From 1 July 2024, the Debt Deduction Creation Rules (“DDCR”) permanently deny debt deductions (e.g. interest expenses) for payments arising in connection with certain related party transactions. Broadly, where entities have debt deductions that arise in relation to the acquisition of assets from associates, or fund distributions or royalties to associates, the rules will permanently deny those deductions. The rules can apply to wholly-domestic arrangements and the lack of transitional rules means that historic funding arrangements may now result in significant denials of deductions. Further, new and existing integrity provisions may prevent entities from restructuring their arrangements to avoid the application of these provisions.
What are the Debt deduction rules about?
From 1 July 2024, the DDCR will broadly apply to deny debt deductions (e.g. interest) that are paid or payable in relation to loans and debts to associates in two key instances:
- Acquisitions of assets or obligations from an associate (“asset acquisition rule”); and
- Where financial arrangements are used to fund one or more prescribed payments or distributions to an associate (“payment or distribution rule”).
The rules will apply to disallow the debt deductions to the extent that they are incurred in relation to the respective acquisition or payment/distribution. Unlike deductions that are denied under the Fixed Ratio Test rule (i.e. because they exceed the new 30% limit), deductions that are caught by the DDCR are not carried forward and are permanently denied.
The rules do not contain a purpose requirement. Where the conditions are satisfied, debt deductions can be permanently denied even if the parties to the arrangement had no purpose of obtaining a tax benefit when entering into the relevant transaction.
Which entities are subject to the DDCR?
Essentially, the DDCR applies to all entities that are subject to thin capitalisation.
Critically however, the exception to thin capitalisation for Australian headquartered groups whose Australian assets are 90% or more of its group’s worldwide assets does not apply for the purpose of the DDCR. Therefore, an Australian entity with a minimal investment in a foreign company or trust (in which they hold a 10% or greater interest) may be subject to the DDCR even if they do not otherwise have to apply the main thin capitalisation rules. For example, an Australian group that is otherwise excluded from the thin capitalisation rules but has even a single foreign branch or foreign subsidiary (even a $2 subsidiary) can be subject to these rules.
How does the asset acquisition rule work?
The asset acquisition rule applies where an entity, directly or indirectly, acquires a Capital Gains Tax (CGT) asset or legal or equitable obligation from an associate and incurs debt deductions (payable to an associate) in relation to loans to fund the acquisition or the subsequent holding of that asset or obligation.
Certain CGT assets are not subject to the asset acquisition rule:
- New membership interests in an Australian entity or a foreign company;
- The issue of new debt interests;
- The acquisition of certain new tangible depreciating assets that the acquirer expects to use for a taxable purpose within Australia within 12 months of acquisition.
The first two of these essentially allow the related party borrowing to be used to subscribe for equity in related parties (e.g. shares and units) or make loans to other related parties (whether interest-free or interest-bearing). This can be contrasted with the transfer of pre-existing debt or equity that was already on issue. Unfortunately, no exception was provided for the acquisition of trading stock.
As the rules can apply to indirect acquisitions from associates, there may be a need to trace through one or more entities even when the immediate use of the borrowed funds is an acquisition of an asset for which an exception applies.
Example 1
On 1 July 2021, ABC Pty Ltd (an entity subject to the thin capitalisation rules) obtained a $10m loan from the ABC Finance Trust (a related party) to fund the acquisition of trading stock from ABC Distributor Pty Ltd (another related party). The interest payable under the loan is 6% per annum. The loan remains on foot and ABC Pty Ltd incurs debt deductions of $600,000 for the 2024-25 income year under the loan.
ABC Pty Ltd’s $600,000 of debt deductions for the 2024-25 income year will be denied as they have been incurred in relation to the acquisition of the CGT assets acquired from an associate (ABC Distributor Pty Ltd) and no exceptions apply. The ABC Finance Trust remains assessable on the $600,000 of interest income.
How does the payment or distribution rule work?
The payment or distribution rule applies where an entity enters into a financial arrangement (e.g. an ordinary loan) to, directly or indirectly, fund a payment or distribution to an associate. It also applies where the loan facilitates the payment or distribution.
The payment or distribution must be one of a kind specified in a list of specific payment types that include, notably, a dividend, distribution, royalty or return of capital, as well as the repayment of principal under a debt interest that would have otherwise been denied deductions under DDCR (among others).
The rule operates to permanently disallow the debt deductions incurred in relation to the financial arrangement to the extent that they are paid or payable to an associate.
Example 2
On 1 July 2020, XYZ Trust obtains a $10m loan from XYZ Investor Co (a related party) to fund a return of capital of $10m as part of an internal restructure. The interest payable under the loan is 7% per annum. The loan remains on foot and XYZ Trust incurs debt deductions of $700,000 for the 2024-25 income year under the loan.
XYZ Trust’s debt deductions of $700,000 for the 2024-25 income year will be denied as they have been incurred in relation to a financial arrangement that was used to fund a return of capital by the trust. The XYZ Investor Trust remains assessable on the $700,000 of interest income.
When do the rules start to apply?
