Thin Capitalisation – ATO publishes final third party debt test guidance

What you need to know

• On 1 October 2025, the Australian Tax Office (ATO) published its final guidance on the third party debt test.
• The final guidance is likely to have a material impact on a number of common financing structures, including (for example) acquisition finance to acquire Australian entities with an offshore footprint, as well as debt recapitalisations.
• The guidance also creates problems for common financing structures in the real estate and infrastructure space, particularly in respect of equity commitments provided during the development phase.

What you need to do

• Taxpayers should consider their financing structures in the light of the ATO's guidance, to consider whether they meet the third party debt test (and, if not, the impact on the efficiency of their financing structure).
• Taxpayers should also consider in detail potential restructures to bring their financing structures into compliance with the ATO's guidance, noting the ATO indicates in the Practical Compliance Guideline that it will devote minimal compliance resources to certain restructures.

Overview

On 1 October 2025, some 541 days after the passage of the thin capitalisation legislation, the Commissioner of Taxation (Commissioner) finalised two key publications setting out the Commissioner's views on the third party debt test (TPDT): Taxation Ruling TR 2025/2 Income tax: aspects of the third party debt test in Subdivision 820-EAB of the Income Tax Assessment Act 1997 (TR 2025/2) and Schedule 3 (Third party debt test compliance approach) of Practical Compliance Guideline PCG 2025/2 Restructures and the thin capitalisation and debt deduction creation rules – ATO compliance approach (PCG 2025/2).

While elements of the finalised guidance are an improvement on the draft guidance, particularly its expansion on the ATO's interpretation of the meaning of "Australian assets", critical elements of the TPDT remain uncertain, and the ATO's approach to the requirement that debt finance is used for "commercial activities in connection with Australia" will result in many common financing arrangements with third parties failing the TPDT.

Some examples of common financing structures that (on the ATO's view) may not be able to satisfy the TPDT include:

• Debt finance that is used to acquire an Australian entity, where that Australian entity directly or indirectly holds foreign assets. In the ATO's view, borrowed funds deployed in these circumstances are not used for "commercial activities in connection with Australia", notwithstanding that the funds are used to acquire interests in an Australian entity.
• Debt finance that it used to fund a return of capital or a distribution/dividend. In the ATO's view, a debt recapitalisation of this nature also does not meet the "commercial activities in connection with Australia". This is the case, notwithstanding court decisions (and associated ATO rulings) that confirm that interest incurred on such debt may be incurred in the course of carrying on business and is therefore deductible under general principles.
• Refinancings where the debt is moved down a level within a (non-consolidated) structure. To take an example, if a subsidiary entity borrows debt, which is used to make a return of capital or pay a distribution to a holding entity, and that holding entity repays pre-existing third party debt, the ATO also considers that the debt finance is not used for "commercial activities in connection with Australia".

In addition, despite substantial industry feedback during the consultation process, the final ruling does not address a number of key issues raised. Certain matters have deliberately been treated as outside the scope of the finalised guidance, notably the conduit financing rules, the interaction of the TPDT with the taxation of financial arrangements provisions, and the application of the rules in a consolidation context.

In many respects, the finalised guidance simply reaffirms what was already apparent from the Commissioner's earlier draft publications from last year. The Commissioner's position and practice remains unchanged – that the TPDT is "designed to be narrow" – a point the Commissioner underscores more than once in the ruling itself (though, thankfully, with one less occurrence than at the draft ruling stage). Unhelpfully, the Commissioner does not refer as frequently to the subsequent part of that sentence from the Explanatory Memorandum – that the TPDT is designed "to accommodate only genuine commercial arrangements relating only to Australia business operations".

Given the unworkable nature of many of the Commissioner's views, the TPDT conditions will continue to be difficult for taxpayers to satisfy. Attention will now turn to Government's mandatory review of the 'new' thin capitalisation rules, including the TPDT, which must commence no later than 1 February 2026.

Australian assets

The Commissioner has expanded the guidance on the meaning of Australian assets in TR 2025/2.

In the Commissioner's view, the assessment is a question of fact and degree, focussing on the nature of the asset and its connection or relationship with Australia from a business and practical point of view. There is no single, definitive test, but rather a range of factors that, considered together, should determine whether an asset has a substantial connection to Australia or not.

