When Type 2: Payment of distribution case applies
The Type 2: Payment or distribution case disallows all or part of a debt deduction of an entity for an income year if all the following conditions are met:
- An entity (the 'payer') enters into or has a financial arrangement with another entity.
- To the extent the payer uses the financial arrangement to fund or facilitate the funding of one or more payments or distributions
- the payer makes to an 'associate recipient' that is an associate pair of the payer
- that are a prescribed payment or distribution.
- The entity (the 'relevant entity') is any of
- the payer
- an associate pair of the payer
- an associate pair of an associate recipient.
- The relevant entity's debt deduction is wholly or partly in relation to the financial arrangement mentioned above.
- The relevant entity's debt deduction is referable to an amount paid or payable, either directly or indirectly, to any of
- an associate pair of the relevant entity
- an associate pair of the payer
- an associate pair of an associate recipient.
- The entity has not made a choice to use the third-party debt test for the income year.
A recipient of the payments or distribution described above may be the entity with whom the payer enters into or has the financial arrangement, or another entity.
Prescribed payments or distributions
Prescribed payments or distributions include:
- dividends, distributions or non-share distributions
- distributions by a trustee or partnership
- returns of capital, including returns of capital made by a distribution or payment made by a trustee or partnership
- cancellations or redemptions of a membership interest
- royalties (or similar payments or distributions for the use of, or right to use, an asset)
- repayment of principal under a debt interest issued by the payer if the debt interest satisfies paragraphs 820-423A(5)(a), (b) and (c)
- payments or distributions of a similar kind to any of the above
- a payment prescribed by the regulations (no regulations currently exist).
Debt deductions referable to an amount paid or payable (directly or indirectly) to an associate pair are disallowed under Type 2 to the extent the relevant financial arrangement was used to fund, or facilitate the funding of, the prescribed payments or distributions.
Example 1: Type 2 – financial arrangement used to fund a prescribed payment or distribution
Pay Co borrows $1,000 from Fin Co, an associate pair of Pay Co.
Pay Co uses the proceeds of borrowing to pay dividends to its offshore parent entity, Foreign Co, which is an associate pair of Pay Co.
In the current income year, Pay Co pays an interest expense of $50 in relation to the $1,000 associate borrowing from Fin Co.
The DDCR will apply to disallow Pay Co's debt deductions for the $50 interest expense since the debt deductions are in relation to the funding of a prescribed payment or distribution.
Example 2: Type 2– refinancing a debt interest that originally funded a prescribed payment or distribution
On 1 July 2022, Pay Co borrows $1,000 from Fin Co, an associate pair of Pay Co.
Pay Co uses the proceeds of borrowing to pay dividends to its offshore parent entity, Foreign Co, which is an associate pair of Pay Co.
On 6 July 2024, Pay Co refinances the $1,000 related party borrowing from Fin Co with a new $1,000 related party borrowing from Treasury Co, an associate pair of Pay Co.
In the 2025 income year, Pay Co pays an interest expense of $60 in relation to the $1,000 associate borrowing from Treasury Co.
The DDCR will apply to disallow Pay Co's debt deductions of the $60 interest expense. This is because:
- The new $1,000 related party borrowing is used to fund a repayment of principal to an associate pair under a debt interest issued by Pay Co that was subject to the DDCR.
- The original $1,000 related party debt which the new debt refinanced funded a prescribed payment or distribution (dividends) to its offshore parent, Foreign Co.
Indirect payments or distributions covered by Type 2
Type 2 also applies to relevant prescribed payments or distributions made 'indirectly' through one or more interposed entities. In determining whether a payment or distribution is made indirectly through one or more interposed entities:
- it is sufficient if payments exist between each interposed entity
- it is not necessary to demonstrate that each payment in a series of payments funds the next payment or is made after the previous payment.
Example 3: indirect royalty payment subject to Type 2 DDCR
Aus Co A borrows $1,000 from Lending Co, an associate pair of Aus Co A.
Aus Co A uses the proceeds of the borrowing to acquire $1,000 of shares in Aus Co B, an associate pair of Aus Co A.
Aus Co B pays a royalty of $1,000 to Foreign Co, an associate pair of Aus Co A.
In the current income year, Aus Co A pays an interest expense of $40 under the $1,000 borrowing from Lending Co.
The DDCR will apply to disallow Aus Co A's debt deductions for the $40 interest expense since the debt deductions are in relation to the $1,000 related party borrowings used to fund a prescribed payment (that is, royalty payment) which Aus Co A indirectly makes to its associate pair.