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October 11, 2024
2024-1871

Australian Tax Office issues draft Practical Compliance Guidance on debt deduction creation rules and restructures

  • The new draft Practical Compliance Guideline (PCG) provides the Australian Tax Office's (ATO's) compliance approach to reviewing arrangements that have been restructured in response to the new debt deduction creation rules (DDCR).
  • The ATO may apply a specific DDCR anti-avoidance rule or the general anti-avoidance rule to cancel all or part of a tax benefit.
  • A color-coded risk-assessment framework in the PCG helps illustrate the ATO's level of compliance scrutiny, based on low and high-risk factors; general guidance and examples of how the rules operate are also provided.
  • The ATO plans to issue additional guidance regarding the thin-capitalization rules.
 

Executive summary

The Australian Taxation Office (ATO) issued a draft Practical Compliance Guideline (draft PCG 2024/D3)1 on 9 October 2024, setting out the ATO's compliance approach to reviewing arrangements that have been restructured in response to the new debt deduction creation rules (DDCR),2 including for the potential application of the general anti-avoidance rule in Part IVA of the Income Tax Assessment Act 1936 and the DDCR specific anti-avoidance rules. (For background, see EY Global Tax Alert, Australian thin-capitalization changes and new subsidiary disclosure rules — December 2023 update, dated 15 December 2023.)

The draft PCG outlines the ATO's compliance approach with a series of low-risk and high-risk factors and a four-color-coded risk-assessment framework (white, yellow, green and red zones). The colors denote varying levels of scrutiny to indicate when the ATO is likely to have cause to devote compliance resources to further examine restructures by taxpayers.

As part of this further examination, the Commissioner of Taxation may apply either the specific DDCR anti-avoidance rule or Part IVA to cancel all or part of a tax benefit if a taxpayer is considered to have restructured to avoid the application of the DDCR in a manner that preserves tax benefits going forward.

The PCG provides eight examples of low-risk or high-risk restructures. Low-risk restructures include repaying the debt interest, disposing of foreign assets and terminating swaps, provided they meet certain criteria. High-risk restructures involve arrangements in which debt deductions are expected to be disallowed and similar deductions are claimed under restructured arrangements.

When finalized, the PCG will apply to restructures entered into on or after 22 June 2023 (the date the Act was introduced as a Bill into Parliament). The ATO may update the guidance as its engagement with affected taxpayers and compliance activity increases throughout the implementation of the new thin-capitalization rules and DDCR.

The draft PCG is open for comments until 8 November 2024.

Given the necessary limited coverage of possible scenarios where the DDCR may apply and for which the ATO may or may not conduct compliance activities, as well as the lack of technical analysis and guidance, some taxpayers will need to consider how they might obtain comfort for whether the rules, including the anti-avoidance rules, apply. Options include seeking a private binding ruling from the ATO on their circumstances.

DDCR overview

The DDCR applies to income years commencing on or after 1 July 2024 to disallow debt (interest) deductions that arise from related-party arrangements used to fund acquisitions of a capital gains tax (CGT) asset, or legal or equitable obligation, or payment/distribution to an associate pair, i.e., broadly associates (as defined in the Australian tax legislation) of one another.

The rules apply to "general class investors" and inward and outward investing financial entities (non-authorized deposit-taking institutions). There are various exemptions from the rules including for entities with less than AU$2m in debt deductions in a year (calculated on an associate inclusive basis) and for certain special entities. Notably, the thin-capitalization exclusion where 90% or more of the value of the entity's average assets are Australian assets does not apply for the DDCR.

The rules are complex and apply before the thin-capitalization rules. In particular, they may apply in respect of arrangements that occurred on or before 1 July 2024, as well as from that date.

The draft PCG is not a detailed tax ruling, but it includes a summary of the DDCR rules and 11 examples of different scenarios where the DDCR may or may not apply in Schedule 1 of the draft PCG. There are eight additional examples in Schedule 2 of the draft PCG that cover restructures. These examples are welcome given the absence of examples in the explanatory memorandum (EM) to the amending Bill.

