Understanding debt deduction creation rules and restructures

Australia’s new debt deduction creation rules and restructures - ATO compliance guidance

On 9 October 2024, the Australian Taxation Office (ATO) published Draft PCG 2024/D3 Restructures and the new thin capitalisation and debt deduction creation rules - ATO compliance approach (draft PCG) for consultation, with responses due by 8 November 2024.

This draft PCG sets out the Commissioner’s compliance approach to the restructures carried out by taxpayers in response to the introduction of the debt deduction creation rules (DDCR).

The draft PCG provides a risk assessment framework which categorises restructures into a certain risk zone in relation to the application of certain anti-avoidance provisions.

The ‘high risk’ restructures are generally those where, as a result of the restructure, the debt deductions claimed before the restructure are similar to the debt deductions claimed before the restructure. Therefore, when determining the risk zone of a restructure of an intra-group debt financing arrangement, you should consider the level of debt deduction pre and post restructure.

When finalised, the draft PCG will apply to restructures entered into on or after 22 June 2023, the date the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share—Integrity and Transparency) Act 2024 (the Act) was introduced into Parliament.

The new thin capitalisation rules and debt deduction creation rules

The draft PCG provides a summary of the new thin capitalisation rules and DDCR, which is consistent with the Act but does not further elaborate on many of the technical uncertainties which exist, for example on what it means to acquire a legal or equitable obligation for the purposes of the acquisition case.

The DDCR applies to deny debt deductions for related party debt in two types of cases:

Type 1 - acquisition of an asset or legal or equitable obligation from associate pair
Type 2 - payment or distribution to an associate pair.

For a more detailed summary of the new Thin Capitalisation and DDCR rules, refer to our previous tax technical update on these rules.

Proposed compliance approach and risk assessment framework

The draft PCG acknowledges concerns raised about the ATO potentially applying the DDCR or the anti-avoidance provisions to cancel all or part of a tax benefit when a restructure is undertaken to avoid the application of the DDCR while preserving the tax benefits going forward (such as debt deductions arising from transactions covered by Type 1 or Type 2 arrangements).

A risk rating based on the framework provides an indication of the likely level of engagement from the ATO. The risk ratings are as follows:

Risk Zone	Risk Level	Categories	ATO compliance approach
White Zone	Further risk assessment not required	There is a settlement agreement with the ATO post 8 April 2024 and the terms include the tax outcomes under DDCR,or There is a court decision in relation to the tax outcomes of the arrangement including the DDCR.	No need to apply risk assessment framework ATO may apply resources to substantiate that the conditions have been met.
Yellow Zone	Compliance risk not assessed	Restructure is not in the green or red zone (i.e. not covered by one of the low or high risk restructure examples below).	ATO may engage to understand the compliance risks of the restructure.
Green Zone	Low risk	The restructure is covered by the low-risk examples in the draft PCG (discussed below), is otherwise commercial and has all of the following features: Accurate calculation of debt deductions disallowed by the DDCR prior to the restructure Prior to the restructure, the arrangements would not have attracted the application of Part IVA The restructure occurs in a straightforward manner without any contrivance or artificiality, and on arm's length terms The arrangement following the restructure will not attract the application of Part IVA. Alternatively, the ATO has conducted a review or audit of the restructure and provided a ‘low risk’ rating or ‘high assurance’ a Justified Trust review and there is no material change in the arrangement.	ATO may apply resources to obtain comfort and verify the self-assessment.
Red Zone	High risk	The restructure is covered by the high-risk examples in the draft PCG (discussed below), or The ATO has conducted a review or audit of the restructure and provided a ‘high risk’ rating or ‘low assurance’ under a Justified Trust review. The ATO considers the highest risk restructures will involve arrangements where debt deductions expected to be disallowed under the DDCR, are restructured or re-characterised to maintain a similar level of debt deductions. High risk arrangements may include round robin financing, contended change in 'use' of debt under other related party arrangements, or contrived arrangements to use the TPDT to avoid the DDCR.	ATO will prioritise resources to review or audit the arrangement. An arrangement in this zone does not necessarily mean that the DDCR or Part IVA will apply.

Examples of ‘high risk’ and ‘low risk’ restructure

The draft PCG provides examples of restructures in response to the DDCR, that the ATO considers as either ‘low risk’ (green zone) or ‘high risk’ (red zone) under the risk assessment framework. The risk rating determines the likelihood of the ATO allocating compliance resources to review or audit the restructure. It does not imply that any anti-avoidance provision necessarily applies to the restructure.

