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The ATO has issued updated guidance in Practical Compliance Guideline (PCG) 2025/2, setting out the ATO’s compliance approach in relation to the new thin capitalisation rules specifically relating to:
- The Debt Deduction Creation Rules (“DDCR”) – Schedule 1;
- Restructures in response to the DDCR – Schedule 2;
- Third-party debt test compliance approach - Schedule 3; and
- Restructures in response to the thin capitalisation changes – Schedule 4.
This PCG is particularly important in allowing taxpayers to calibrate risk for particular arrangements involving debt issuances, and also it determines the disclosures that will mandatorily need to be made in the International Dealings Schedule, and any Reportable Tax Position (RTP) schedule that a taxpayer is required to complete.
While Schedules 1, 2, and 4 have been finalised, the ATO is still in the process of finalising Schedule 3 relating to the application of the third-party debt test.
This pending guidance is intended to focus on the qualifying third-party debt conditions in subsection 820-427A(3) of the Income Tax Assessment Act (“ITAA”) 1997. This includes key conditions that debt interests issued by an entity must satisfy, such as recourse being only to Australian assets and the proceeds of the debt interest funding commercial activities in connection with Australia.
Notably, the ATO’s “Advice under development – international issues” indicates that the expected completion date for the Schedule 3 guidance will be August to September 2025. Taxpayers and advisors eagerly await the release of this guidance.
While the DDCR applies to assessments for income years that commence on or after 1 July 2024, PCG 2025/2 applies to restructures entered into on or after 22 June 2023, being the date the relevant Bill was introduced to Parliament.
RSM's Key Takeaways
- The ATO will seek to apply compliance resources in a wide range of circumstances;
- The application of the new thin capitalisation rules and DDCR are a key focus of the ATO, evident in expanded questions contained within Section H of the IDS as well as the inclusion of Question 47 in the Category C reportable tax positions of the RTP Schedule;
- The ATO will continue to take a broad view of the circumstances in which the integrity provisions may apply where debt deductions are preserved or, in fact, increase;
- The ATO have confirmed they will not offer a concessionary approach to arrangements that predate the relevant commencement of 1 July 2024 notwithstanding that taxpayers previously had no requirement or expectation that there may in future be legislation requiring the retrospective tracing of funds, and hence would be very unlikely to have evidence to facilitate retrospective tracing exercises. (N.B. the approach the ATO has taken here is a departure from Treasury and OECD recommendations);
- Additional guidance on apportionment and tracing is limited and favours an approach to allocating the entire amount of the arrangement to being funded by the debt interest, which we would regard as unfair and unreasonable for the reasons above; and
- Given the number of requirements and narrowness the particular facts in each example (either low-risk or high-risk), taxpayers may struggle to fall within the Green risk zone.
Our more detailed analysis of the PCG and its implications is set out below.
Contained within PCG 2025/2 is a risk assessment framework that the ATO will apply where taxpayers seek to restructure their arrangements in response to the new thin capitalisation rules and/or the DDCR.
The ATO provide four risk zones as follows:
| Risk Zone | Risk Level |
| White | Further risk assessment not required |
| Yellow | Compliance risk not assessed |
| Green | Low Risk |
| Red | High Risk |
Broadly, a taxpayer will fall into the Green risk zone if its restructure is covered by one of the low-risk examples in either Schedule 2 or Schedule 4, and includes the following features:
- debt deductions disallowed by the DDCR prior to the restructure have been accurately calculated;
- the arrangements (prior to or following the restructure) would not otherwise attract the application of Part IVA of the ITAA 1936; and
- the restructure occurs in a straightforward manner without any associated contrivance or artificiality and is on arm’s length terms.
Conversely, a taxpayer will fall into the Red risk zone if its restructure is covered by one of the high-risk examples in either Schedule 2 or Schedule 4.
Taxpayers will fall into the yellow zone if they have undertaken at least one restructure and do not fall into the Red or Green risk zones.
