Thin capitalisation
The thin capitalisation provisions limit the debt deductions that certain entities can claim for tax purposes based on the tests set out in Division 820 of the ITAA 1997. These rules ensure that taxpayers fund their Australian operations with an appropriate amount of equity.
When thin capitalisation rules apply
Subject to the exclusions, the thin capitalisation rules will apply to a trust if:
- the trust has at least one trustee which is an Australian resident (an Australian trust) and either
- the trust, or any of its associate entities, is an Australian controller of an Australian controlled foreign entity or carries on business at or through an overseas permanent establishment
- that trust is foreign controlled, either directly or indirectly, or
- the trust doesn't have any trustees that are Australian residents, and the trust carries on a business in Australia at or through a permanent establishment or otherwise has assets that produce assessable income.
Exclusions
The thin capitalisation rules will not apply if:
- an Australian trust is neither foreign controlled or has any overseas operations or investments (unless it is an associate of another Australian entity that does)
- a foreign trust that has no investments or presence in Australia
- the trust's debt deductions (including combining the debt deductions of its associate entities) don't exceed $2 million in the income year
- an Australian trust with overseas operations or investments, or that is an associate of an Australian entity with such operations or investments, that isn't also foreign controlled and meets the Australian assets threshold test, see section 820-37 of the ITAA 1997.
Exclusions for certain special purpose entities also exist, see section 820-39 of the ITAA 1997.
For more information, see Thin capitalisation.
Control
The rules measuring control consider both direct and indirect interests:
- that the trust holds in the other entity (or vice-versa)
- that associate entities of the trust hold in the other entity.
This means an Australian trust can be an Australian controller of a foreign entity even if it holds a direct interest of less than 50% in the foreign entity.
Debt deduction creation rules
For income years that commence on or after 1 July 2024, the debt deduction creation rules (DDCR) operate to disallow related party debt deductions for certain related party arrangements. The debt deduction creation rules apply in relation to both:
- arrangements entered into before 1 July 2024 where debt deductions continue to arise
- new arrangements entered into on or after 1 July 2024.
The DDCR applies to multinational businesses (that is, businesses operating in Australia and at least one other jurisdiction), including private businesses and privately owned groups.
Exemptions from the DDCR
The DDCR don't apply to:
- entities that, together with their associate entities, have $2 million or less of debt deductions for an income year
- authorised deposit-taking institutions (ADls)
- securitisation vehicles
- certain special purpose entities
- Australian plantation forestry entities.
Applying the DDCR
- The DDCR can apply to:
- an Australian resident entity that either:
- carries on business in a foreign country at or through a permanent establishment
- has a controlling interest in any offshore entity (no matter the size or turnover of that offshore entity).
- a foreign resident entity with operations or investments in Australia that is claiming debt deductions.
The DDCR disallow debt deductions for certain related party arrangements. As the rules focus on the creation of debt deductions, it doesn't matter whether the arrangement involves resident or non-resident entities. This means that onshore and cross-border related party arrangements can trigger the debt deduction creation rules.
The rules disallow debt deductions arising in relation to certain related party arrangements, including arrangements undertaken (entirely or partially) prior to 1 July 2024. For example, the rules will apply to interest arising under a related party loan that is still on foot (or has been refinanced) where the related party loan funded a historical transaction caught by the debt deduction creation rules.
DDCR operation
The DDCR operates to disallow debt deductions arising on certain related party arrangements. The rules broadly capture 2 types of arrangement as follows.
Type 1: Acquisition case
The DDCR may disallow debt deductions where an entity acquires a capital gains tax (CGT) asset or a legal or equitable obligation from an associate pair. An entity is an associate pair of another entity if the entity is an associate of the other entity or the other entity is an associate of the entity.
This applies to all such acquisitions except:
- new membership interests in an Australian entity or foreign company,
- new depreciating tangible assets the acquirer will use for a taxable purpose in Australia within 12 months that have not previously been installed or used by the acquirer, an associate pair or the disposer for a taxable purpose
- new debt interests an associate pair issues to the acquirer.
Debt deductions that are paid or payable (directly or indirectly) to a related party are disallowed to the extent that they're for the acquisition (or holding) of the CGT asset or legal or equitable obligation.
Type 2: Payment or distribution case
The debt reduction creation rules may disallow debt deductions where an entity uses a financial arrangement to fund, or facilitate the funding of, prescribed payments or distributions to an associate pair.
Prescribed payments and 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),
- refinancing a debt interest that was originally funding a prescribed payment,
- payments or distributions of a similar kind to any of the above,
- payment prescribed in regulations (no regulations currently exist).
Debt deductions that are paid or payable (directly or indirectly) to a related party for the financial arrangement to the same extent that the financial arrangement was used to fund, or facilitate the funding of, one or more prescribed payments or distributions.
If the thin capitalisation or debt deduction creation rules affect you this year
If the thin capitalisation or debt deduction creation rules apply, the trust must complete the International dealings schedule 2025. See, Section D and F of the International dealings schedule instructions 2025.
Where you must lodge a tax return because the thin capitalisation or debt deduction creation rules apply, and the trust had a period in the income year when it was not a member of a consolidated group or MEC group (a non-membership period) the trust must complete an International dealings schedule 2025.
Breach of the thin capitalisation or debt deduction creation rules
If there is a breach of the thin capitalisation or debt deduction creation rules are breached, some of the trust’s debt deductions may be denied. Include the amount denied at item 5 – label B Expense reconciliation adjustments. If the trust incurs debt deductions for other types of income (for example, rental income, dividend income or foreign income) the amount of deductions you show at the relevant entries must exclude the debt deductions amount denied.
For more information, see:
- Debt deduction creation rules and Division 7A
- Draft Practical Compliance Guideline PCG 2024/D3 Restructures and the new thin capitalisation and debt deduction creation rules
- Thin capitalisation rules
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