Implications of the ATO’s third party debt draft ruling

The ATO's draft ruling on the third party debt test: insights and implications

On 4 December 2024, the Australian Taxation Office (ATO) published draft income tax ruling (draft ruling) TR 2024/D3 - Income tax: aspects of the third party debt test in subdivision 820 - EAB of the Income Tax Assessment Act 1997 (the Act). Responses are due by 7 February 2025

The third party debt test (TPDT) is an alternative thin capitalisation test that a taxpayer can choose instead of the default Fixed Ratio Test (FRT). The TPDT limits debt deductions to those on debt interests with unrelated entities where the funds are used to fund its Australian operations.

However, there are several other conditions that must be met before particular third party debts qualify for the relevant debt deductions, to be deductible under the TPDT. The Commissioner has taken an even more restrictive view of the some of the qualifying conditions than the wording in the legislation.

Examples of these restrictive views of the Commissioner include:

Minor or insignificant non-Australian asset

One of the requirements for the TPDT is that the creditor only has recourse to Australian assets for payment of the debt, with the exception of minor or insignificant non-Australian assets. However, the draft ruling states that this exception only covers assets of ‘minimal or nominal value’ and also the relative values of the assets compared to Australian assets is not determinative for this test.

The draft ruling gives an example of an asset with market value of $2 as meeting this test. This appears to be a too restrictive view on the meaning of the term “minor and insignificant”. It is suggested that ‘minor or insignificant’ should not be interpreted as only relating to assets of ‘minimal or nominal value’, but rather be interpreted in the context of the particular circumstances.

However, the Commissioner has also released additional schedules in PCG 2024/3 giving his compliance approach to the TPDT in which provides a less restrictive interpretation of the meaning of minor or insignificant assets that will apply for years ending on or before 1 January 2027.

The Commissioner states that the ATO will only apply compliance resources to ensure the compliance approach is followed where:

The market value of the assets is less than 1% of all of the assets to which the holder of the debt interest has recourse for the payment of the debt
The market value of each asset (or bundle of identical assets, such as a shareholding) does not exceed $1 million
None of those assets are credit support rights.

While this compliance approach is welcomed, it still a narrow interpretation of minor or insignificant.

Australian commercial activities

Another condition for the TPDT to apply to a debt is that the entity uses all, or substantially all, of the proceeds of issuing the debt to fund its commercial activities in Australia. The term ‘commercial activities’ is not defined in the legislation and the draft ruling relies on a dictionary definition to limit its meaning to acts or operations of trade or business that can return a profit. The draft ruling specifically says this does not include the payment of distributions or capital management activities.

This reliance on a dictionary definition ignores the various judicial guidance on the meaning of commercial activity that indicate it has a wider meaning than given to it in the draft ruling and could be interpreted to include distributions to shareholders and capital management.

Detailed summary

The draft ruling sets out the Commissioner’s views on the operation of the third party debt conditions contained in subsection 820-427A(3).

Those conditions are:

The entity issued the debt interest to an entity that is not an associate entity
The debt interest is not held at any time in the income year by an entity that is an associate entity
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 obliger group, or to membership interests in the entity
The entity uses all, or substantially or, of the proceeds of issuing the debt interest to fund its commercial activities in connection with Australia
The entity is an Australian entity.

Analysis

Subsection 820-472A(2) – Hedges and swaps

This subsection includes hedges and other instruments (such as interest rate swaps) that are treated as a debt deduction that may be subject to the third party debt test. The provision has two parts:

The debt deduction must be directly associated with hedging or managing interest rate risk in respect of a debt interest
The debt deduction must not be referable to an amount paid, directly or indirectly, to an associate.

Example

Details

Debt deduction paid directly to associate

An Australian company borrows from an unrelated entity at variable interest rates. The company on lends to a related trust at the same variable rates and enters an interest rate swap with an unrelated entity. The company then enters into a separate interest rate swap with the related trust. The company receives fixed rate swap payments from the trust and makes floating payments to the trust. As these floating payments are made to an associate (the trust) they will not be deductible under the TPDT.

Subsection 820-472A(3) - Associate

This subsection contains the conditions that must be satisfied for a debt interest to qualify as third party debt.