Welcome changes from PCG2024/D3 (the prior working draft) that have been incorporated into the final PCG 2025/2 include:
- the expansion of the white zone to include circumstances where:
- the taxpayer and its associates have debt deductions of less than $2m (i.e., where the thin capitalisation rules do not apply) for an income year, and
- the ATO have conducted a review or audit of a restructure and provided a ‘low-risk’ rating (or ‘high assurance under a Justified Trust review).
Schedule 1 continues to provide examples where the application of the DDCR should be considered and specifies instances where the ATO may seek to apply compliance resources. There are three new examples (two of which are extensions to existing examples from the previous draft PCG 2024/D3) where the DDCR need to be considered as well as an additional three new examples in relation to tracing and apportionment.
While there were repeated requests during consultation that the ATO offer a concessionary approach to arrangements that predate the relevant commencement of 1 July 2024, it has indicated that it will apply compliance resource to ongoing related party funding of historical transactions. This will be both disappointing and challenging for taxpayers and advisors alike, given the practical challenges of tracing the use of historical funds where there was no contemporaneous requirement to do so.
Examples where the debt deduction creation rules will need to be considered:
| Examples in PCG 2025/2 | Changes from PCG 2024/D3 |
| Example 1 – timing and the 'associate pairs' conditions | Example confirms that where two entities are not associate pairs at the time of the acquisition of a CGT asset, the ATO will not apply compliance resources to determine whether the DDCR applies where these entities subsequently become associate pairs a result of the acquisition. Addition of paragraph 78 in PCG 2025/2 confirming that there is no requirement to test the application of the DDCR at a later date unless there are factors indicating contrivance or artificiality. |
| Example 2 – funding capital expenditure with related party debt | There have been no changes to Example 2 from PCG 2024/D3 |
| Example 3 – funding capital expenditure with related party debt | New Example - Example 3 in PCG 2025/2 is a new example which is an extension of the existing Example 2. It clarifies that the ATO expect that once a borrower begins generating assessable income, interest-bearing debt (including both interest and principal) should be paid down using cash generated by the operations. It is not clear when the ATO would consider it reasonable for the entity to pay a dividend. That is, whether it is acceptable to pay a dividend while the interest-bearing debt is in the process of being paid down. |
| Example 4 – bridging finance | This example was Example 5 in PCG2024/D3. There have been no changes to this example in PCG 2025/2. |
| Example 5 – related party transactions to recharge outcomes arising from swaps | This example was Example 7 in PCG 2024/D3. There have been no changes to this example in PCG 2025/2. |
| Example 6 – cash pooling | This example was Example 4 in PCG 2024/D3. The example confirms the ATO expect taxpayers to assess the DDCR to the extent cash pooling arrangements gives rise to debt deductions. In PCG 2025/2 the ATO clarify that the cash pool leader is an associate pair of both Foreign Co and Aus Co which is a prerequisite condition for the DDCR to apply. |
| Example 7 – funding working capital and dividends with related party debt | This example was Example 3 in PCG 2024/D3. There have been no changes to this example in PCG 2025/2. |
| Example 8 – funding working capital and dividends with related party debt | New Example - Example 8 in PCG 2025/2 is a new example which is an extension of the existing Example 7. It clarifies that taxpayers will need to consider the application of the DDCR on refinanced arrangements where the original arrangements funded or facilitated the payment of a dividend and that the ATO will apply compliance resources to determine the correct application of the DDCR in these circumstances. |
| Example 9 – refinancing third-party debt | New Example – Example 9 in PCG 2025/2 is a new example that considers a scenario where an Australian company uses related party debt to refinance a third-party debt facility. Notwithstanding a four-year temporal difference between the (Type 1) acquisition and the refinancing event, it is expected that taxpayers trace the use and source of funds associated with such transactions (and apportion as required). In these circumstances, the ATO will likely consider applying compliance resources to determine the correct application of the DDCR. |
| Example 10 – related party financing of related party acquisition | This example was Example 6 in PCG 2024/D3. There have been no changes to this example in PCG 2025/2. |
| Example 11 – debt deductions in relation to an acquisition from an associate pair | This example was Example 8 in PCG 2024/D3. There have been no changes to this example in PCG 2025/2. |
| Example 12 – acquisition from a related trust | This example was Example 9 in PCG 2024/D3. There has been a minor change in this example to clarify that the Trust that held a Division 7A compliant loan arrangement and acquired CGT assets from a related trust, is part of a privately owned group which predominately carries on business in Australia. The example confirms the ATO intends to apply compliance resources to consider the application of the DDCR to Division 7A compliant loan arrangements. |
| Example 13 – loan funding distribution by trustee | This example was Example 10 in PCG 2024/D3. There have been no changes to this example in PCG 2025/2. |
| Example 14 – related party lending between multinational subsidiaries | This example was Example 11 in PCG 2024/D3. There have been no changes to this example in PCG 2025/2. |
In the consultation further guidance was invited on the ATO’s expectations in relation to tracing including. There have been no changes to the ATO’s comments on tracing which are limited to:
“We consider that tracing is a factual exercise and should be the method used to determine the disallowed debt deduction under subsection 820-423A(1) wherever possible” .