Despite that the summary and examples provide a useful background to circumstances in which a taxpayer may restructure its arrangements to seek to avoid the further application of the rules (see below), the draft PCG takes a conservative view that any restructuring that leads to the same amount of debt being in existence post restructuring is likely high-risk and deserves ATO resources devoted to examining it. One of the few exceptions to this is the repayment of bridging financing (see example 5). This could be an overly restrictive view of the application of the rules, because a commercial reorganization of existing structures giving rise to the same level of debt in Australia post reorganization might not enliven the anti-avoidance provisions covered in the draft PCG.

There is further guidance in the PCG on recordkeeping and apportionment of denied deductions but limited technical analysis; however, it is possible that the ATO may provide other technical views on the rules in future guidance products.

The thin-capitalization rules and DDCR are complex and must be factored into all new financing decisions of impacted entities. In addition, existing related-party financing arrangements should be reviewed given there is no grandfathering of these arrangements.

Specific DDCR anti-avoidance rule

The specific DDCR anti-avoidance provision is designed to address schemes seeking to avoid the debt-creation rules. The anti-avoidance rule applies a "principal purpose" test rather than the higher threshold "dominant purpose" test and may readily impact any attempts to sidestep the application of the rules. This anti-avoidance provision may be problematic for taxpayers who might seek to reorganize their affairs, either before the commencement of the rules or thereafter.

Although the Supplementary EM to the amending Bill suggested that the specific anti-avoidance rule will not be applied if a taxpayer is "merely restructuring, without any associated artificiality or contrivance, out of an arrangement that would otherwise be caught by the debt creation rules," the actual legislation does not include this language.

The draft PCG does not include any further technical analysis of this DDCR anti-avoidance rule nor for the technical application of the Part IVA provisions.

Compliance approach

The draft PCG sets out the ATO's compliance approach to restructures by providing a risk-assessment framework. Taxpayers can assess the risks associated with restructuring in response to the DDCR in accordance with this guidance.

A "restructure" encompasses any restructure or refinancing, including any change, or reorganization of group structure, business affairs or financial arrangements and includes any part of a broader restructure or a restructure that is partially complete and yet to be completed.

By following this guidance, taxpayers can understand the compliance risks associated with restructures being contemplated or already undertaken. If a restructure is low-risk, the ATO states that the taxpayer can have confidence that the ATO will not allocate resources to intensive examinations beyond verifying the self-assessment. Similarly, it provides certainty on areas of higher compliance risk that are likely to result in further and more intensive ATO examinations.

In addition, the ATO states that if the DDCR needs to be considered for an arrangement, in the course of compliance activity the ATO would ordinarily expect to allocate resources to ensure that the correct amount of debt deductions were disallowed.

Risk-assessment framework

The draft PCG sets out a risk-assessment framework that provides guidance regarding the level of compliance resources that will be devoted to the types of restructures and assists entities in assessing their compliance risks.

The risk-assessment framework includes white, yellow, green and red risk zones, with the different zones each indicating a different level of risk and a different risk rating, as follows:

Risk zone

Risk level

White

Further risk assessment not required

Yellow

Compliance risk not assessed

Green

Low-risk

Red

High-risk

An entity's risk rating will influence the ATO's engagements with the entity, including the intensity of assurance activities or whether the ATO is likely to engage with the entity to review the restructure. The ATO will generally prioritize resources and undertake more intensive investigations to address higher-risk restructuring.

It is worth noting that as the ATO continues to administer the DDCR, it will revisit the risk-assessment framework, the zones and whether they accurately reflect the risks associated with each restructure.

The draft PCG provides information on each risk zone, when an entity is in a particular zone and examples of both low-risk and high-risk structures.

The "white zone"

The "white zone" means that further risk assessment is not required. An entity is in the white zone if it has entered into a settlement agreement with the ATO since the enactment of the DDCR on 8 April 2024 or is a party to a court proceeding that involves a decision on the Australian tax outcomes of the entity's arrangement under the DDCR.

An entity's restructure will be in the white zone as long as there has not been a material change in the arrangement since the time of the agreement or court decision.

The ATO does not anticipate that many entities will have restructures in the white zone at this early stage of administration of the DDCR. However, if an entity is in the "white zone," the ATO will not have cause to apply compliance resources beyond simply verifying that the entity has met one of the two conditions for the white zone.

