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Debt deduction creation rules – coming to a private group near you

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For many private groups with offshore connections, the thin capitalisation rules in Division 820 often have minimal application due to the exclusions where:

  1. associate inclusive debt deductions are less than $2 million for the income year (although the increase in interest rates may have reduced the benefit of this exclusion); or

  2. the value of the Australian assets held by the group is equal to, or greater than, 90% of the total assets of the group.

From 1 July 2024, while those exclusions continue to apply to the thin capitalisation rules, the new game in town for private groups is the debt deduction creation rules (DDCR) in Subdivision 820-EAA. Notably, the 90%+ Australian asset exclusion does not apply to the DDCR.

Where the DDCR applies, it prevents an entity from claiming a debt deduction paid to an associate in relation to certain acquisitions or distributions (see below). Importantly:

  1. unlike many specific or general anti-avoidance provisions, the DDCR applies automatically without the need to prove a tax avoidance purpose;

  2. there is no grandfathering, the DDCR applies both to pre-existing arrangements as well as new arrangements after 1 July 2024; and

  3. there is no exclusion for purely Australian arrangements, including under Division 7A, and entities which are not subject to the thin capitalisation rules may still be subject to the DDCR.

What transactions does the DDCR apply to?

The DDCR may apply to deny deductions on related party – that is, not third party – debt in two cases:

  1. where related party debt has been used to fund the acquisition of a CGT asset or a legal or equitable obligation directly or indirectly from an associate (Acquisition Event); or

  2. where related party debt has been used to fund or facilitate the funding of certain payments or distributions to an associate (Distribution Event).

However, the breadth of the provisions is unclear. For example, with an Acquisition Event, what does indirect mean? And how does one go about determining the indirect nexus, particularly if there is a mix of related party debt and third-party debt used within a group? In relation to a Distribution Event, the scope of which payments and distributions are covered may capture more than one would expect.

What entities are subject to the DDCR?

Unless an exclusion applies (see below), where there has been an Acquisition Event or Distribution Event, a debt deduction of an entity will be denied under the DDCR if the entity is either:

  1. a ‘general class investor’; or

  2. an outward (or inward) investing non-ADI financing entity.

A ‘general class investor’ means:

  1. an Australian entity that controls a foreign entity or carries on business at or through an overseas permanent establishment;

  2. an Australian entity controlled by a foreign entity or entities; or

  3. a foreign entity.

What are the exclusions from the DDCR?

Exclusions from the DDCR fall into two categories:

  1. certain types of entity; and

  2. certain types of acquisitions (Acquisition Events only).

The DDCR will not apply to an entity where:

  1. the entity is a securitisation vehicle or ADI;

  2. the entity has associate inclusive debt deductions of $2 million or less for the income year;

  3. the entity is an insolvency remote special purpose entity; or

  4. the entity chooses the ‘third party debt test’ under the thin capitalisation rules (assuming the entity is subject to those rules).

The DDCR will not apply to the following acquisitions from associates:

  1. newly issued membership interests in an Australian entity, or a foreign entity that is a company;

  2. new tangible depreciating assets expected to be used for a taxable purpose in Australia within 12 months (this exclusion does not include intangible assets); or

  3. the acquisition of debt interests issued by an associate.

Importantly, there is no exclusion for the acquisition of trading stock from an associate.

But wait, there is more!

While the DDCR applies automatically without a purpose test, the DDCR includes a specific anti-avoidance rule that has a purpose test. If the Commissioner is satisfied that it is reasonable to conclude that one or more entities entered into or carried out a scheme for the principal purpose of ensuring that the DDCR does not deny debt deductions, the Commissioner may determine that the DDCR applies.

What does this mean for private groups?

While the thin capitalisation rules have traditionally had limited application to many private groups, the DDCR is a clear creep into that space.

For Australian private groups that control a foreign entity (irrespective of size), or are controlled by a foreign entity (or entities), the DDCR will mean that there needs to be careful consideration of related entity financing, including pre-1 July 2024 financing, to determine whether debt deductions are deductible.

For example, if an entity borrowed from a related entity to fund a pre-1 July 2024 Acquisition Event or Distribution Event transaction, the DDCR could deny debt deductions on that borrowing irrespective of whether the borrowing was on arm’s length terms or Division 7A terms. The same considerations would apply to Acquisition Event or Distribution Event transactions on or after 1 July 2024.

Advisors need to consider the DDCR when planning for 30 June 2025 year end. That debt deductions on related party borrowing were deductible previously does not mean they necessarily will be moving forward. Similarly, that the entity was not, and still may not be, subject to the thin capitalisation rules does not mean that the DDCR rules cannot apply.

The Australian Taxation Office has issued Draft Practical Compliance Guideline PCG 2024/D3 on the DDCR. Submissions on PCG 2024/D3 close on 8 November 2024.

For more information please contact:

Neil Brydges
Principal | Accredited Specialist in Tax Law
M +61 407 821 157 | T +61 3 9611 0176
E: nbrydges@sladen.com.au

Kaitilin Lowdon
Principal Lawyer
M +61 402 859 214 | T+61 3 9611 0120
E: klowdon@sladen.com.au

Daniel Smedley
Principal | Accredited Specialist in Tax Law
M +61 411 319 327 |  T +61 3 9611 0105
E: dsmedley@sladen.com.au

Rob Warnock
Principal Lawyer
T +61 3 9611 0155 | M +61 419 892 115
E: rwarnock@sladen.com.au

Edward Hennebry
Senior Associate
T +61 3 9611 0113 | M +61 428 439 730
E ehennebry@sladen.com.au


Neil Brydges