Essential insights for Multinational Enterprises

In December 2024, the ATO introduced Draft Practical Compliance Guideline PCG 2024/D3, which outlines the compliance approach for restructures of financing arrangements under the new thin capitalisation and debt deduction creation rules. This article explores the workings of these rules and their implications for MNEs' intercompany dealings.

Third Party Debt Test

• What it is: The Third Party Debt Test (TPDT) is a component of Australia's new thin capitalisation regime, designed to ensure that debt deductions are only claimed for genuine third-party debt arrangements.
• Who it applies to: The TPDT applies to general class investors, which include foreign-controlled Australian entities, foreign entities with Australian permanent establishments, and Australian controllers of controlled foreign entities.
• When it applies: The TPDT is part of the new thin capitalisation rules effective for income years commencing on or after 1 July 2023.
• How it works: The TPDT requires that the debt must be owed to an unrelated third party and must meet specific conditions set by the Australian Taxation Office (ATO). These conditions include ensuring the debt is not part of a back-to-back arrangement and is used for producing assessable income.

The ATO's draft guidance outlines scenarios where the TPDT may not be available, such as holding foreign assets or borrowing to pay dividends.

The guidance also provides a compliance approach for restructures undertaken to meet TPDT conditions, allowing taxpayers to claim pre-restructure debt deductions without the ATO challenging their position.

Debt Deduction Creation Rules

• What it is: The Debt Deduction Creation Rules (DDCR) are designed to prevent taxpayers from artificially creating debt deductions through related party transactions.
• Who it applies to: The DDCR applies to all entities subject to thin capitalisation, including those with minimal foreign investments. This includes Australian entities with even a single foreign branch or subsidiary.
• When it applies: The DDCR is effective from 1 July 2024.
• How it works: The DDCR permanently denies debt deductions for payments arising in connection with certain related party transactions. This includes two key instances:
• Asset Acquisition Type: Disallows debt deductions for interest expenses incurred in relation to loans used to acquire assets from an associate.
• Payment or Distribution Type: Disallows debt deductions for interest expenses incurred in relation to loans used to fund payments or distributions to an associate.

Unlike other thin capitalisation rules, the DDCR does not allow for the carry-forward of denied deductions, meaning once a deduction is denied, it is permanently disallowed

The ATO's draft Practical Compliance Guideline PCG 2024/D3 provides further details on the application of the DDCR and the compliance approach for restructures in response to these rules.

Restructures

• What it is: Restructures refer to the reorganization of a company's financial arrangements to comply with the new thin capitalisation rules, including the TPDT and DDCR.
• Who it applies to: The compliance approach for restructures applies to all entities subject to the new thin capitalisation rules, including those undertaking restructures to meet the TPDT and DDCR conditions.
• When it applies: The compliance approach for restructures is effective from the enactment of the new thin capitalisation rules, with specific time limits for undertaking restructures to benefit from the ATO’s compliance approach.
• How it works: The ATO's draft guidance provides a compliance approach for restructures undertaken to meet the conditions of the TPDT and DDCR. This includes specific types of restructures that can be undertaken and prescribes time limits for these restructures to benefit from the ATO’s compliance approach.
• Low-risk restructures can involve actions such as repaying debt interest, settling bridging finance, disposing of foreign assets, and engaging in cash pooling.
• On the other hand, high-risk restructures may include attempts to alter the nature of incurred costs or substituting related party debt with third-party debt.

The guidance also outlines a risk assessment framework to help taxpayers understand the ATO's compliance focus and the steps they can take to mitigate risks.

Potential implications for taxpayers

• Permanent Denial of Deductions: Debt deductions denied under the DDCR are permanently disallowed, impacting the overall tax position of MNEs.
• Risk Management: The ATO's compliance approach includes a risk assessment framework, which MNEs must navigate to avoid high-risk categorizations.
• Strategic Planning: MNEs need to strategically plan their financing arrangements to avoid triggering the DDCR, which may involve complex financial planning and restructuring.
• Compliance Burden: MNEs must ensure their restructures align with the ATO's guidelines to avoid penalties. This involves detailed documentation and possibly significant changes to existing structures.
• Increased Scrutiny: MNEs must ensure that their debt arrangements do not fall foul of the DDCR, requiring thorough review and possibly restructuring of existing debt.

Conclusion

The introduction of the Third Party Debt Test, Debt Deduction Creation Rules, and the compliance approach for restructures marks a significant shift in Australia's thin capitalisation regime. These measures aim to curb excessive debt deductions and ensure that multinational corporations pay their fair share of tax in Australia.

Taxpayers must carefully review their debt arrangements and related party transactions to comply with these new rules and avoid potential penalties.