As part of the changes to the thin capitalisation rules, provisions were enacted with a view to limiting interest deductions where the financing and acquisition of an asset are between related parties or fund a particular payment. These provisions known as the “debt deduction creation rules” (“DDCR”) will apply to income years commencing on or after 1 July 2024. Importantly, the DDCR apply both to pre-existing arrangements as well as new arrangements entered into after the start date. As such, historically allowable interest deductions may no longer be available.
Overview
The DDCR apply in priority to the thin capitalisation rules and do so to all taxpayers subject to the thin capitalisation rules with the exception of:
- taxpayers whose debt deductions are less than A$2 million on an associate inclusive basis;
- taxpayers who use the external third-party debt test.
There are a number of other specialised exceptions.
The thin capitalisation rules can apply to taxpayers where they are controlled from outside of Australia or control a foreign entity. As such, a $2 dormant NZ incorporated subsidiary could result in a taxpayer group being subject to the DDCR rules.
Importantly, where Australian groups had previously relied upon the 90% asset test to avoid the application of the thin capitalisation tests, this exception is not available in respect of the DDCR. In addition, the DDCR can apply to solely domestic financing arrangements (ie the debt does not need to fund an overseas asset nor be between overseas and Australian entities).
Broadly, the DDCR may apply to related party debt in two cases:
- Asset acquisitions
Where related party debt has been used (whether in the current or prior years) to fund the acquisition of a Capital Gains Tax (‘CGT’) asset or a legal or equitable obligation directly or indirectly from an associate. For example, a trust acquires shares from a related party and uses a Division 7A loan to fund the acquisition.
- Prohibited payment rule
Where related party debt has been used (whether in the current or prior years) to make a payment to an associate for a variety of things including:
- a dividend or other profit like distribution;
- a capital return; or
- a royalty or similar payment for the use of or right to use an asset.
Indirect payments can also be caught under this rule.
Exemptions
There are a number of exemptions, however, these are relatively limited and contain lock through rules to identify the actual use of funds. Importantly, there is no exemption for the acquisition of trading stock in the rules.
Where groups have outbound investments or have controlled from overseas, then they should review the groups funding arrangements to ensure that they do not fall foul of the DDCR’s.
Should you have any questions about how these changes will impact you please reach out to your Engagement Partner.