The "yellow zone"

The "yellow zone" means that the compliance risk is not assessed, and the entity has undertaken one or more restructures in response to the DDCR that do not fall into the green or red zones. The ATO may engage with the entity to understand compliance risks of the restructure.

The "green zone"

The "green zone" means that the restructure is low-risk, and the ATO will generally only devote compliance resources to tax risks in scope of the draft PCG to obtain comfort and verify the entity's self-assessment.

An entity's restructure is in the green zone if the restructure is covered by the low-risk examples in Schedule 2 of the draft PCG, exhibits the features of low-risk restructures (outlined below) and is otherwise commercial. An entity's restructure is also in the green zone if the ATO has conducted a review or audit of the restructure and provided the entity with a "low-risk" rating and there has not been a material change in the arrangement that informed the basis of the rating.

The "red zone"

The "red zone" means that the restructure is high-risk, and these restructures are expected to attract intensive compliance action.

An entity's restructure is in the red zone if the restructure is covered by the high-risk examples in Schedule 2 of the draft PCG, or the ATO has provided the entity with a "high-risk" rating (or low assurance under a Justified Trust review).

The red zone is a reflection of the features the ATO considers indicate greater risk. If an entity's restructure is in the red zone, the ATO will prioritize resources to review the arrangement, which may involve commencing a review or an audit. However, it is not presumed that the DDCR special anti-avoidance provision or the general anti-avoidance provision in Part IVA of the ITAA 1936 will necessarily apply to the arrangement.

Low-risk restructures

The draft PCG notes that the following factors must be present for a restructure to be low-risk:

  • Debt deductions disallowed by the DDCR prior to the restructure have been accurately calculated.
  • Prior to the restructure, the arrangements would not have attracted the application of Part IVA of the ITAA 1936.
  • The restructure occurs in a straightforward manner having regard to the circumstances without any associated contrivance or artificiality and is on arm's-length terms.
  • The arrangement following the restructure will not attract the application of Part IVA of the ITAA 1936.

All of these features must be present for the restructure to be classified as low-risk and if any of the features are not present, the restructure will not be regarded as low risk.

Where a restructure is only low-risk, the ATO will generally only allocate compliance resources to obtain comfort and verify the self-assessment.

The ATO expect that the lowest-risk restructures generally involve the repayment of all related-party debt in relation to covered transactions without any additional debt being issued or acquired.

Examples of low-risk restructures include:

  • Example 12 — repaying debt interest using retained earnings and dividends
  • Example 13 — repaying bridging finance prior to sourcing additional external financing
  • Example 14 — disposing of foreign subsidiary so it is no longer classified as a general class investor
  • Example 15 — repaying debt interest by the injection of equity, terminating swaps and recapitalizing a subsidiary
  • Example 16 — repaying debt interest with the issuance of additional equity interests
  • Example 17 — repaying cash pooling that was used in relation to the acquisition of CGT assets from associate pairs and payment of dividends and royalties to associate pairs

High-risk restructures

The draft PCG notes that higher-risk arrangements may include round robin financing, contended change in "use" of debt under other related-party arrangements, or a contrived arrangement to choose and use the third-party debt test, to prevent the DDCR from applying.

Examples of high-risk arrangements include:

  • Example 18 — an entity enters into a debt factoring arrangement of the same value as the initial debt interest, contending there is a change in use of the debt and change in the character of debt deductions incurred
  • Example 19 — an entity enters into a third-party debt arrangement to replace related-party debt with third-party debt

Other guidance

Record keeping

The draft PCG includes comments on the ATO's expectations for record keeping and obtaining sufficient information for tracing the use of related-party debt to determine if an arrangement is flagged by the rules.

The ATO acknowledges challenges in obtaining records for historical transactions but expects taxpayers to provide sufficient documentation for compliance. A list of example documents and other information is provided that may help taxpayers demonstrate whether the DDCR applies to debt deductions in relation to historical transactions.

The ATO expects that contemporaneous documentation and associated analysis on the operation of the DDCR (including evidentiary support for tracing the use of funds) would be kept for transactions since the enactment of the law and states that a deduction should not be claimed unless sufficient information is available to support a conclusion that the DDCR does not apply.