Notwithstanding the above commentary, the ATO have included three new examples in relation to tracing and apportionment as summarised below.
| Example 15 – fair and reasonable identification of disallowed debt deductions | New Example – Example 15 in PCG 2025/2 is a new example that sets out the application of a fair and reasonable apportionment in a relatively straightforward example where a taxpayer borrows funds from a related party of which it uses a portion to pay a dividend. |
| Example 16 – fair and reasonable apportionment of debt used for multiple purposes | New Example – Example 16 in PCG 2025/2 is a new example that sets the application of a fair and reasonable apportionment in relation the debt which is used for multiple purposes including the acquisition of trading stock and the payment of a dividend. |
| Example 17 – borrowing under a cash pool for dividend and refinancing | New Example – Example 17 in PCG 2025/2 is a new example that sets out a fair and reasonable apportionment in relation to debt interest issued under a cash pooling arrangement with an associate pair that is used to pay a dividend. The amount borrowed through the cash pooling facility is then subsequently refinanced through a new debt interest with another associate pair. |
While the above examples in relation to the apportionment of debt deductions are welcomed, the examples illustrate that the fundamental assumption the ATO will take is that where the debt interests exceed the amount of either the Type 1 Arrangement (acquisition of a CGT asset) or Type 2 Arrangement (payment of a distribution) the entire amount under the arrangements will be attributable to the debt interests. Furthermore, the ATO clarify that the onus is on taxpayers to prove the DDCR does not apply that this can done through the provision of the type of information and documentation set out in the PCG including copies of loan documentation, financial accounts, cash flow statements, general ledgers, journals, bank statements, and copies of board minutes, resolutions and papers that relate to the decisions of transactions and entering into debt arrangements.
Schedule 2 provides both low-risk and high-risk examples of restructures in response to the DDCR. There are three new examples (including two low-risk examples and one high-risk example) from the previous draft PCG 2024/D3.
In particular, the two new low-risk examples include circumstances where related party debt is replaced with third-party debt. The inclusion of these two new examples is welcomed as the previously issued draft PCG 2024/D3 provided for an exceedingly broad application of the relevant integrity rules to restructures (e.g., ostensibly extending even to the mere replacement of related party debt with third party debt). Notwithstanding the above, it is clear the ATO will continue to take a broad view of the circumstances in which the integrity provisions may apply.
