Australia’s new thin capitalisation regime: ATO’s finalised guidance on third party debt test

Third party debt conditions

The 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. 

TR 2025/2 is detailed and considers various aspects of each of the TPDT conditions. In many cases it also provides examples to illustrate the ATO’s position. This final Ruling largely maintains positions that are consistent with the draft ruling released in December 2024, while providing expanded commentary and examples for certain conditions. 

Below, we have highlighted key points from the ATO’s Ruling relevant to two key TPDT conditions – the ‘recourse’ condition and the ‘use of proceeds’ condition.

The ‘recourse’ condition

The ‘recourse’ condition is one of the key requirements of the TPDT. It requires that “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”. There are a number of elements to this condition which are set out below, along with the key points that are made in the Ruling.

Meaning of ‘recourse for payment of the debt’

• 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. The ATO confirms that the concept of recourse is not the same as the concept of security.

“Minor or insignificant assets” exclusion

• The ATO has maintained its view that this exclusion covers assets of minimal or nominal value only. It 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.
• Credit support rights are unlikely to ever be minor or insignificant. 

Assets that are ‘rights against another entity’ or ‘membership interests in another entity’

• Where the lender has recourse against assets that are rights against another entity or membership interests in another entity, those rights or membership interests themselves are the relevant assets. 
• This condition involves an enquiry as to whether those rights or membership interests are permissible assets and that enquiry does not require a ‘look-through’ approach to the underlying assets that are held by another entity. 
• However, in the case of assets that are membership interests in an entity, a ‘look-through’ to the underlying assets directly or indirectly held by that entity may be appropriate for determining whether the membership interests are ‘Australian assets’ for the purposes of satisfying the TPDT (see below).

Meaning of ‘Australian assets’

• The determination of what constitutes an Australian asset should be “made from a business and practical point of view, bearing in mind the purpose for which the provision was enacted”, which the ATO has described to be to “prevent entities from using offshore assets to inflate borrowing capacity (and therefore Australian debt deductions) beyond what the entity’s Australian assets would support”. 
• The Ruling notes that the following factors may point towards an asset ‘having a substantial connection to Australia’ (a requirement to be an Australian asset):
  • physically located in Australia
  • used in Australia
  • used by, or benefits, an Australian entity (and not attributable to a foreign permanent establishment or offshore operations)
  • connection to an Australian legal framework
  • used for the purpose of producing Australian sourced assessable income, or
  • no, or only a limited or remote connection to another jurisdiction.
• Additional guidance has been provided for tangible assets, intangible assets and membership interests. 
• For a membership interest to be an Australian asset, the ATO’s view is that it must be a membership interest in an Australian entity. However, this alone is not sufficient to be an Australian asset. The ATO supports a ‘look-through’ approach that examines the composition of underlying assets held by that entity. If that Australian entity directly and indirectly holds both Australian and foreign assets, the ATO's view is that the membership interests will only qualify as Australian assets if the underlying foreign assets are minor or insignificant.

Membership interests in the borrower

• The ATO’s view is that the TPDT does not permit recourse to membership interests in the borrower entity if that entity holds any direct or indirect interest in a foreign asset - even if that asset is minor or insignificant. 

The ’use of proceeds’ condition 

The use of proceeds condition requires 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”. Similar to the recourse condition discussed above, this test also has several limbs, which are considered below with the key points from the ATO guidance.  

Relevant test time 

• The use of proceeds condition is tested continuously throughout the period the relevant debt interest is on issue (i.e. it is not a once-off test). 

“All, or substantially all” 

• The ATO takes the view that this phrase should be interpreted as “nearly all” or “almost all”. This means the threshold is very high for determining whether debt proceeds were used for commercial activities in connection with Australia. 

“Commercial activities in connection with Australia” 

• Activities undertaken in the course of the entity’s business connected with Australia (including activities that are ancillary to or support these activities) and the refinancing of debt used to fund Australian commercial activities can be treated as ‘commercial activities in connection with Australia’. 
• Controversially, the ATO has maintained its view that the payment of dividends and returns of capital does not constitute ‘commercial activities in connection with Australia’.  
• In the accompanying Compendium, the ATO has stated that it does not agree that debt proceeds are used to fund Australian commercial activities simply because the associated debt deductions are deductible outside Division 820. In addition, the ATO does not accept that the phrase ‘commercial activities in connection with Australia’ takes the same meaning as under the former arm’s length debt test. 