The first two conditions relate to the debt interests being issued to and held by parties that are not associates of the issuer. The Commissioner states that these conditions will be satisfied where:

The taxpayer issued the debt interest to an entity that is not an associate. The Commissioner states where this condition is satisfied in relation to the income year in which the debt interest is issued, the condition will be satisfied in relation to subsequent income years in which the debt interest remains on issue
In relation to an income year, the debt interest is not held at any time in that year by an entity that is an associate of the issuer. The Commissioner states this condition is tested continuously throughout the period the debt interest is on issue. Where the debt interest is on issue for the whole income year, it must satisfy this condition for the entire year. Where the debt interest is issued for part of the income year, it will satisfy this condition if it has not been issued to an associate throughout the period it is on issue.

Subsection 820-472A(3) – Recourse

One of the key areas in the draft ruling is the Commissioner’s opinion in relation to the expression recourse for payment of the debt. The Commissioner states this refers to the holder’s ability to recover amounts owed to it by the issuer. This test must be continuously applied throughout the term of the debt interest.

The Commissioner states this test is a practical question of fact based on the relevant agreements and the applicable legislation that may apply to the debt interest.

The Commissioner further states having recourse does not require a default event to have occurred, or for the holder of the debt to have immediately enforceable rights of recourse. The focus is on the assets that may be available in the event of default. This is contrasted with security, which is a different concept, such that security assets may not be the same as default assets.

Where the issuer is a member of an obligor group, the issuer or other group members may hold rights against the assets of other group members. Those rights can also be recourse assets for the holder of the debt interest, however there is no requirement to trace through to the underlying assets of the other entity.

Example	Details
2	*Recourse not expressly limited to Australian assets* An Australian resident entity borrows from an unrelated entity. Under the loan, recourse for payment is not expressly limited to the borrower’s Australian assets. The borrower has nothing but Australian assets. The lender does not have recourse to assets other than Australian assets.
4	*Unsecured debt* An Australian entity borrows from an unrelated entity on an unsecured basis. The lender has recourse to all of the borrower’s assets.
6	*Third party guarantee* Two trusts in an Obligor group with one of the trusts has a property that it leases to an unrelated company (Sub Co). The head company of Sub Co guarantees the lease obligations of Sub Co. The other trust in the Obligor group borrows from a bank. The bank has recourse to both trusts’ assets including the property, rights under the lease and the rights under the guarantee. The bank does not have recourse against the assets of the lessee company nor its parent. The bank is not considered to have recourse to the assets of the unrelated Head Company or Sub Co. However, because the guarantee rights are credit support rights, regard must be had to whether they are excluded credit support rights under subsection 820-427A(5), see the credit support rights section below.

Subsection 820-472A(3) – Australian assets

The next requirement is that the assets to which recourse applies are Australian assets, disregarding recourse to minor or insignificant non-Australian assets. The Commissioner considers the minor or insignificant asset exclusion covers assets of minimal or nominal value and the hypothetical impact of any assets on the quantum or terms of the debt interest is not determinative of them being minor or insignificant.

The Commissioner says that the term Australian assets is intended to capture assets that are substantially to Australia. It specifically excludes the following:

Assets that are attributable to the entities overseas permanent establishments
Assets that are otherwise attributable to the offshore commercial activities of the entity.

The Commissioner states the question is determined on the facts and circumstances of each case, including the nature of the asset involved, its connection or relationship to Australia. The Commissioner further states the designation is intended to be narrow and it will only accommodate genuine commercial arrangements relating only to Australian business operations.

The Commissioner gives examples of the types of assets that will satisfy this test, including Australian real property and other assets exclusively connected to Australia, such as tangible assets owned by an entity located in Australia that are used exclusively in that entity's Australian operations. The Commissioner states the mere fact an asset generates assessable income does not necessarily establish a sufficient connection to Australia.

Example	Details
8	*Minor and insignificant assets* Australian company borrows money. It holds shares in a subsidiary which holds shares in a foreign subsidiary. The lender has recourse to all assets. The foreign subsidiary has a $2 share capital, and it holds no assets. The shares in the foreign company are minor and insignificant.
9	*Relative values not determinative* Borrower holds shares in 2 Australian subsidiaries and a NZ subsidiary. The loan has recourse against all assets. The NZ shares are worth $10m, which is 2% of the value of the entire group. The ATO considers they are not minor or insignificant.
10	*Actual or hypothetical impact of ineligible assets* Borrower holds various Australian and foreign assets. The lender has recourse against all assets. The foreign assets were not taken into account in the making of the loan. This is not determinative of whether the foreign assets are minor or insignificant.

