The TPDT is one of three tests introduced under Australia’s thin capitalisation rules. It is available on an elective basis and designed to allow deductions for financing costs related to genuine third-party debt, provided strict conditions are met.
Even if you qualify, before electing for the TPDT a few ancillary outcomes should be considered, including:
- If elected, the test effectively disallows all debt deductions that are not attributable to third-party debt.
- If there are a group of related entities that form part of an ‘obligor group’, then all entities must elect to apply this test to qualify.
- Unlike the Fixed Ratio Test (FRT), any interest deductions denied under TPDT cannot be carried forward.
Qualifying for the TPDT is not automatic, even where an entity or group’s borrowings are all lent by unrelated third parties.
The ATO’s recently released guidance (TR 2025/2 and Practical Compliance Guidelines PCG 2025/2) provides numerous examples on the application of this test and re-confirms the strict and prescriptive nature of the conditions.
Note: These rules do not apply to an entity for an income year if the total debt deductions of the entity and all its associate entities for that year are A$2 million or less.
Key conditions for TPDT
1. Debt holder
- Debt must be issued by an unrelated third-party lender (e.g., a bank).
- Limited exceptions apply for group financing structures such as where a group uses a FinCo to procure external third-party debt, but these are highly prescriptive.
Action: Consider these rules when determining who should be the borrower of the debt as well as who should hold the interests in the borrowing entity
2. Recourse to Australian assets
From a commercial perspective, one of the more challenging conditions for the TPDT is that the lender must have recourse only to ‘Australian assets’.
Further, recourse to Australian assets that are rights under or in relation to a guarantee, security or other form of credit support (referred to as credit support rights) are generally prohibited. This is to ensure that multinationals do not have the ability to fund their Australian operations with third party debt that is recoverable against the global group.
Where a lender has recourse to ‘minor or insignificant’ non-Australian assets, the TPDT may disregard these assets in determining whether a lender has only recourse over Australian assets. However, the ATO has noted in their ruling that this exception only covers assets of minimal or nominal value.
Example
An Australian tech company, Aus Tech Co, borrows $50m from an Australian bank. Under the terms of the loan, the bank has recourse to all of the Australian company’s assets, including shares the Australian company holds in a Singapore subsidiary (SG Sub) worth $2m.
The debt covenants did not carve out Aus Bank taking a security over the shares in SG Sub. In this case, unless Aus Tech Co is able to demonstrate that the shares in SG Sub are ‘minor and insignificant’ the recourse to Australian assets only condition will not be met.
TR 2025/2 provides further guidance on the ATO’s interpretation of ‘minor and insignificant’. If shares in SG Sub were worth a nominal amount, the ruling states that this will be accepted as minor and insignificant. However, in this case, the shares in SG Sub have a market value ($2M). Although the market value is proportionately a lot less than the value of Aus Tech Co ($50m), the ruling suggests that this is not to be taken as suggesting they are minor or insignificant.
Therefore, while the shares in SG Sub represent a relatively small proportion of the market value of Aus Tech Co, the conditions of TPDT are not met as the lender has recourse to non-Australian assets (being shares in the SG Sub).
Action: Consider whether the borrowing arrangement should be restructured by amending debt covenants. In PCG 2025/2, the ATO has extended the period to undertake certain restructures, until 1 January 2027. This broadly means that where restructures are consistent with examples, and meet certain requirements in the PCG, the ATO will generally not devote compliance resources to the restructure.
3. Use of funds
One of the more controversial tests that the legislation has outlined in relation to the TPDT is a requirement that the borrowing entity must “use all, or substantially all, of the proceeds of issuing the debt interest to fund its commercial activities in connection with Australia”.
Key takeaways from the ATO’s ruling include:
- The ATO interprets “substantially all” as meaning “nearly all” or “almost all”.
- The interpretation of the phrase “Commercial activities in connection with Australia” is discussed in the ruling. This includes activities undertaken in the course of the entity’s business, provided they are connected with Australia, as well as the refinancing of debt used to fund commercial activities in connection with Australia.
For example:
- Real property located in Australia and used in the Australian business is connected with Australia.
- Business carried on by the entity at or through its overseas permanent establishments is not considered as connected with Australia.
The most controversial aspect of the ATO’s guidance on this requirement is the view that if the debt is used for funding dividends or returns of capital, the test is failed. The assertion being that this would not be an activity that is concerned with “commercial activities in connection with Australia”. There is no real support provided for this view by the ATO.
Action: Like a lot of other tests, the ATO expects taxpayers to be able to trace specifically what business funds are used for. Ensure contemporaneous documentation is maintained to show how the funds were used.
Practical implications
- TPDT remains narrow and challenging to apply for many commercial financing arrangements. This is especially the case where lenders have recourse to foreign assets.
- Multinationals and private equity groups may need to restructure their debt arrangements should they wish to obtain debt deductions under the TPDT.
- The time available to restructure debt arrangements in compliance with PCG 2025/2 closes 1 January 2027.
Next steps
- Review debt covenants for recourse issues.
- Assess funds usage against TPDT requirements. Ensure documentation is put in place to track debt usage for ‘permissible’ purposes.
- Plan debt restructures early to comply with the ATO’s guidance in PCG 2025/2.
How we can help
If your business is impacted by the thin capitalisation rules, please get in touch to ensure compliance with these measures and to discuss optimising your financial strategies.
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