Companies in Australia Should Check Debt Deduction Rules Exposure

Australia’s new guidance on what steps companies should take when deducting debt to reduce their tax burden marks a shift in compliance expectations for businesses involved in cross-border financing. While it provides a structured framework, taxpayers should take a comprehensive, holistic approach to navigate the complexities and mitigate potential challenges regarding any restructures from the Australian Taxation Office.

The ATO guidance issued this month clarifies the interaction among thin capitalization rules, transfer pricing rules, and debt deduction creation rules. Thin capitalization is when a company’s debt is much greater than its equity, and transfer pricing refers to transactions between related companies in multinational groups.

The clarifications supplement the ATO’s related draft practical compliance guideline, or PCG 2024/D3, which outlines compliance approaches and risk assessment frameworks for restructures prompted by the rules.

Order of Application

The ATO can challenge intragroup financial arrangements in many ways. Taxpayers must work out their debt deductions in the following order: adjusting transfer pricing, creating debt deductions after transfer pricing adjustments, and applying thin capitalization on remaining deductions after applying the debt deduction creation rules. Under the new safe harbor thin capitalization rule, debt deductions exceeding 30% of profits will be denied.

Since July 1, the rules have denied debt deductions for related-party arrangements. This includes debt-funded acquisitions of assets from associates and borrowing from associates to repay loans, return capital, or distribute dividends.

Companies must apply the debt deduction creation rules before the new thin capitalization rules—notably, the new guidance clarifies that the 90% Australian assets threshold exemption test for thin capitalization purposes doesn’t exempt businesses from the debt deduction creation rules.

Taxpayers may consider applying the debt deduction creation rules prior to transfer pricing. The ATO is likely to challenge the arrangement based on the debt deduction creation rules instead of transfer pricing or anti-avoidance measures, as the latter requires expert evidence, complex counterfactual scenarios, and proof that the dominant purpose was to obtain a tax benefit.

Transfer pricing needs to ensure both the price of debt (such as interest rates) and the amount of the debt are on arm’s-length terms. The new thin capitalization rules would be applied only after the amount of those deductions is determined under the transfer pricing rules. As highlighted in the Federal Court of Australia’s 2023 ruling in the Mylan case, the ATO may successfully challenge arrangements under both transfer pricing and anti-avoidance rules simultaneously.

General Restructures

PCG 2024/D3 provides a risk assessment framework for restructuring debt under the debt deduction creation rules, and it soon will incorporate the new thin capitalization rules. These updates are critical for taxpayers undertaking genuine restructures to comply with the debt deduction creation rules, provided the arrangements aren’t tax-contrived.

The ATO has specific anti-avoidance provisions that target schemes designed to circumvent the debt deduction creation rules, complementing general tax avoidance rules. Taxpayers bear the burden of proving that debt deduction creation rules don’t apply to them.

Meeting that burden requires robust documentation for historical transactions such as loan documentation, financial statements, working papers prepared by professional advisers, general ledgers, bank statements and copies of board minutes, resolutions, or other documentation relating to the decision-making process involved in a transaction.

Taxpayers must report their self-assessments or restructures under the ATO’s risk-assessment framework. This framework is particularly relevant for compliance with the Foreign Investment Review Board, as foreign investors navigating debt arrangements in Australia may face increased scrutiny. It also may be a relevant framework to be adopted for the increasing ATO review and audit activities concerning private group related-party financing arrangements.

The draft practical compliance guideline provides examples of how debt deduction creation rules may apply to common private group structures—using a complying Division 7A loan to fund the acquisition of a capital gains tax asset from an associate or to settle a beneficiary’s unpaid present entitlement.

Outlook

The ATO is soliciting comment on the interest-limitation rules, and we await additional guidance from the ATO on the interaction of these rules before the end of 2024.

The debt deduction creation rules apply retroactively to debt interests issued before July 1, with no exemptions for historical transactions despite industry submissions. Restructures undertaken in anticipation of the rules must be disclosed in the 2024 International Dealings Schedule to be lodged with a company’s income tax return.

In light of these developments, taxpayers should review existing related-party arrangements, assess current financing structures for potential exposure under the debt deduction creation rules, and ensure they keep thorough records to substantiate compliance—particularly for historical transactions that may be scrutinized under the new rules.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Amy Liu is special counsel in the corporate and commercial team at Colin Biggers & Paisley. Her practice includes income tax, international tax, goods and services tax, and stamp duty.

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