Key factors indicating a substantial connection to Australia include:

• the asset is physically located in Australia
• the asset is used in Australia (noting that the ruling no longer refers to "exclusive" use in Australia)
• the asset is used by, or provides a benefit to, an Australian entity (provided it is not attributable to the entity's overseas permanent establishment or offshore commercial activities)
• the asset is governed by, or originates from, an Australian legal framework
• the asset is used for the purpose of producing Australian sourced assessable income
• the asset has no, or only a limited or remote connection to another jurisdiction (provided that it is substantially connected to Australia)

With respect to tangible assets (e.g., plant and equipment), the Commissioner accepts that assets physically located in Australia and used exclusively in Australian operations will qualify as Australian assets. The Commissioner also confirms that real property located in Australia will be an Australian asset – a point that may have been considered uncontentious before the issuance of the draft ruling, which inexplicably referred to this as being the case only "generally". There is also recognition that an asset with a limited or remote connection to another jurisdiction is not fatal to its classification as an Australian asset, provided that the asset nonetheless has a substantial connection to Australia.

From an intangible assets perspective (e.g., contractual rights (swaps, insurance contracts), licences and IP) the ATO has set out a different approach. Key factors relevant for such assets may include:

• the location of the contracting parties and whether or not they are Australian entities
• the jurisdiction governing the relevant assets or contracts
• the extent to which the asset is used or held in a business carried on in Australia, or conversely, one not carried on in Australia
• the situs of the asset for the purpose of succession, estate law or private international law
• whether the intangible asset is supported by assets of the counterparty that are themselves Australian assets – for example, where any payments or obligations under the asset are expected to be met from Australian assets.

Specifically with respect to membership interests, the Commissioner's view is that there is first a threshold question that the membership interests must be membership interests in an Australian entity. If so, there is then a 'look-through' test (the legislative basis for which is entirely unclear). Where all underlying assets are Australian assets, the membership interests will be Australian assets. Where the underlying assets are a mix of Australian assets and foreign assets, the membership interests in that Australian entity would only be Australian assets if the underlying non-Australian assets are minor or insignificant.

Minor or insignificant

TR 2025/2 simply refers to assets being minor or insignificant where they are of minimal or nominal value. The example provided in this regard is not of practical assistance in most instances – the example of a minor or insignificant asset is shares in a foreign company where the foreign company "has share capital of A$2 and does not hold any assets". The Commissioner persists in his view that relative values of assets are not a relevant factor in determining if an asset is minor or insignificant, notwithstanding that the plain reading of the word minor (and its comparative nature) would suggest a relative approach is called for. The example in this regard is shares in a foreign company that is worth A$10 million, and represents 2% of the total value of all assets that the financier has recourse to – the Commissioner considers this asset is not minor or insignificant.

PCG 2025/2 confirms that the compliance approach to disregarding recourse to minor or insignificant assets will only apply to income years starting on or after 1 July 2023 and ending on or before 1 January 2027. While the Commissioner has indicated that consideration may be given to extending the compliance approach, this is not guaranteed. Where taxpayers satisfy all of the following criteria prior to a restructure, the Commissioner will only apply compliance resources to verify that the compliance approach applies:

• the taxpayer has made reasonable efforts to identify minor or insignificant assets of the obligor group that are not Australian assets
• the market value of those assets identified is less than 1% of the assets to which the holder of the debt interest has recourse for the payment of the debt
• the market value of each asset (or bundle of identical assets, such as a shareholding) does not exceed A$1m
• none of the assets are credit support rights.

Commercial activities in Australia

The Commissioner's interpretation of the phrase "commercial activities in connection with Australia" is highly restrictive, to the point of being unworkable. The Commissioner's approach, as outlined in TR 2025/2, is to treat this phrase as a tracing rule (again, the legislative basis for which is entirely unclear), focussed on use or deployment of funds and whether this is for commercial activities in connection with Australia.

In some welcome news for taxpayers, the Commissioner has accepted that where debt is borrowed to refinance debt (that was in turn used for commercial activities in connection with Australia), that the refinancing should be capable of satisfying this requirement. The Commissioner had expressed (in the draft ruling) that funds borrowed as part of capital management activities would not meet this requirement.

However, and importantly, in the Commissioner's view, the term "commercial activities in connection with Australia" does not include:

• any business carried on or by the entity at or through an overseas permanent establishment
• the holding by the entity of any associate entity debt, controlled foreign entity debt or controlled foreign entity equity
• the acquisition, directly or indirectly, of assets that are not Australian assets
• the payment or distribution of dividends or capital returns

The Commissioner's views in respect of the last two items are problematic and lose sight that the TPDT, while "designed to be narrow", is intended to apply to genuine third party financing. In the Commissioner's view, simple, uncontrived debt financing from unrelated lenders would fail the TPDT for no other reason than the ATO taking an unworkable approach to its interpretation of those laws. To illustrate, we draw attention to two fairly vanilla scenarios.

