Background to the Draft Practical Compliance Guideline

In 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 (the Draft PCG). In our earlier article on the Draft PCG, we discussed the background to the debt deduction creation rules (DDCR), the ATO's proposed compliance approach, and the risk rating of certain restructures.

Having considered submissions regarding the Draft PCG, the ATO has published in final form Practical Compliance Guideline – PCG 2025/2, Restructures and the thin capitalisation and debt deduction creation rules – ATO compliance approach (PCG 2025/2). While the ATO has added a few examples, limited changes have been made to the PCG, despite the extensive requests for guidance on topics such as tracing and apportionment.

PCG 2024/D3 and Compendium PCG 2025/2EC

To recap, the DDCR were introduced in April 2024, and broadly apply to two types of arrangement:

• Type 1 arrangements involve an entity acquiring an asset, or a legal or equitable obligation, directly or indirectly 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.
• Type 2 arrangements involve an entity borrowing from an associate to fund certain payments, including dividends, returns of capital and royalties 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 years commencing on or after 1 July 2024.

The DDCR include a specific anti-avoidance provision, intended to directly target schemes entered into to avoid the application of the DDCR. In the compendium to PCG 2025/2, the ATO – in response to queries as to whether it was the existing general anti-avoidance rules (Part IVA) or the specific DDCR anti-avoidance provisions that constituted the 'risk' in the 'high risk' examples – did not expressly identify one or the other.

The ATO identified several issues raised in response to the Draft PCG. A common theme among queries raised, and one that will be front of mind for taxpayers, was parties seeking clarification on whether the Commissioner would consider it low-risk:

• to undertake a restructure that includes the replacement of related party debt that attracts the operation of the DDCR with third-party debt;
• to undertake a restructure that includes the replacement of related party debt with interest-free debt; or
• for an Australian group to use a conduit financing entity to pass through third-party debt to operating and asset entities in circumstances where the third-party debt test choice is not made.

Significantly, in respect of the second and third points above, the ATO confirmed that where such arrangements exist, they will not be considered to fall in the 'green zone' (see Issue Numbers 18 and 19 of the Compendium). Further, while Schedule 2 now contains an example of a 'low risk' (ie green zone) restructure where related party debt is replaced with third party debt (Example 20), the conclusion reached in this example needs to be compared with high risk Example 27 (see our further comments below) to highlight that the position is very finely balanced.

The ATO also identifies in the Compendium that the PCG is not intended to provide interpretive guidance about the rules to taxpayers, particularly on:

• the overlap between Type 1 and Type 2 arrangements;
• the 'associate pairs' concept, including in the context of joint ventures; and
• the meaning of the phrase 'facilitate the funding' in paragraph 820-423A(5)(b).

In the absence of any interpretative guidance on the phrase 'facilitate the funding of' for Type 2 arrangements, compounded by the lack of practical guidance on reasonable tracing and apportionment methodologies, taxpayers will continue to face considerable uncertainty in respect of both historical and future loan arrangements. Guidance on these issues may follow, in time.

The ATO also indicates that there will be no grandfathering of historical transactions from the operation of the DDCR. It does not consider a grandfathering approach to be an available administrative position for the Commissioner.

When the DDCR need to be considered

General observations

In our earlier article, we discussed the common scenarios identified by the Draft PCG where the DDCR needs to be considered. The draft (and final) PCG describe these examples as providing 'guidance to assist taxpayer considering whether to restructure'. Schedule 1 of PCG 2025/2 contains largely the same set of examples as was in the Draft PCG, which the finalised PCG describes as 'examples where the DDCR will need to be considered'. While some further examples have been provided, most of the examples demonstrate a relatively straightforward application of the law.

Interestingly, we observe:

• Example 1 – an additional paragraph has been included flagging the possibility of needing to test the associate pairs definition at a later point in time only if there are factors indicating contrivance or artificiality in relation to the timing of entering into the acquisition or borrowing. No further guidance on what this could mean is provided. However, it would appear that the Commissioner is reserving his position to apply the avoidance provisions where the timing of the arrangement creating the associate pair relationship results in the DDCR not applying.
• Example 2 – this example contains a situation where related party debt is used to fund development of a gold mine by an Australian subsidiary (Aus Sub Co 2) of an Australian company (Aus Co). Aus Co has a separate subsidiary that pays a dividend and the ATO concludes that Aus Co will not need to consider the application of the DDCR while Gold Mine 2 is in development. The example is useful in that it acknowledges that the DDCR will not automatically apply where there is related party debt and there are Type 1 or Type 2 payments.
• Example 6 – the ATO flags that it will apply compliance resources to verify the correct application of the DDCR where cash pool arrangements result in debt deductions in a particular income year. For taxpayers with a cash pool or central treasury function, significant effort will need to be made to appropriately document and trace relevant funds, and manage cash flows, to demonstrate that the DDCR does not apply. The ATO's clear position is that the onus is on the taxpayer to demonstrate that the DDCR does not apply to their arrangements.
• Example 9 – this example demonstrates the significant reach of the DDCR including the impact it can have on refinanced arrangements due to historical transactions. In this example, while the DDCR does not apply to the initial transaction (given the borrowing is not from a related party), a refinancing of the debt with a related party in the future may still be caught by the DDCR. This is despite the fact that repayments under the initial borrowing exceeded the amount of the initial borrowing that had been used to fund an acquisition from a related party. This example highlights an interesting question about the order in which a taxpayer may seek to repay debt subject to the DDCR while leaving other debt (not subject to the DDCR) on foot. Unfortunately, the PCG does not answer this question.
• Examples 15, 16 and 17 – new examples have been included to demonstrate what the ATO considers is a 'fair and reasonable' apportionment of debt deductions between amounts claimable and amounts that should be denied under the DDCR, where tracing is not possible. The examples are limited in their utility given they are overly simplistic and, in each example, the reasoning provided clearly shows that the funds can be traced specifically to a particular Type 1 or Type 2 transaction. Accordingly, the conclusion reached in each example is not so much a product of a reasonable apportionment being applied but rather a tracing exercise. There is no meaningful guidance for taxpayers on how the apportionment exercise should be undertaken where tracing is in fact not possible.