High risk restructure examples

Details

Artificial recharacterisation of costs

An Australian entity issues debt interest to a foreign sister company (B Sub) to fund a dividend payment to the foreign parent (Type 2 distribution). B Sub then enters into a factoring arrangement with another foreign related entity (C Co), where C Co acquires the debt interest from B Sub at face value minus a 5% factoring fee. The Australian entity claims that the debt deductions for the factored debt do not relate to the funding of the underlying dividend.

The ATO considers this restructure as high risk because the contended change in use (of the debt) does not reflect the underlying arrangement.

‘Debt dumping’ by replacing related party debt subject to the DDCR with third-party debt

An Australian entity repays debt interest issued to B Co (used to acquire a CGT asset from B Co) with funds borrowed from an external bank (Bank Co). Around the same time, B Co repays the same amount of debt owed to Bank Co.

The ATO views restructures where related party debt is replaced with third-party debt to shift debt into Australia (whilst reducing third-party offshore debt) as high risk.

Under both ‘high risk’ restructure examples, the debt deductions incurred by the Australian entity remain the same or similar following the restructuring arrangement.

Low risk restructure examples

No	Details
12	Repaying debt interest Repaying debt interest subject to the DDCR from retained earnings and/or dividends received (i.e. without resorting to additional debt funding).
13	Replacing related party bridging finance subject to the DDCR with external financing This is applicable where the bridging finance was initially issued in anticipation of external financing and supported by contemporaneous documentation and correspondence with external lenders to evidence that external financing was always intended.
14	Disposal of foreign assets An Australian resident general class investor liquidates its dormant foreign subsidiary. The following year, the Australian entity is no longer classified as a general class investor (and thus not subject to the DDCR rules). The ATO views disposals of dormant entities where business operations remain unaffected by the restructure as low risk.
15 & 16	Repaying debt interest, terminating swaps, recapitalising subsidiary Repaying debt interest subject to the DDCR by injecting or issuing additional equity and terminating any related party interest rate swaps. The ATO considers such restructures as low risk because debt deductions are no longer incurred in relation to the acquisition from / distributions to an associate pair following the restructure.
17	Cash pooling Where an Australian entity’s negative balance from a global cash pooling arrangement subject to the DDCR is paid down to nil, and subsequently: Additional capital is provided to the Australian entity (through issuing additional equity interests) with annual reviews to ensure the Australian entity has sufficient capitalisation to fund transactions and payments with associate pairs. Transactions and payments with associate pairs are conducted from a separate account or borrowing that is non-interest bearing (or used to offset other accounts).

Despite the ‘low risk’ rating, the ATO advises taxpayers must still determine the correct amount of debt deductions disallowed due to the DDCR until the related party debt is fully repaid.

Other examples of where the debt deduction creation rules may need to be considered

The ATO illustrate through examples different scenarios where the DDCR may need to be considered to ensure the correct amount of debt deductions are disallowed. Below are some of the more interesting examples.

No	Details	Need to consider the application of DDCR?
1	Timing and the 'associate pairs' conditions An international corporate group with an Australian company (Aus Co) borrowing from its offshore parent (B Co) to fund the acquisition of a 50% interest in Australian land. Aus Co and the unrelated seller, being a third-party company (Third party Co), were not associate pairs at that time, however, become associate pairs subsequently after entering into a joint venture arrangement to develop the land.	No
4	Cash pooling An international corporate group in which a foreign company (Foreign Co) operates a global cash pooling arrangement. Broadly, the cash pool participants (Participants), of which Foreign Co’s Australian subsidiary (Aus Co) is included, have on a daily basis, positive account balances transferred to the cash pool leader (Leader) and negative balances replenished by the cash pool leader. Aus Co uses its cash pool account to acquire assets from its associate pairs and pay dividends, royalties and returns of capital to associate pairs. In the former case, the Leader will pay interest to the participant, and in the latter case, the Participant will pay interest to the Leader.	Yes, when its cash pooling account is negative , and importantly, debt deductions arise.
6	Related part financing of related party acquisition An Australian corporate special vehicle (Aus Co SPV) which acquires real property from an associate pair of which it shares domestic ownership. The example shows the shareholders loans funds to the Aus Co SPV which are also an associate pair.	Yes
8	Debt deductions in relation to an acquisitions from an associate pair An Australian company (Aus Co) acquiring a CGT asset from an Australian associate pair (B Co) being funded by an interest-bearing loan from B Co. Aus Co enters into an interest rate swap (IRS) with another associate pair (C Co).	Yes
9	Acquistion from a related trust (Division 7A loan) A privately owned group that includes a private company (BBB Co) and two trusts (AAA Trust & CCC Trust) and each of the entities are associate pairs of each other. BBB Co provides a complying Division 7A loan to the trustee of AAA Trust and the trustee uses the borrowed money to purchase CGT assets from CCC Trust for use in the business carried on by AAA Trust.	Yes
10	Loan funding distribution by trustee (Division 7A loan to pay out UPE) A privately owned group that includes a private company (Gold Co) and a trust (Zinc Trust) that are an associate pair. Gold Co provides a complying Division 7A loan to the trustee of Zinc Trust and the trustee uses the borrowed money to pay Mr Zinc a previously unpaid present entitlement (UPE) amount.	Yes

