On 9 October 2024, the ATO released Draft Practical Compliance Guideline - PCG 2024/D3 Restructures and the new thin capitalisation and debt deduction creation rules - ATO compliance approach (Draft PCG). This is the first substantive ATO guidance in relation to the new thin capitalisation and debt deduction creation rules (DDCR).
Comments on the Draft PCG are due to the ATO by 8 November 2024.
It is intended that the PCG guidance will apply with retrospective effect, once finalised.
The Draft PCG is broadly broken into three parts – the first containing the general principles of the ATO's risk approach to the DDCR and restructures, the second containing examples where, in the ATO's opinion, the DDCR may need to be considered, and the third covering compliance risks arising from restructures in response to the DDCR. There is to be a fourth section in the Draft PCG, addressing restructures in response to the new thin capitalisation provisions. This will be added to the Draft PCG at the same time as the ATO issues its draft public ruling on the third party debt test, which is still under development.
1. DDCR Rules – Background
The DDCR in Subdivision 820-EAA of the Income Tax Assessment Act 1997 were introduced on 8 April 2024 in Treasury Laws Amendment (Making Multinationals Pay Their Fair Share—Integrity and Transparency) Act 2024 (the Act).
Broadly, the DDCR apply to 2 types of arrangement:
a. The first involves an entity acquiring an asset from one of its associates that is funded by debt, where debt deductions are disallowed to the extent that they are incurred in relation to the acquisition.
b. The second involves an entity borrowing from an associate to fund certain payments, including the repayment of loans or returns of capital, or like distributions (e.g. dividends), to that or to another associate. The debt deductions are disallowed to the extent that they are incurred in relation to the prescribed payment.
The DDCR applies to all debt deductions in respect of new and historical arrangements from the start of income year commencing on or after 1 July 2024.
As is becoming a common trend, the DDCR (themselves constituting an anti-avoidance regime) include a specific anti-avoidance provision, intended to directly target schemes entered into to avoid the application of the DDCR. This is significant, as the DDCR apply to debt interests even if they were issued prior to the start date of the DDCR provisions. Additionally, the Draft PCG specifically notes that the ATO will not disregard historical transactions, even though extensive submissions have been made for the provision of administrative relief for historical transactions that occurred before a certain period (e.g. 5 years prior to the enactment of the DDCR).
2. Draft PCG
The Commissioner had previously indicated that the ATO would be releasing guidance on restructures undertaken in response to the DDCR and in respect of the application of the anti-avoidance provision.
Specific - Anti Avoidance Provision
The DDCR include a specific anti-avoidance rule (the DDCR SAAR) in section 820-423D to target schemes entered into for the purpose of avoiding the operation of the DDCR. The DDCR SAAR applies to any scheme where it is reasonable to conclude that it was carried out for the principal purpose of the DDCR not applying to debt deductions.
The Draft PCG provides a risk-assessment framework in respect of the application of the DDCR SAAR to any restructures entered into in response to the DDCR. Importantly, the Draft PCG notes that taxpayers may be required to report their self-assessments of restructures against the risk assessment framework, so it is expected that the Draft PCG may feature in ATO compliance activity or FIRB assessments in the near future.
Compliance approach
The risk assessment framework outlined by the ATO consists of 4 zones - White, Yellow, Green and Red. The zones are defined as follows:
a. White – Being within the White zone results in no further risk assessment. This zone is only applicable to taxpayers that have a settlement agreement with the ATO regarding their arrangement, or a court decision applies to the arrangement with respect to the DDCR. The ATO considers it unlikely that many taxpayers will have restructures in the White zone in the initial phase of the DDCR.
b. Yellow – The Yellow zone applies to entities with restructures not in the Red, Green or White zones , as outlined by Schedule 2 of the Draft PCG, and may result in further enquiries from the ATO.
c. Green – The Green zone only applies to taxpayers with all restructures covered by a low-risk example in the draft PCG. The ATO is unlikely to engage further with entities in the Green zone. A taxpayer will not be in the Green zone where one of their restructures is not covered by a low risk example, even if all other restructures are covered by a low risk example.
d. Red – Any taxpayers in the Red zone are likely to attract the greatest scrutiny from the ATO and this may involve the commencement of an official review or audit. The Red zone applies to taxpayers with any restructures covered by a high-risk example in the Draft PCG.
When ATO Considers DDCR to be relevant
The ATO has confirmed that the DDCR need to be considered in the course of broader compliance processes, requiring taxpayers to trace the use of debt both directly and indirectly. The Draft PCG emphasises that the taxpayer bears the onus of showing that the DDCR do not apply and that taxpayers should not claim debt deductions if they cannot discharge this evidentiary burden, even though the ATO recognises that it can be challenging to obtain the relevant documentation for historical transactions.
Importantly, in relation to tracing and the use of funds, the Draft PCG notes that:
a. tracing is a factual exercise and should be the method used to determine the disallowed debt deduction; and
b. apportionment is not a substitute for factual tracing, but may be used where it is not factually possible to trace.
There is limited guidance on appropriate apportionment methodologies in the Draft PCG, but the ATO gives examples of skewed methodologies designed to minimise disallowance and notes that such methodologies would attract ATO scrutiny as they are not fair and reasonable.
Relevant documents which may assist in the evidentiary process include loan documentation, financial statements, working papers prepared by professional advisors, general ledgers, bank statements and copies of board minutes, resolutions or other documentation relating to the decision-making process involved in a transaction.
