In brief
The Australian Taxation Office (ATO) has finalised Practical Compliance Guideline PCG 2025/2, outlining how it will assess restructures undertaken in response to the new thin capitalisation regime and the debt deduction creation rules (DDCR). The final PCG mostly expands upon last year’s draft, without significant deviations from it. Nonetheless, the newly added examples and guidance will have practical relevance for taxpayers that are considering the repayment of related party debt using third party debt or the repayment of third party debt using related party debt.
For an overview of the new thin capitalisation rules in Australia, refer to our earlier Tax Alert.
In detail
Risk assessment framework – four ‘traffic-light’ zones
PCG 2025/2 groups restructures into four zones that will drive the intensity of ATO engagement:
| Zone | What it means | Likely ATO action |
White
Further risk assessment not required |
A restructure will be in the white zone if:
Prior ATO review and the application of the $2m de minimis are welcome additions to the white zone (prior ATO review fell into the green zone in the draft Guideline). |
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. |
Green
Low risk |
Restructures covered by the low-risk examples in Schedule 2 or 4 of the PCG. Restructures in response to the DDCR will only fall within the green zone if they also exhibit the features set out in paragraph 202 of the PCG (see further below). | The ATO will generally only have cause to devote compliance resources to obtain comfort and verify a taxpayer’s self-assessment. |
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. |
Red
High risk |
Restructures in the following categories:
|
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 risk assessment framework is largely unchanged from the previous draft.
Schedules 1 and 2 – Restructures responding to the DDCR
Schedule 1 provides practical examples of arrangements where the DDCR may need to be considered. These examples cover a range of scenarios, such as funding acquisitions or distributions with related party debt, refinancing, cash pooling, and working capital arrangements. Schedule 1 also outlines the ATO’s expectations for record-keeping, tracing the use of funds, and fair and reasonable apportionment of debt deductions. The examples are designed to help taxpayers identify when the DDCR may apply and what evidence is required to support their tax positions.
Schedule 1 contains a number of new examples which may assist taxpayers in understanding where DDCR risks may arise. This includes examples where existing related party or third party debt, that was originally used to pay dividends to associates or acquire assets from associates, is refinanced with related party debt (examples 8 and 9). Where third party debt is refinanced with related party debt, it will be important to identify the original use of the third party debt proceeds to determine whether the post-refinance related party debt deductions may be disallowed due to the DDCR. The mere fact that the related party debt proceeds were used to fund the repayment of third party debt is not sufficient for the ATO to find that the DDCR does not apply. The accompanying compendium (PCG 2025/2EC) indicates that the repayment of external debt with related party debt will attract the ATO’s attention.
Three new examples (examples 15, 16 and 17) have been included to illustrate what the ATO considers to be a fair and reasonable identification of disallowed debt deductions and acceptable apportionment methodologies. However, these ‘apportionment’ examples involve scenarios where an in-scope transaction (i.e. a Type 1 acquisition, or Type 2 payment or distribution) was directly funded through related party debt drawdowns and therefore will provide limited assistance for a large number of taxpayers that may have funded in-scope transactions from a bank account with cash inflows from various sources (including related party debt, third party debt and operating cash proceeds).
Schedule 2 builds on the DDCR examples in Schedule 1 and classifies restructures as low or high risk. Importantly, a restructure will only sit in the green zone if the taxpayer can show:
- debt deductions disallowed under the DDCR prior to the restructure have been correctly calculated
- no Part IVA concerns existed prior to the restructure
- 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 otherwise attract the application of Part IVA.
Low risk examples (green zone)
- Repaying related-party debt (example 18) – Debt that would otherwise be caught by the DDCR is fully repaid using retained earnings or dividends from a subsidiary.
- Bridging finance repaid with external debt (example 19) – Short-term shareholder funding is replaced by arm’s-length bank debt once available.
- Replacing related-party debt with third-party debt (example 20) – A genuine external refinancing where group leverage is not artificially increased and no circular cash flows exist. This example is new.
- Replacing Division 7A loan with third party debt (example 21) – Similar to example 20, this involves a genuine external refinancing of a Division 7A loan with third party debt. This example is also new.
- Asset disposals (example 22) – Liquidating dormant foreign subsidiaries so that the taxpayer ceases to be a general class investor and therefore no longer subject to the DDCR.
- Recapitalisation and issue of new equity (examples 23 and 24) – Capitalising an Australian entity to repay related party debt to eliminate DDCR exposure.
- Cash-pool clean-up (example 25) – Paying down negative cash-pool balances and funding future intra-group transactions with equity or non-interest bearing accounts.