Refinancings

The examples also highlight the difficulty that taxpayers will have in respect of refinancing arrangements (particularly Examples 9 and 17). As noted in the PCG compendium, the ATO included additional refinancing related examples in response to requests for guidance. The additional examples (see Examples 8, 9, 15, 16 and 17) all appear to emphasise the importance of being able to demonstrate (using tracing methodologies) that the balance of any prior loans (before their repayment / refinancing with a 'new loan') did not relate to any borrowings that would be subject to debt deduction denials under the DDCR (eg borrowings related to dividends). Further, a significant flaw in the rules from a policy perspective is that the DDCR can operate as a result of refinancing third party debt with related party debt even though there is no increase or creation of new debt in a structure (as best highlighted in Example 9). This seems contrary to the primary purpose of the provisions.

Risk ratings

Except for broadening the 'white zone' to restructures that the ATO has reviewed and confirmed as low-risk, and those to which section 820-35 applies, the ATO has maintained the same risk assessment framework from the Draft PCG.

Any situation which is not covered by the examples in PCG 2025/2 falls into the 'yellow zone'. Given the potential breadth of the DDCR, and despite submissions requesting that more risk zones should be included to differentiate further gradients of risk, many taxpayers will be left in a state of uncertainty as to whether there will be any compliance engagement from the ATO. This highlights the need for taxpayers to seek advice on their debt arrangements, including any restructuring or refinancing of that debt.

Restructures in response to DDCR

Schedule 2 of PCG 2025/2 provides examples on the compliance risks associated with restructures in response to the DDCR. As outlined above, where examples are highlighted by the ATO as being 'high risk', the ATO does not provide any guidance on whether the particular risk identified is in the context of the existing general anti-avoidance rules applying, or the specific DDCR anti-avoidance provisions.

Unsurprisingly, the examples demonstrate that repayment of debt that may otherwise be subject to DDCR denials is 'low risk'. However, a missing feature of the examples on this topic is where the borrower has multiple debts, only some of which are subject to DDCR denials, and the borrower uses available funds to repay only the debt that would otherwise be caught by the DDCR, leaving debt not subject to the DDCR outstanding.

• Examples 20 and 21 demonstrate that replacement of related party debt with third party debt can be considered 'low risk'. In addition to three specifically identified factors in each of the examples, it seems a key feature is that the borrower entity would not have the financial capacity to repay the existing related party loan itself due to loss making operations, which makes the examples unnecessarily restrictive having regard to the relevant parts of the supplementary explanatory memorandum which introduced the rules. Notably, both examples only consist of loans between Australian entities.

• Example 27 is a similar example in which a different 'high risk' conclusion is reached. The substance of what is occurring in Example 27 is effectively the same as in Example 20. That is, in relation to the Australian element of the arrangement, a related party loan is being replaced with third party debt. However, the ATO attributes a 'high risk' rating to this restructure on the basis that the refinancing of related party debt with third party debt has the effect of 'dumping' debt into Australia. Again, focussing only on the Australian elements of this arrangement, it is hard to rationalise this comment with the facts given the level of debt in Australia both before and after the restructure is the same.

The examples therefore seem to infer that simply replacing related party debt with third party debt will not be low risk unless there are either (or perhaps both):

• features that support the necessity of there being debt in the structure (eg financial incapacity of the borrower to repay the initial debt); and
• no cross border element to the restructure.

• Example 28 highlights the importance of the tracing exercise and being able to evidence funds flow via appropriate documentation. The ATO's 'high risk' conclusion seems to stem from an implied assumption that what the taxpayer 'contends' had occurred did not in fact occur. If the taxpayer in this example was able to demonstrate through appropriate records that the funds had indeed flowed as they had 'contended', then a conclusion that the DDCR would operate to deny debt deductions on the related party debt would seem unsupportable.

Final remarks

Historical arrangements

While the ATO appears to recognise the challenges with obtaining documents or information on how borrowings may have been used in respect of historical transactions, the ATO's clear position is that the onus is on the taxpayer to demonstrate that the DDCR does not apply to their arrangements. Further, the ATO appears unwilling to limit its compliance resources in a way that would effectively grandfather historical debt arrangements.

It is therefore critical that taxpayers take proactive steps to prepare for ATO engagement on any historical loans that remain or remained on foot post 1 July 2024 for June balancers or post 1 January 2025 for December balances. This will likely involve complex tracing exercises and management of gaps in accounting and other records. For taxpayers seeking to restructure in response to the DDCR, careful consideration of the rules will be necessary, noting the potential application of specific anti avoidance rules and Part IVA.

Future arrangements

For future borrowings and transactions, taxpayers should consider updating internal record keeping policies to ensure appropriate and contemporaneous documentation to facilitate the tracing of funds from borrowings. Please contact us if you would like to know more about how the ATO's guidance may impact your organisation's funding arrangements.