Each of the examples are considered below:
Low-risk restructures
| Example 18 – low risk: repaying debt interest | This example was Example 12 in PCG 2024/D3. There have been no changes to this example in PCG 2025/2. |
| Example 19 – low risk: repaying bridging finance | This example was Example 13 in PCG 2024/D3. There have been no changes to this example in PCG 2025/2. |
| Example 20 – low risk: replacing related party debt with third-party debt | New Example – Example 20 is a new example where a taxpayer replaces its related party debt with third-party debt following the acquisition of a CGT asset from an associate pair. It is important to note that here that the broader economic circumstances of the group are that it does not have the capacity to repay the related party debt due to loss making operations. Furthermore, the restructure is not associated with any broader reorganisation or refinancing, back-back arrangements, or reduction in any third-party debt. While the example is intentionally narrow, it does at least represent a low-risk example where a taxpayer may replace related party debt with third-party debt for which the previous PCG 2024/D3 did not. |
| Example 21 – low risk: replacing Division 7A loan with third-party debt | New Example – Example 21 is a new example which leverages from Example 12 in Schedule 1 in relation to the application of the DDCR to a Division 7A compliant loan arrangement. The ATO consider a restructure to this arrangement low risk, where the Trust does not have the financial capacity to repay the loan itself due to loss making operations and therefore obtains a third-party loan from an Australian bank to repay the Division 7A loan. Similar to Example 20, the restructure is not associated with:
Equally, while the example is intentionally narrow it does assist taxpayers in providing a low-risk option to restructure their arrangements where the DDCR may apply to a Division 7A compliant loan arrangement. |
| Example 22 – low risk: disposing of foreign assets | This example was Example 14 in PCG 2024/D3. There have been no changes to this example in PCG 2025/2. |
| Example 23 – low risk: repaying debt interest, terminating swaps, recapitalising subsidiary | This example was Example 15 in PCG 2024/D3. There have been no changes to this example in PCG 2025/2. |
| Example 24 – low risk: repaying debt interest | This example was Example 16 in PCG 2024/D3. There have been no changes to this example in PCG 2025/2. |
| Example 25 – low risk: cash pooling | This example was Example 17 in PCG 2024/D3. There have been no changes to this example in PCG 2025/2. |
High-risk restructures
| Example 26 – high risk: contending to change the character of costs incurred | This example was Example 16 in PCG 2024/D3. There have been no changes to this example in PCG 2025/2. |
| Example 27 – high risk: replacing related party debt with third-party debt | This example was Example 16 in PCG 2024/D3. There have minor changes in this example, including the ATO clarifying that the example would still be high-risk even in the absence of the Interest Rate Swap (“IRS”) arrangement with an associate pair. |
| Example 28 – high risk: using related party debt to fund offshore operations | New Example – Example 28 is a new example which illustrates a high-risk example of a taxpayer using related party debt to fund offshore operations where the contended use of funds does not reflect the underlying arrangement due to temporal and quantitative similarities between the arrangements. |
As noted above, this is under development and is expected to be completed in August to September 2025.
Schedule 4 provides both low-risk and high-risk examples of restructures in response to the changes in the thin capitalisation rules. There is one new example which provides for a low-risk scenario where there are amendments to conduit financing interest rates (the previous draft PCG 2024/D3 included only one high-risk example relating to amendments to conduit financing interest rates).
Based on the examples provided, the ATO are concerned with arrangements that seek to utilise any excess capacity under the fixed ratio test or otherwise artificially increase the rate on debt interests where there is no commercial reason to do so.
Low-risk restructures
| Examples in PCG 2025/2 | Changes from PCG 2024/D3 |
| Example 37 – low risk: restructuring to account for differing individual tax EBITDA of entities within a group | This example was Example 27 in PCG 2024/D3. There have been no changes to this example in PCG 2025/2. |
| Example 38 – low risk: amending conduit financing interest rates | This example was Example 27 in PCG 2024/D3. There have been no changes to this example in PCG 2025/2. |
High-risk restructures
| Example 39 – high risk: introducing debt to maximise debt deductions under the fixed ratio test | This example was Example 28 in PCG 2024/D3. There have been no changes to this example in PCG 2025/2. |
| Example 40 – high risk: amending conduit financing interest rates | This example was Example 29 in PCG 2024/D3. While there have been minor changes to the format of this example to cater for the inclusion of Example 38, the substance of the example remains the same. |
For completeness, RSM Australia’s submission in relation to PCG 2024/D3 is included as an Appendix to this tax insight. Click here to download.
