ATO Finalises Guidance On Third Party Debt Test

1. Third Party Debt Test: Final ATO guidance

On 1 October 2025, the ATO finalised its guidance on the third party debt test (TPDT) for thin capitalisation purposes in Taxation Ruling TR 2025/2 (Ruling) and updated its compliance approach to restructures carried out in response to the TPDT in Schedule 3 of Practical Compliance Guideline PCG 2025/2 (PCG). Our observations on the prior draft guidance are available here.

By way of a refresher, the TPDT is one of three methods available for calculating allowable debt deductions for an entity subject to the thin capitalisation rules and it limits an entity's gross debt deductions for an income year to an amount equal to the sum of its debt deductions for that year that are, broadly, 'attributable to' debt interests:

• which are issued to non-associated entities (subject to certain permitted conduit financing arrangements);
• which are used to fund the entity's Australian commercial activities; and
• where lenders have recourse only to Australian assets of the borrower and the obligor group.

In summary, whilst the Ruling helpfully clarifies certain key aspects of the TPDT, it still contains narrow views of certain aspects of the TPDT, with limited flexibility for the commercial realities of third party financing. Most concerningly, the ATO is maintaining its view that debt used to fund distributions to investors will not satisfy the requirements of the TPDT – this will be a material and ongoing issue for the infrastructure and real estate sectors which may materially affect valuation models.

Whilst some of the transitional compliance approaches in the PCG will offer relief, taxpayers should approach any restructure with caution to ensure compliance with the TPDT. Unless extended, these compliance approaches will only apply to income years ending on or before 1 January 2027. This means that for most taxpayers (with a June year-end), the transitional compliance period will end on 30 June 2026.

The PCG also covers the ATO's compliance approach in relation to debt deduction creation rules, including restructures in response to those rules, which are not discussed in this note. However, the compendium in relation to the PCG suggests that while the ATO will in some circumstances view replacement of non-DDCR compliant debt with equity as low-risk, the same low-risk position will not apply if the debt is simply made interest free – the basis for this distinction is unclear.

Notable updates and clarifications from the finalised Ruling and PCG (and accompanying compendiums responding to certain feedback received in consultation) are outlined below.

2. 'Recourse' to 'Australian assets'

• Meaning of 'Australian asset'

The ATO added additional comments to explain the process for determining when an asset is an 'Australian asset', separated into guidance for tangible assets, membership interests (discussed below) and intangible assets other than membership interests. The ATO considers such a question is a matter of fact and degree, and listed a number of factors the ATO considers relevant to the question.¹ With respect to intangible assets such as contractual rights, the ATO notes that important factors will include the location of the contracting parties and whether or not they are Australian entities and the extent to which the asset is used in a business carried on in Australia.² Former Example 22 in the draft PCG (which implied that an account that an Australian entity with only Australian operations holds with a non-Australian bank is not an Australian asset) was removed from the PCG.

The comments in relation to tangible and intangible assets (other than membership interests) provide helpful guidance. In particular, the comments provide some comfort that Australian entities contracting with (for example) foreign suppliers, banks and insurers in relation to Australian projects should not prevent reliance on the TPDT.

• Membership interests

Consistent with the position in relation to credit support rights, the Ruling helpfully clarifies that when identifying the assets to which a lender has recourse, where an obligor holds membership interests in another entity, the relevant asset is the membership interests itself and not the assets held by the other entity.³ However, the ATO considers that a membership interest will only be an Australian asset if the relevant interest is in an Australian entity, and the underlying assets of that entity - held directly or indirectly - are all Australian assets (except for minor or insignificant non-Australian assets), reading a 'look-through' test into the rules and creating difficulty for taxpayers with global operations to structure their debt in a way which satisfies the requirements of the TPDT.⁴

Additionally, the Ruling clarifies that the 'minor or insignificant non-Australian asset' carve-out doesn't apply for the purposes of s 820-427A(4)(b), which permits recourse to membership interests in the borrower. That is, where a borrower holds non-Australian assets that are minor or insignificant, the borrower can enter into a debt arrangement where the lender has recourse to all of the borrower's assets and satisfy the TPDT requirements, but if the lender also has recourse to membership interests in the borrower the TPDT requirements will not be satisfied unless the entity that owns those membership interests is itself a member of the obligor group (which wouldn't generally be the case for project financings, for example).

A new Example 33 has been included in the PCG, which provides a low risk rating to restructures undertaken by taxpayers who amend the terms of the loan so that the lender does not have recourse to the membership interest of the borrower (which indirectly holds minor or insignificant non-Australian assets). However, it is unclear how this might be helpful in practice, given that lenders will often require security over the membership interests in the borrower to provide flexibility in an enforcement scenario.