High risk examples (red zone)
- Changing the character of costs (example 26) – Interposing a factoring entity to argue that existing DDCR-impacted costs are now outside the scope of rules.
- Refinancing using external third party debt (example 27) – Repaying related-party debt using third-party debt while simultaneously reducing offshore third-party borrowings. This example was present in the draft released last year and received stakeholder feedback that further explanation was needed to understand why the ATO considered the arrangement to be high risk. The ATO has now added a statement that this ‘presents risk associated with the effective reallocation of group third-party debt to Australia’, which the ATO views as ‘debt dumping’ into Australia. However, noting that the restructure would not be expected to change (or materially change) the level of net debt deductions in Australia and offshore where the intercompany debt was implemented on arm’s length terms, it is still unclear how this example presents a different level of risk to the low risk third party refinance example (example 20).
- Funding indirect acquisition of assets from associate pairs via offshore subsidiary (example 28) – Using Australian related-party borrowings to inject equity offshore, which is then used to fund the acquisition of assets from associate paid. In this example, the Australian entity contends that it uses the related party borrows to repay existing third party debt, but then immediately redraws an identical amount from a third party debt facility to inject equity into its offshore subsidiary. This is a new red zone example.
Many taxpayers will be looking to refinance related-party debt caught by the DDCR with third party debt in similar circumstances to low-risk examples 20 and 21. As such, these are welcome additions to the green zone which were not included in the previous draft guideline.
Schedule 3 – TPDT guidance still to come
The ATO has flagged that Schedule 3, a targeted compliance approach for the TPDT, will be released once Taxation Ruling TR 2024/D3 is finalised which is expected in August or September 2025. Taxpayers intending to rely on the TPDT should watch for this guidance and be prepared to revisit their positions, in particular taking into consideration that many of the compliance approaches outlined in the draft guideline have time limited application.
Restructures that relate to the application of the TPDT are covered by Schedule 4 (examples 38 and 40).
Schedule 4 – Restructures responding to the new thin-capitalisation rules
Schedule 4 focuses on how taxpayers might reorganise to manage the impact of the new thin capitalisation tests, including the fixed ratio test (FRT), group ratio test (GRT) and TPDT.
Low risk examples (green zone)
- Forming a tax-consolidated group (example 37) – Consolidation simply offsets tax EBITDA surpluses/deficits between Australian entities; no new debt introduced.
- Aligning conduit financing terms (example 38) – Amending intra-group loans so that interest rate and tenor mirror the underlying external borrowings. This is a new green zone example.
High risk examples (red zone)
- Introducing artificial leverage (example 39) – Additional intra-group debt is drawn solely to maximise the 30% tax EBITDA capacity under the FRT.
- Picking the highest external rate (example 40) – Re-pricing on-lending to match the group’s highest external interest rate, inflating debt deductions without commercial justification.
The takeaway
Any taxpayers undertaking restructures—in the broadest sense—as a result of the introduction of the new thin capitalisation rules and the DDCR should consider self-assessing their risk zone against the ATO’s framework. Whilst this is not mandatory, it is generally considered best practice, and taxpayers should be prepared to disclose their self-assessment to the ATO in the future (for example, to answer Question 47 in Category C of the 2025 Reportable Tax Position Schedule or during a risk review).
Where restructures fall within the green zone, maintaining contemporaneous evidence will be important, including robust records demonstrating use of funds, tracing and any apportionment methodologies. Red zone examples are likely to attract the ATO’s attention, so taxpayers with restructures that resemble any high risk scenario should expect ATO scrutiny and consider remedial action or early engagement with the ATO.
While the final PCG expands upon last year’s draft, there are no significant deviations from it. Nonetheless, there are a number of key practical implications from the added guidance and examples:
- There is now a low risk scenario of genuine related party debt refinancing with external debt, where group leverage is not artificially increased and circular cash flows are not present. This is a welcome addition, as the previous draft had only a high risk example of external debt refinance.
- When refinancing third party debt with related party debt, it will be important to identify the original use of third party debt proceeds. The ATO may disallow related party debt deductions post-refinance under the DDCR to the extent that the original third party debt had been used to fund a transaction that was within the scope of the DDCR (Example 9).
- The ATO has provided examples of ‘fair and reasonable’ apportionment approaches, which appear to focus on what most taxpayers might describe as ‘direct tracing’ rather than apportionment. This may not offer the clarity taxpayers were seeking.
For those relying on the TPDT, keep an eye out for the ATO’s forthcoming guidance and be prepared to act swiftly if seeking to take advantage of the ATO’s compliance approaches.
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James Nickless
Chris Colley
Partner, Sydney, PwC Australia
Clement Lui
Patricia Muscat
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