Records and evidence requirements for the DDCR

In the draft PCG, the ATO expresses their view that the DDCR requires taxpayers to trace the use of debt funding for transactions that are covered by the DDCR, including both direct and indirect transactions. Consequently, the ATO advises the related parties (i.e., associate pairs) involved in the debt arrangements should obtain sufficient information to determine whether the DDCR applies to the arrangement, including in relation to indirect transactions. Clearly, the evidential burden involved for taxpayers in response to the DDCR is to be significant with the ATO providing no real bright line to what information if provided will be sufficient – ultimately, it will be fact specific to each taxpayer.

Historical transactions

The DDCR has no grandfather provisions for transactions that were entered into before the law’s start date and therefore, the DDCR also applies to historical transactions.

In this regard, although the ATO advises that it recognises there may be challenges for taxpayers in obtaining the relevant documents and information to evidence or substantiate use of related party debt funding for historical transactions, the ATO states that it considers it would be inappropriate if the ATO did not apply compliance resources to administer the DDCR in relation to historical transactions. The ATO confirms the onus is on the taxpayer to prove that the DDCR does not apply, and this is achieved by the provision of information and documentation to the ATO when required.

The ATO provides examples of documents that a taxpayer may have that can assist with demonstrating compliance with the DDCR for historical transactions.

Transactions since enactment

For transactions that are entered into post enactment of the DDCR, the ATO expects taxpayers to maintain best practice record-keeping, including taxpayers keeping contemporaneous documentation and associated analysis on the operation of the DDCR (including evidentiary support for the tracing of the use of funds). The ATO expresses a view that a deduction should not be claimed unless sufficient information is available to support the conclusion that the DDCR does not apply to deny the debt deductions associated with the arrangement.

Tracing of funds and apportionment

The ATO provides limited guidance in relation to how to trace the use of funds and also how to apply apportionment. However, the ATO does provide the following:

Tracing is a factual exercise and should be the method used to determine the disallowed debt deduction under the DDCR wherever possible
Apportionment is only appropriate where tracing is not possible. In the draft PCG, the ATO suggests such a situation would be where funds from various sources that were used for different purposes are combined into a single debt interest
Any apportionment should be done on a fair and reasonable basis. The ATO provides examples of apportionment methods that the ATO does not consider are fair and reasonable and consequently, are methods where the ATO advises it is likely to apply compliance resources to investigate if such apportionment approaches are appropriate

BDO Comment

On the basis that the DDCR applies to all income years commencing on or after 1 July 2024 and the rules do not have any grandfathering provisions, careful consideration will need to be given to all existing and future intra-group debt financing arrangements to determine whether any debt deductions could be denied under the DDCR.

The draft PCG provides guidance on structures that require the DDCR to be considered and record / evidence requirements for the DDCR. Given the broad application and the complexity of the DDCR, it is strongly recommended that all aspects (in particular, the specific use of the funding obtained) of an intra-group debt financing arrangement are analysed and thoroughly documented to ensure compliance of these rules.

The release of the draft PCG with the risk assessment framework suggests that the ATO is concerned with restructures that are undertaken in response to the new thin capitalisation and DDCR. The restructure examples and the risk zones assigned to these examples in the draft PCG indicate that a restructure that results in a reduction of debt deduction is more likely to have a lower risk rating whereas a restructure that results in the same level of debt deduction could attract a higher risk rating. Given this, one of important factors to consider in determining the risk zone of a restructure of an intra-group debt financing arrangement would be the level of debt deduction pre and post restructure.

It is expected that significant taxpayer consultation in connection with the draft PCG will occur, with submissions due by 8 November 2024 which given broad range of scenarios to which the DDCR is expected to impact, it is hoped further guidance will emerge in due course.

Reach out to your BDO adviser from our tax services team if you would like further information regarding the new thin capitalisation and DDCR and any restructures required in response to these new rules. Our team of experts can assist you with a full suite of corporate and international tax services.