Common scenarios where DDCR may apply
The Draft PCG puts taxpayers on notice of common scenarios where the DDCR will need to be considered, including:
a. dividends paid to a foreign parent company funded by related party debt from a subsidiary of the same parent company;
b. global cash pooling arrangements in which the Australian entity fluctuates between a negative and a positive cash flow position during an income year;
c. acquisition of property from an associate partially or wholly funded by related party debt;
d. acquisition of property from an associate partially or wholly funded by related party debt with an interest rate swap with another associate entity;
e. acquisition of property from a related trust using debt funds from an associate company under a complying Division 7A loan;
f. distributions made by a trust to beneficiaries using debt funds from an associate company under a complying Division 7A loan; and
g. acquisition of property from an associate using related party debt in a back-to-back arrangement.
The Draft PCG also includes a list of common scenarios where the DDCR would not need to be considered, providing a 'safe harbour' of sorts. These scenarios include:
a. an acquisition of a land interest from a third party entity funded by related party debt;
b. global cash pooling arrangements in which an Australian entity remains in a positive cash flow position for the entirety of an income year;
c. an acquisition funded by related party bridging finance which is shortly repaid from proceeds of external financing, with no debt deductions arising from the related party debt; and
d. acquisition of property from a third party entity using related party debt in a 'back-to-back' arrangement.
These examples evidence the potential breadth of the DDCR, which may not previously have been appreciated by some taxpayers and their advisors. Taxpayers with these kinds of arrangements should review them immediately against the guidance provided in the Draft PCG to determine whether a restructure may be appropriate.
Risk ratings of restructures
The Draft PCG acknowledges that taxpayers may wish to restructure their affairs to ensure that the DDCR do not apply. The Draft PCG acknowledges that concerns have been raised about the potential to apply the DDCR SAAR or Part IVA of the Income Tax Assessment Act 1936 to cancel all or part of a tax benefit where a taxpayer restructures to avoid the application of the DDCR but preserves interest deductions. The Draft PCG applies a safe harbour approach by identifying a number of low risk restructure examples where the ATO would not seek to apply compliance resources, including under the anti-avoidance rules.
Low risk restructures
The Draft PCG outlines that low risk restructures would mostly involve repayment of related party debt without acquisition of additional debt. The ATO advises that a restructure would only be low risk where it is commercial and exhibits all of the following features:
a. the presence of arm's length circumstances without any associated contrivance;
b. the lack of Part IVA application both prior to and following the restructure taking place; and
c. the accurate calculation of disallowed debt deductions under the DDCR prior to the restructure.
The ATO confirms that the following scenarios will be considered low risk and for such arrangements, the ATO will not dedicate compliance resources to consider the application of the anti-avoidance provisions to the restructure other than to confirm that the required low-risk features are present. The identified low risk arrangements are:
a. repaying all related party debt utilising retained earnings and dividends;
b. repaying bridging finance using external financing;
c. disposing of a dormant foreign subsidiary to fall outside the definition of a 'general class investor';
d. repaying related party debt using an equity capital injection or issuing additional equity interests;
e. terminating a related party swap; and
f. repaying a cash pooling arrangement balance to nil.
The scope of low risk restructures is narrow and very specifically construed to ultimately involve a complete removal of debt deductions.
High risk restructures
The Draft PCG outlines that high risk restructures would involve arrangements in which debt levels remain constant and may include round robin financing or a change in the ultimate use of debt funding.
The ATO confirms that the following two scenarios will be considered high risk and will result in intensive compliance action:
a. repaying offshore related party debt utilising third party debt issued by an external Australian lender; and
b. an offshore related party entity acquiring related party debt under a factoring agreement for funds previously used to pay dividends to a parent entity.
The high risk examples are extremely broad and surprisingly apply in circumstances where external debt is used to repay related party debt. It appears that the Commissioner takes the view that the restructure is high risk even if the conditions in the third party debt test (for thin capitalisation purposes) would be satisfied.
It would be unfortunate if the expectation now is that Australian or overseas investments need to be fully funded by anything other than related party debt, as that would place significant commercial constraints on doing business in and from Australia.
The Commissioner has previously indicated that the ATO would not be looking to apply integrity rules in the proposed new law or elsewhere where taxpayers are restructuring their arrangements as a means of seeking to comply with the underlying intent of the new law. However, the Draft PCG seems to indicate otherwise. In particular, it appears based on the low risk and high risk restructure examples that the Commissioner considers a restructure which preserves debt deductions to inherently be high risk.
3. Next Steps
It is obvious that the Draft PCG shows that restructuring in response to the DDCR is exercising the Commissioner's mind and that any restructure carries with it substantial potential risk and exposure for taxpayers, particularly as restructures undertaken in response to the DDCR will need to be disclosed in the tax return. The Draft PCG is of some assistance in understanding the type of restructures that the ATO will scrutinise and it is clear from the Draft PCG that taxpayers and advisors should be aware of the significant risk posed by any restructuring that results in the DDCR not applying.
Taxpayers should review their existing related party arrangements and consider whether any actions will need to be taken. This may involve parent entities contributing additional equity to their Australian subsidiaries.
Please contact us if you would like to know more about how the ATO's draft guidance may impact your organisation's future restructures.