Example 1: Acquisition financing to acquire Australian group with offshore footprint

Assume an Australian fund establishes an Australian company (Bid Co) to acquire an Australian target company (Target Co). Bid Co borrows funds from an unrelated bank to finance the acquisition. Target Co has both Australian and offshore subsidiaries (Target Co Sub).

Applying the Commissioner's views on whether Bid Co uses all, or substantially all, of the proceeds of issuing the debt interest to fund its commercial activities in connection with Australia, this condition under the TPDT would be failed.

The Commissioner's views in this regard are set out at Example 17. The Commissioner expresses his views in unusual terms, as follows: "To the extent the proceeds of the Loan are used to fund Bid Co's indirect acquisition of Target Co Sub, they are not used to fund Bid Co's commercial activities in connection with Australia." The Commissioner's views imply that there is a way for the proceeds of the loan to only be used to acquire the Australian assets (and not indirectly the foreign assets). However, in any acquisition of the shares in an entity, it is not possible to argue the debt was only used to acquire the Australian assets; it was used to acquire the shares.

In addition, there is no consistency in the Commissioner's approach. For example, Target Co could issue debt interests that satisfy the TPDT (if, for example, it limits recourse in respect of the borrowing to Australian assets, and uses those funds in its Australian business). But an acquirer cannot borrow funds and satisfy the TPDT to acquire Target Co.

This is likely to have a significant impact of M&A activity, providing material advantages to taxpayers who are not subject to the thin capitalisation rules (and can rely on certain exemptions from the thin capitalisation rules applying to outbound taxpayers), or are subject to different thin capitalisation rules (e.g., financial entities).

Example 2: Debt recapitalisation

Assume the unitholders in an Australian trust (Trust) have a right to require redemptions of units (to provide liquidity), and some of the unitholders seek to exercise those rights. The subscription amounts provided by the units have been deployed in the Australian business of the Trust. In order to meet the redemption requirements in respect of the units, the Trust borrows funds from an unrelated bank. The Trust uses the funds to return capital (by way of redemption) to the unitholders.

Under the Commissioner's interpretation, borrowing to fund a capital return would fail the "commercial activities in Australia" TPDT condition. The Commissioner's view is that borrowed funds used to repatriate amounts to equity holders are not used as part of the entity's commercial activities. It is worth highlighting that the Commissioner has argued (and lost) cases in court that, in these circumstances, the interest incurred on the debt is not incurred in the course of carrying on business. However, the Commissioner considers that the funds are not used for commercial activities in connection with Australia. In other words, the Commissioner's position effectively relies on a distinction between the meaning of "business" and "commercial activities". It remains to be seen whether such a distinction holds up to the scrutiny of the courts.

The Commissioner's approach relies on dictionary definitions of "commercial activities". The interpretation is not directly supported by case law or by the explanatory materials regarding the new thin capitalisation rules The example above highlights the formalistic nature of the Commissioner's approach and its disconnect with the commercial reality that money is fungible. Expanding on a variation of the second example above, if available cash was used to pay the distribution and, having found itself without sufficient funds for working capital, the Trust borrowed funds for working capital, that would appear to be acceptable. In substance, the net impact of the transactions is the same – but the former (in the ATO's view) does not satisfy the TPDT, whereas the latter should satisfy the TPDT.

In what may potentially be a significant own goal, the Commissioner's approach is likely to increase debt deductions (with additional costs for taxpayers). It is common for a taxpayer that finds itself with excess available cash to pay down debt, if it can redraw that debt as part of its capital management activities (e.g., to fund a distribution or dividend). Essentially, the Commissioner's approach will require taxpayers to instead not pay down debt, and leave the available cash aside for the subsequent distribution or dividend. Throughout this period, debt deductions will continue to accrue and be available.

PCG 2025/2 contains a compliance approach regarding the application of the "commercial activities in Australia test" where certain conditions are satisfied and the arrangements are consistent with Example 34. Under the compliance approach, the Commissioner will only apply compliance resources to verify that the compliance approach applies. However, the compliance approach is of limited practical application given Example 34 is strictly limited, poorly drafted and difficult to follow. In particular, the compliance approach:

• Is only applicable to income years starting on or after 1 July 2023 and ending on or before 1 January 2027 (consistent with the ATO's approach to the treatment of minor or insignificant assets);
• Requires that the taxpayer makes reasonable efforts to identify what the proceeds of issuing the debt interest are used for (including refinancing debt interests), and can demonstrate, with contemporaneous documentation, the extent to which the proceeds were used to fund commercial activities in connection with Australia consistent with TR 2025/2;
• Is limited to a specific arrangement that involves using the proceeds from third party debt to finance annual trust distributions but subject to a number of specific limitations (e.g. the annual trust distributions do not exceed 10% of the "available balance" of the debt facility at the time at which they are made) and includes a requirement that prior to the end of the compliance period (i.e. 1 January 2027), the trust "amends its governance documents and procedures and no longer pays distributions using the debt facility".