• Views on 'minor or insignificant' remain the same

Despite the feedback received, the ATO maintains that 'minor or insignificant' means 'minimal or nominal value' and that the relative value of assets, as compared with the market value of a taxpayer's total assets, is not determinative.⁵ However, the ATO also maintains that as a compliance measure, a taxpayer may treat assets as minor or insignificant where the market values of such assets are no more than $1 million, and in aggregate represent less than 1% of the market value of all assets to which the lender has recourse. 6

3. 'Commercial activities in connection with Australia'

• The ATO has doubled down on its view that paying distributions of dividends or capital returns to investors do not constitute relevant 'commercial activities', but rather are 'appropriations of profit or equity'. The ATO's view is disappointing but not unexpected, and will affect regearing transactions that are common in the infrastructure and property sectors to which the TPDT is said to be directed. Given the substantial value impact that this view will have for cash-flow valuation models of new and existing projects, and the lack of clear and compelling support for the ATO's views, it seems that this may be an issue which taxpayers are forced to challenge.
• Debt refinancing permitted. The ATO now explicitly states that commercial activities for these purposes include the refinancing of debt that was used to fund commercial activities in connection with Australia (but not the refinancing of debt used for other purposes, including paying distributions).
• Limited flexibility for taxpayers to restructure historical arrangements involving debt-funded distributions. The PCG introduced new Example 34 which sets out the ATO's compliance approach on restructures undertaken to address this requirement of the TPDT. The ATO will not challenge arrangements where:

1. historical debt-funded distributions have been limited to 10% of the available balance of the debt facility (there is no explanation as to how this figure was determined, but it would tend to rule out regearing transactions),
2. prior to and during the compliance period, repayments are made at least equal to the total distributions and are funded entirely from operating cashflows; and
3. before the compliance period ends, the borrower amends its governance documents and procedures and no longer pays distributions using the debt facility. While a targeted compliance approach is a welcome development, it appears somewhat rigid in practice and will necessarily result in a reduction in gearing of the structure which has valuation implications. The 10% threshold seems arbitrary and it is unclear whether the Commissioner will apply it as a strict limit.

4. Credit support rights

• View on credit support rights remain largely unchanged. The ATO unhelpfully maintains that for the purposes of satisfying the TPDT, taxpayers will need to evaluate credit support rights that do not directly support the credit of the borrower. For example, the ATO considers the guarantees in Example 6 and in new Example 19 of the Ruling to relevantly constitute credit support rights even though they do not support the credit of the borrower but rather support the credit of the lessee in relation to the lessee's obligation under the lease in favour of the borrower.
• Uncertainty remains around guarantees. Given the ATO's stance on credit support rights as outlined above and also its view that credit support rights are 'unlikely to ever be minor or insignificant assets'⁷, this leaves a number of other potential issues with guarantees, creating uncertainty. In particular, how are performance guarantees viewed for these purposes, when they generally do not have an impact on the borrower's ability to obtain finance but are instead commercial arrangements entered into to secure performance under the relevant contracts?
• Clarification on associate entity credit support. New Example 19 of the Ruling clarifies the ATO's view that if a credit support right is issued by an associate entity which is a member of the obligor group, such right may be permissible under the TPDT rules if it provides recourse only to Australian assets that are covered by the rules and it is not a right that is prohibited by the rules. The ATO's facts and reasoning suggests that a credit support right would be prohibited under the TPDT rules if the right provided recourse to assets of an entity that was not a member of the obligor group, even if limited to Australian assets.⁸ The example is also inconsistent with the ATO's comment in paragraph 42 that the recourse requirement does not require an entity to 'look-through' rights and membership interests to underlying assets.
• Targeted compliance approach for restructuring involving amendment to credit support rights is a welcome development. Notwithstanding the uncertainty above, new Example 31 in the PCG outlines the ATO's compliance approach to taxpayers restructuring to limit credit support rights to satisfy subparagraph 820-427(A)(5) – in this case, limiting the cost overrun support deed to the development phase of an Australian real property asset – and is a welcome addition.

5. Swaps and on-swaps

• No guidance on cross-currency interest rate swaps. It is still unclear whether foreign currency related hedging costs of cross-currency interest rate swaps can qualify as debt deductions for the purposes of the TPDT rules.
• Treatment of on-swaps largely unchanged; though clarification on compliant approach is a welcome development. The ATO's views on the treatment of on-swaps appear largely unchanged, being that swap costs arising under a separate swap agreement between a conduit financier and an ultimate borrower are not deductible under the TPDT rules (Example 1 in the Ruling, although the example now includes a footnote that it does not consider the application of the conduit financing rules), but that swap costs incorporated in the terms of an on-loan may be deductible (Example 37 in PCG). The legislative basis for this distinction on how the swap costs are passed on remains unclear, and the Ruling still focusses only on the deeming rule in s 820-427A(2) without considering whether on-swap costs are attributable to a complying debt interest under the ordinary meaning of those words in s 820-427A(1). The amendments to Example 37 in the PCG, however, helpfully clarify that the outcome arising in the example (i.e. swap costs being deductible) can be achieved where the on-loan passes on the swap costs other than as an adjustment to the interest rate.⁹

Footnotes

1. Ruling, [85]-[87]. With respect to tangible assets where the application of the test is relatively straightforward, the Ruling also helpfully clarifies at [90] that tangible assets that are in the process of being physically transported to Australia to be used in Australian operations will also generally qualify as Australian assets.

2. Ruling, [94].

3. Ruling, [42].

4. Ruling, [95]-[96]. Example 13 is amended to add that the assets attributable to the Australian company's foreign PE are not minor or insignificant and therefore the shares in the Australian company (which also operates in Australia) are not an Australian asset.

5. Ruling, [65], Example 9.

6. PCG, [296], [298].

7. Ruling, [67].

8. Ruling, [155].

9. PCG, [331].