Other matters 

As the Ruling is not intended to cover all possible factual circumstances or interpretative questions, there remain a number of commonly encountered matters that are not currently covered by formal guidance, including: 

• the application of the ‘conduit financing conditions’ for internal on-lending arrangements (the conduit financing rules are entirely outside of the scope of the Ruling) 
• the interaction between the TPDT’s recourse requirements and tax consolidated groups, and  
• what ‘debt deductions’ arise from non-conventional interest rate swaps (e.g. a cross currency and interest rate swap (CCIRS)).  

Conduit financing and debt deductions related to hedging 

The final Ruling reconfirms the ATO’s previous position regarding the use of back-to-back swaps in conduit financing arrangements.  

As a reminder, 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 Ruling depicts a conduit financing arrangement 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'). The Ruling confirms 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, even if the debt deduction is effectively passed-on by that associate to a non-associate entity of the entity. 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 2025/2 indicates that these debt deductions will be disallowed under the TPDT. 

This position remaining unchanged in the final Ruling 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. The provision of a compliance approach in Schedule 3 of PCG 2025/2 to remove back-to-back swaps in a conduit financing scenario and instead embed the cost of hedging into the intercompany lending (discussed further below) is helpful, but requires affected taxpayers to incur significant costs to restructure their arrangements and end up in the same position economically. 

ATO compliance approach to the TPDT 

PCG 2025/2 has been updated to now include Schedule 3 relating to the ATO’s compliance approach for the TPDT. Schedule 3 was first released in draft in December last year. 

Unlike the other Schedules in PCG 2025/2, Schedule 3 is not intended to help taxpayers self-assess their risk against a risk assessment framework. Instead, it provides targeted compliance approaches which taxpayers can rely on to restructure their arrangements to fall within the TPDT without attracting ATO compliance resources.  

Practically, where the restructure falls within the compliance approach outlined by the ATO, the taxpayer will be treated as having met the requirements of the TPDT for the period prior to the restructure. This is largely in line with the draft version. A welcome change is the extension of the period in which to undertake some restructures to 1 January 2027 (previously this was to be limited to the end of the income year in which the PCG was finalised). For a 30 June balancing taxpayer, this provides an additional 6 months to undertake the restructure, and an additional year for a 31 December balancer.  

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 or conditions where more than one 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 PCG, which should be read in conjunction with TR 2025/2, broadly outlines four compliance approaches, summarised in the table below. These are intended to facilitate taxpayers determining whether to restructure their affairs to comply with the TPDT. There is currently no requirement in the income tax returns or associated schedules to disclose reliance on any of these compliance approaches. 

Entities that have already lodged a tax return 

To choose the TPDT for an income year, a taxpayer must complete an approved form by the earlier of the date it lodges, or is required to lodge, its tax return. The Commissioner may grant an extension of time to make this choice. Once made, the choice can only be revoked if the Commissioner deems it fair and reasonable. The ATO has published guidance outlining when extensions or revocations may be appropriate. 

As the first tax returns under the new thin capitalisation rules were generally due earlier this year, many taxpayers have already lodged returns. Some used the default Fixed Ratio Test because they did not qualify for restructure examples in the draft PCG or could not complete a restructure within the draft PCG’s timeline. With new restructure examples now added—likely relevant to many entities—and the deadline extended to 1 January 2027, many are now expected to seek to apply the TPDT for the first income year.

In this case, taxpayers need to request an extension of time to choose the TPDT and, if they previously selected the Group Ratio Test, also request revocation of that choice. It would be helpful that such requests will be granted where restructures are genuine and align with the ATO’s compliance approach in PCG 2025/2. 

The TPDT was intended to accommodate genuine commercial arrangements relating to Australian business operations, and to balance tax integrity policy intent of the thin capitalisation rules (to prevent base erosion and profit shifting through the use of interest deductions) with the desire to ensure that genuine commercial arrangements were not unduly impeded. Unfortunately, some taxpayers may find that the practical reality of these rules might be somewhat misaligned with this intention.  

Some of the positions adopted by the ATO in the Ruling are likely to restrict the availability of the test to common commercial arrangements without restructuring. Whilst the compliance approaches in the PCG are a welcome and somewhat novel approach from the ATO, there are significant costs and practical impediments associated with restructuring to fall within the scope of these concessions.  

It is likely that the next opportunity to address the perceived failings of this test will come with the post-implementation review of the thin capitalisation rules that must commence no later than 1 February 2026. This process will hopefully provide an opportunity to assess the impact of these changes, including whether the amendments have denied deductions for genuine financial arrangements, and had an impact on Australia’s ability to attract foreign investment.