Credit support rights

The thin capitalisation rules generally include a prohibition of a financier having recourse to a "credit support right", unless certain exceptions are satisfied. The Commissioner has persisted in his view that a credit support right includes any "guarantee, security, or other form of credit support", even where the arrangement bears no relationship to the debt.

To take some examples, if an entity enters into a lease with a special purpose entity, and obtains a guarantee of the lessee's lease obligations from a parent, that is a credit support right. If an entity enters into a large supply contract, and receives a guarantee in respect of payment obligations from a parent entity, that is a credit support right. If a property trust receives a bond from the developer to mitigate risks associated with developer default during the development, that is a credit support right.

No ordinary commercial person would describe these arrangements as being "credit support rights" in respect of the debt. They are performance guarantees. In the ordinary course, a financier would not be expected to have recourse (in a practical sense) to these arrangements, as recourse would only arise if there was also a contractual breach under the terms of those arrangements (e.g., a failure to make payments under the lease). Given the Commissioner's views in this regard, it is now necessary to consider each and every arrangement of this nature, and determine whether it falls within a specific exception.

More generally, foreign sponsors that provide equity commitments (or equivalent), which is common in respect of real estate or infrastructure developments, will fall foul of these rules (and not potentially fit within an exception) where the foreign entity holds 20% or more of the equity in the Australian entity (for assets that do not qualify for the development assets concession), or where the foreign entity holds 50% or more of the equity in the Australian entity (even where the asset does qualify for the development asset concession). Generally speaking, it will often not be possible to obtain financing without these arrangements in place. Given the pipeline of Australian infrastructure requirements (including the energy transition) and housing requirements, and the significance of foreign capital in funding these projects, the ATO's approach runs contrary to the Government's ambitions.

Areas of uncertainty and inconsistency

There remain a number of areas of considerable uncertainty, which are unresolved by the guidance. These include:

• The treatment of cross-currency interest rate swaps, and whether amounts arising under those arrangements are debt deductions (and, if so, whether swaps with third parties can be considered to give rise to debt deductions that are treated as attributable to debt interests).
• The conduit financing conditions, which are expressly not considered in the Taxation Ruling (but are considered in the PCG, creating uncertainty as to the Commissioner's views on a number of technical issues).
• The Commissioner continues to advance the view (in a footnote) that the Commissioner's earlier guidance on the meaning of "form of credit support" applies in the current legislative context. That guidance considered that a form of credit support includes implicit credit support, such as a non-binding letter of comfort. That position must be incorrect, as the legislation refers specifically to "rights under or in respect of" a "form of credit support".

In addition, the Commissioner's approach to a number of issues highlights that whether debt interests satisfy the third party debt test is highly dependent on the form of the arrangement and the structure, often with inconsistent results. Example 13 in TR 2025/2 relates to a structure in which an Asset Trust holds Australian real property and minor or insignificant foreign assets, Finance Trust holds Asset Trust, and Head Trust holds Finance Trust. Finance Trust borrows debt from a third party, and recourse is provided to all of the assets of Asset Trust and Finance Trust, and the units held by Head Trust in Finance Trust. Because Head Trust has provided security over equity in an entity that indirectly holds foreign assets (even through these are minor or insignificant), the TPDT is failed. Interestingly:

• If, instead, Asset Trust was the borrower, the above recourse arrangements would be perfectly acceptable, and the debt would satisfy the TPDT. This is because, in this case, Head Trust would be a member of the obligor group (it not being excluded from the obligor group, as it has not provided recourse only over equity in the borrower);
• Similarly, if Head Trust provided recourse to its units in Finance Trust, and a controlled account (holding nominal cash), the debt would also satisfy the TPDT (again, because Head Trust would be in the obligor group).

It may be hoped that such different treatment of what is fundamentally the same structure will be resolved following the review of the thin capitalisation rules. If not, the thin capitalisation rules will operate as a tax on the poorly advised.

Next Steps

We recommend that taxpayers subject to the thin capitalisation rules consider their financing structures in the light of the finalised guidance. Given the PCG, there are a number of restructures that should be considered prior to 1 January 2027, in order to rectify structures in a manner that is likely to limit the application of compliance resources.

We also recommend that taxpayers consider participating in the review of the thin capitalisation rules. It appears that without legislative change, we will be stuck with a set of unworkable rules.

Want to know more?

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