets from obligor group by amending an agreement (as noted above, this may be challenging as a practical matter), removing recourse to foreign assets from obligor group by transferring the assets to an associate, and the disposal of a foreign asset completely (eg, closing a foreign bank account). The Draft PCG also outlines a compliance approach where assets can be treated as insignificant (for income years ending before 1 January 2027) if they are valued at less than $1 million.

• The meaning of ‘Australian asset’: The undefined term ‘Australian asset’ is intended to capture assets that are substantially connected to Australia.¹¹ Australian real property is clearly an Australian asset.¹² In the Commissioner’s view, shares in an Australian company which carries on business only in Australia will be Australian assets,¹³ while shares in an Australian company that carries on an Australian business but also has an overseas permanent establishment will not be Australian assets. This is on the basis that the company has ‘a connection with a foreign jurisdiction which […] is more than tenuous or remote’.¹⁴ In our view, this analysis is imprecise, and leaves a number of questions open. For example, are shares in a company which engages in business in equal proportions in Australia and overseas Australian assets? The Draft Ruling also includes an example of an Australian company which owns a CFC – that example concludes that the shares in the CFC are not Australian assets but is silent on the treatment of the shares in the Australian company.