Tracing of funds and apportionment

The draft PCG makes clear that the onus of proof remains with the taxpayer, even for historical transactions that span into the early past, with no time limit applying. Where there is mixed use of debt funding, the ATO considers that tracing should be the method used to determine the disallowed debt deduction wherever possible. The taxpayer will need to prove a tracing of funds if it wishes to demonstrate that "tainted DDCR debt" has since been repaid. The draft PCG provides examples of some of the records that a taxpayer will need to produce but ultimately the onus is on the taxpayer to demonstrate its case in terms of specific fund flows.

However, apportionment may be appropriate if it is not possible to trace the flow of funds, such as where funds from various sources that were used for different purposes are combined into a single debt interest.

The ATO considers a fair and reasonable apportionment method to be one in which the debt deductions under a facility are disallowed in the same proportion as the "DDCR debt" to total debt and related-party debt that funded covered transactions is refinanced into a single related-party debt facility that also includes debt incurred for other purposes. This includes any repayments of principal and capitalization of interest. The ATO would apply compliance resources to investigate apportionment approaches based on hypothetical circumstances or allocating repayments first to debt that may be subject to the DDCR without contemporaneous documentation to support that allocation.

Reportable tax position and other disclosures

The draft PCG flags that disclosure of a taxpayer's risk rating applying the risk-assessment framework may be added to the reportable tax position (RTP) schedule.

Note that the International Dealings Schedule (IDS) for the 2024 year includes a new question that requires an entity to disclose whether it has restructured or replaced an arrangement during the income year that would have satisfied the DDCR, if it were still in place on or after 1 July 2024. The ATO stated that the purpose of this question is to identify risks associated with restructuring in anticipation of the DDCR's having effect.

Draft PCG examples where DDCR may or may not apply

The draft PCG includes the following examples of the potential application of the DDCR:

Scenarios in which the DDCR should not apply:

  • Example 1 — timing and the "associate pairs" conditions (asset acquisition case)
  • Example 2 — funding capital expenditures only with related-party debt (payment distribution case)
  • Example 3 — funding working capital and dividends with related-party debt (payment/distribution case)
  • Example 4 — cash pooling
  • Example 5 — bridging finance (asset acquisition case)
  • Example 7 — related-party transactions to recharge outcomes arising from swaps (asset acquisition case)

Scenarios in which the DDCR would apply:

  • Example 6 — related-party financing of related-party acquisition (asset acquisition case)
  • Example 8 — debt deductions in relation to an acquisition from an associate pair (asset acquisition case)
  • Example 9 — acquisition from a related trust (asset acquisition case)
  • Example 10 — loan funding distribution by trustee (payment/distribution case)
  • Example 11 — related-party lending between multinational subsidiaries (asset acquisition case)

Other planned ATO guidance

It had been expected that the draft PCG would also cover the ATO's concerns with restructuring in response to the new thin-capitalization rules that apply for income years commencing on or after 1 July 2023. However, this guidance will now be added to the PCG when the ATO publishes its planned draft public ruling on the third-party debt test, which is under development and expected soon.

The ATO has also committed to providing updated guidance on how the transfer pricing rules will apply to further limit debt deductions following thin-capitalization changes that now require taxpayers to test both the appropriate amount of debt and the applicable interest rate before applying the fixed-ratio or group-ratio tests (to update the existing PCG 2017/4).

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Endnotes

1 PCG 2024/D3 — Restructures and the new thin-capitalization and debt deduction creation rules — ATO compliance approach.

2 Debt deduction creation rules in Subdivision 820-EAA of the Income Tax Assessment Act 1997 were introduced in Treasury Laws Amendment (Making Multinationals Pay Their Fair Share — Integrity and Transparency) Act 2024 (the Act).

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Contact Information

For additional information concerning this Alert, please contact:

Ernst & Young (Australia), Sydney

Ernst & Young (Australia), Melbourne

Ernst & Young (Australia), Perth

Ernst & Young (Australia), Brisbane

Ernst & Young (Australia), Adelaide

Ernst & Young LLP (United States), Australia Tax Desk, New York

Ernst & Young LLP (United Kingdom), Australia Tax Desk, London

Published by NTD’s Tax Technical Knowledge Services group; Carolyn Wright, legal editor