Subsection 820-472A(3) – Australian commercial activities

The next condition is satisfied if the entity uses all or substantially all of the proceeds of issuing the debt to fund its commercial activities in Australia. These can not include any business carried on by the entity through overseas permanent establishments or the holding by the entity of any associated entity debt, controlled foreign entity debt or controlled foreign entity equity.

This condition is tested continuously throughout the period the relevant debt interest is on issue. The question of what an entity uses the proceeds of the issuing of the debt interest is a factual inquiry and needs to be assessed continuously.

The words all or substantially all are designed to accommodate the minor incidental use of the proceeds in ways other than to fund the entity’s commercial activities in Australia. The Commissioner says these words mean nearly all, or almost all, and will only accommodate a minimal or nominal amount of the proceeds being used other than to fund the entity’s Australian commercial activities. Details

Example

Details

Indirect acquisition of foreign shares

An Australian company borrows to acquire a target company which owns shares in foreign subsidiaries. To the extent the loan is used to acquire the shares in the foreign company, the funds are not used to finance the borrower’s Australian commercial activities.

Trust distribution to investors

Trust borrows to fund a property development and to pay a distribution to unitholders. The ATO considers the trust distributions are not in relation to the funding of the trust’s Australian commercial activities

Subsection 820-472A(3) – Australian issuer

The final condition is that the issuer of the debt interest is an Australian entity. The Commissioner states this test is continuously applied throughout the period in which the debt interest is issued.

Credit support rights

The legislation expressly prohibits assets that comprise credit support rights from being assets to which the third party lender has recourse. Examples include rights under a guarantee, security or any other form of credit support. However, the following are excluded from this prohibition:

A right that provides recourse, directly or indirectly, only to one or more Australian assets (as described above) and are not prohibited credit support rights
A right that, assuming the holder of the right exercised the right, would not reasonably be expected to allow, directly or indirectly, recourse against an associate entity of the entity that issued the debt interest
A right that relates wholly to the creation or development of a capital gains tax (CGT) asset that is, or is reasonably expected to be:
Land situated in Australia (including an interest in land, if the land is situated in Australia)
Moveable property situated on land in Australia that is relevant to the income-producing use of the land for the majority of the CGT asset’s useful life
Offshore renewable energy infrastructure situated in a declared area for the majority of its useful life
Offshore electricity transmission infrastructure directly related to offshore renewable energy infrastructure covered in the above point.

However, a credit support right is only covered by these exceptions if it is not reasonably expected to allow, directly or indirectly, an entity to have recourse for payment of the debt against a foreign entity that is an associate of the entity that issued the debt interest.

The Commissioner makes the following comments:

In relation to the creation or development of land in Australia, the Commissioner states the connection must be tested continuously. Where the support right initially relates to the creation or development of land in Australia, but at a subsequent time it relates to other business activities, the exception will not apply once the credit support right applies to other activities
Whether credit support rights relate wholly to the creation or development of movable property situated on Australian land that is covered by the previous exclusion, the movable property is expected to be relevant to income producing use of the land and situated on that land for the majority of the asset’s useful life. The Commissioner states this connection must be tested continually and it is intended to cater for the creation or development of property that is not part of the land but has a close economic connection to the land and is situated on the land with a degree of permanence
The exclusions the credit support right that relates wholly to the creation or development of the relevant CGT asset only apply where any relationship to any other matter is incidental. The commissioner states this is a question of fact and degree. However, a right that relates only remotely to the creation or development of the relevant asset or is designed to serve other objectives will not qualify for the exclusion.

Example

Details

A trust is developing an Australian property. Due to cost overruns, one of the unitholders agrees to provide additional equity if the trustee requires it. The trust borrows from a bank, secured against all of its assets including the rights under the cost overrun agreement. The trust’s rights under the cost overrun agreement qualify for the exemption as they relate to the development of Australian property

If you would like further information in relation to the ATO's draft ruling on the third party debt test, reach out to your local adviser from our corporate and international tax team.