The DDCR rules apply in relation to all debt deductions that arise in income years beginning on or after 1 July 2024, regardless of when the financial arrangements to which the debt deductions were entered into.
The lack of any grandfathering for old debt instruments may impose significant compliance costs for taxpayers in determining whether any related party debt of an entity can be said to relate to the acquisition of any of their assets that may have been acquired from related parties, or to distributions that were made to related parties. For example, the rules may apply to deny debt deductions on related party debt that relates to a transfer of assets that occurred between related parties 20 years ago if the debt used to fund that acquisition continues to be held, even if has since been refinanced one or more times.
In its draft guidance, the ATO has stated that it cannot adopt a compliance approach that would limit its enforcement of the rules to historical transactions (such as those occurring over five years before the rules commenced) where they continue to give rise to deductions.
What is an example of a historical arrangement?
Although the rules can only deny debt deductions incurred on or after 1 July 2024, interest expenses can continue to accrue on related-party debt that was originally used to fund a related-party acquisition or distribution.
Example 3
In 1995, the DEF Finance Trust lent money to the DEF Unit Trust to fund a return of capital to its sole unitholder, the DEF Family Trust. The DEF Unit Trust continues to claim deductions for interest accruing under the loan which it considers as having refinanced its working capital. The loan between DEF Finance Trust and DEF Unit Trust was refinanced in 2000 and again in 2010. In 2020, the DEF Finance Trust No 2 refinanced the loan. DEF Unit Trust continues to pay interest to DEF Finance Trust No 2 during the 2024-25 income year. All entities are associates.
DEF Unit Trust’s debt deductions for interest paid to DEF Finance Trust No 2 are disallowed under the DDCR because the interest is payable on a loan that was used to fund a distribution to an associate. The subsequent refinancing of the original loan in 1995, whether with the same or a different entity, is not considered to break the original connection to the original use of the funds which was to make a related-party distribution.
The potential unlimited application of the DDCR to historic transactions presents as a compliance challenge as taxpayers may no longer have records to evidence the original use of funds that are currently owed or otherwise quantify the extent of potential denied deductions where borrowed funds have been obtained from multiple sources and applied for multiple purposes.
Can I restructure to remove the related party debt?
The DDCR contains specific anti-avoidance provisions that apply if the Commissioner is satisfied that an entity entered into or carried out a scheme for the principal purpose of avoiding the application of the DDCR in relation to a debt deduction. These allow the Commissioner to continue to treat the DDCR as applying. Further, schemes that seek to exploit the related party debt deduction condition to ‘debt-dump’ third-party debt in Australia may also be subject to the general anti-avoidance rules in Part IVA of the Income Tax Assessment Act 1936 (Cth).
The ATO has published Draft Practical Compliance Guide PCG 2024/D3 which sets out its intended compliance approach to restructures undertaken in response to the DDCR and when arrangements will be considered at higher risk of the Commissioner allocating compliance resources to considering the possible application of either the specific or general anti-avoidance rule.
Broadly, the ATO suggests that lower risk restructures are those that involve repayment of related party debt and converting debt to equity. Where restructures are entered into where the same level of debt is maintained, these are likely to be considered a high-risk restructure where there is an element of contrivance involved. Restructures that do not align with either green zone (low-risk) examples or red zone (high-risk) examples are considered yellow zone arrangements for which the Commissioner may undertake further enquiries to better understand.
The Draft PCG also contains examples that provide indicative views about how the ATO is likely to interpret the provisions. The guidance confirms the ATO expects taxpayers to be able to trace the use of funds to determine the correct application of the DDCR and have contemporaneous documentation to support this. One noteworthy aspect of the guidance is that the Commissioner does not propose to adopt a compliance approach that limits the requirements of taxpayers to obtain information for historical transactions entered into before the DDCR was first introduced to the public in June 2023.
Can the DDCR apply to interest paid under a Division 7A loan?
Yes. The ATO has confirmed its view that where the conditions of the DDCR are met, they will operate to disallow a deduction for interest paid or payable under a complying Division 7A loan where that loan has been used to acquire or fund a relevant related party arrangement (see here). Even if a loan is compliant with Division 7A, it does not exempt the entity from the operation of the DDCR.
Are there any other exclusions?
Entities that make an election to use the third-party debt test (“TPDT”) will be excluded from the DDCR. The TPDT limits the deductions for an entity to the amount attributable to third party debt. As the DDCR only applies where interest is paid to a related party, this exclusion offers only limited benefit as simply ensuring that debt is only paid to third parties should result in the DDCR (subject to the anti-avoidance rule) not applying.
However, an election to use the TPDT may facilitate conduit financing arrangements that allow for deductibility of certain related-party debt. In these situations, the election would provide the added benefit of switching off the potential application of the DDCR.
What are the next steps?
It is crucial that affected taxpayers analyse their existing structures and financing arrangement as the DDCR may result in material denials of debt deductions even if entities otherwise fall within the new annual limits. Taxpayers should contact their Pitcher Partners representative to review their existing arrangements and determine what action is required in light of these changes.
