ATO finalises guidance on aspects of the third-party debt test

TR 2025/2 – Income tax: aspects of the third party debt test in Subdivision 820-EAB of the Income Tax Assessment Act 1997

On 1 October 2025, the Australian Tax Office (ATO) issued 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 (the Ruling), which is the finalised version of TR 2024/D3 (the Draft Ruling), published on 4 December 2024.

The Ruling sets out the ATO’s view on the application of certain aspects of the third party debt test (TPDT), in particular providing guidance in respect of its interpretation of key aspects of the third-party debt conditions.

Overview of the third-party debt test

The TPDT supplements the two new earnings-based tests, the fixed ratio and group ratio tests, under the new thin capitalisation rules introduced by the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share – Integrity and Transparency) Act 2024  (Act). Broadly, the TPDT replaces the former arm’s length debt test. The TPDT allows for debt deductions to be claimed for income tax purposes where those expenses are attributable to genuine third party debt (unrelated debt) which is used to fund Australian business operations.

The rules operate such that if a taxpayer chooses to use the TPDT, any debt deductions that are attributable to a debt interest issued by the entity that satisfies the TPDT conditions in relation to an income year are allowable. Conversely, any debt deductions referable to financial arrangements that fail the TPDT conditions will be treated as non-deductible for income tax purposes and permanently denied. In addition to this, to the extent an entity elects to rely on the TPDT, any associate entities in the ‘obligor group’ (where a creditor has recourse to the assets of an entity for payment of a debt interest), will be deemed to have also chosen to use the TPDT for that income year. 
A further stipulation is that where an election is made to rely on the TPDT any carried forward debt deduction denials that had previously been accumulated under the fixed ratio test (and are otherwise eligible to be carried forward for 15 years) are permanently forfeited. 

Primarily, the Ruling provides guidance from the Commissioner on how he interprets the law with respect to the TPDT conditions. 

Recourse to assets

A debt deduction will not satisfy the TPDT conditions if, disregarding recourse to minor or insignificant assets, the holder of the debt interest has recourse for payment of the debt to assets which are not Australian assets or if the debt arrangement has certain credit support rights (subject to some exclusions). In the Draft Ruling, the view taken by the ATO regarding its interpretation of key aspects of this condition was narrow. 

Minor or insignificant assets

The ATO outlines that in its view, whether or not an asset is considered to be ‘minor or insignificant’ is contingent upon the value of the asset being nominal. Feedback was provided during the consultation period, with stakeholders maintaining that this interpretation was overly limited and does not account for the differing nature of certain assets, nor does it allow for consideration of the assets value with respect to the overall size of the business operations. 

Moreover, the Ruling identifies that the extent to which an ineligible asset impacts the quantum or terms of the debt interest, regardless of whether the impact is real or hypothetical, is not determinative of whether the asset may be considered ‘minor or insignificant’. This affirms the ATO’s position that the underlying absolute value of the asset is of primary significance, rather than the nature of the asset itself. Notwithstanding the above, the ATO have offered a transitional compliance approach in Practical Compliance Guideline 2025/2: Restructures and the thin capitalisation and debt deduction creation rules - ATO compliance approach (PCG 2025/2) income years ending on or before 1 January 2027 to treat assets as minor or insignificant where the market value is $1 million or less, and are less than 1% of all the assets to which the holder of the debt interest has recourse for the payment of the debt.

These two factors are showcased in Example 10 of the Ruling, which sets out that despite foreign assets having no impact on the amount of debt that was advanced, it is necessary to consider whether these assets are of a nominal value, or moreover, if they would have had an impact on the terms of the arrangement had they been considered by the lender in establishing the debt arrangement.

As noted above, the design of the TPDT is intended for asset-heavy sectors with long depreciation periods where the other earnings-based rules may not be appropriate. The narrow view taken by the ATO in the Ruling may, in some instances, be viewed as overly restrictive and preclude taxpayers that  would otherwise be benefit from choosing to rely on the TPDT.

Australian assets

The ATO has provided further clarity regarding what constitutes an ‘Australian asset’, specifying factors which may point to an asset having substantial connection to Australia, including:

• Whether the asset is physically located in Australia;
• Whether the asset is used in Australia; 
• Whether the asset is used by, or is to the benefit of an Australian entity;
• Whether the asset is governed by, or originates from an Australian legal framework;
• Whether the asset is used for producing Australian-sourced assessable income; and
• The extent to which an asset has a connection to another jurisdiction. 

It is important to note that the Ruling does not consider any of the foregoing factors determinative in isolation, but rather requires that consideration be given to all relevant factors pertaining to the asset and its use in the Australian operations. 

The Ruling provides specific consideration as to when membership interests qualify as an Australian asset, providing that the interest must be a membership interest in an Australian entity, having regard to the underlying assets that the issuing entity holds. The ATO further states that where not all the underlying assets of the entity are Australian assets, the membership interest will only qualify as an Australian asset if the interest is minor or insignificant. This is consistent with the position put forward in Examples 10 and 12.

Notwithstanding this, Example 13 in the Ruling asserts that “under paragraph 820-427A(4)(b), recourse to Australian assets that are membership interests in the entity is not permitted if the entity has a legal or equitable interest, whether directly or directly, in an asset that is not an Australian asset.” This exemplifies that in the ATO’s view, the fact that the asset is minor or insignificant is not considered relevant in the context of recourse to membership interests in entities that hold non-Australian assets. This conclusion may be an area of particular contention.

Overall, these exclusions provide substantial limitations for Australian entities with foreign subsidiaries, or branch operations, accessing the TPDT, regardless of the activities carried out in those foreign jurisdictions, or their connection to the Australian third party debt arrangement(s). 

Actual purpose and use of the funds 

For a debt arrangement to satisfy the TPDT conditions, the purpose of the funds advanced must be primarily, if not wholly, advanced for the purpose of funding commercial activities in connection with Australia. 

Commercial activities in connection with Australia 

The ATO acknowledges that the expression ‘commercial activities in connection with Australia’ is not defined, and as such, takes on its ordinary meaning in the context of which it appears. This is considered to include things such as:

• Activities undertaken in the course of the business, provided they are connected with Australia;
• Ancillary and supporting activities associated with the primary activity above; and
• Refinancing debt that was used to fund Australian commercial activities, provided the nexus remains the same.

Further, the ATO states that the following activities do not satisfy the requirements:

Any business carried on by the entity at or through its overseas permanent establishments;

• The holding of any associate entity debt, controlled foreign entity debt or controlled foreign entity equity;
• The acquisition directly or indirectly of foreign assets; and
• The payment of distribution of dividends or capital returns. 

The payment or distribution of dividends or equity is not directly referenced in the legislation, though the ATO states that these are effectively appropriations or profit or equity and thus, does not satisfy the requirement of “commercial activities”. There is no further guidance provided from the ATO with respect to how these distributions can be disaggregated or substantiated as being distinct from the activities for which the advanced funds were used. Tracing of funds and apportionment have been suggested by the ATO for use in assessing the application of the Debt Deduction Creation Rules in PCG 2025/2 and may also be required in this context for the TPDT

Credit support rights

In general, where a lender has recourse to assets under credit support rights, prima facie, the TPDT conditions will be failed. The ATO’s approach to parental support arrangements remains largely unchanged from the Draft Ruling, providing substantial challenges for foreign investors seeking to operate in the Australian infrastructure industry.
Whilst there are certain circumstances under which credit support rights are allowable, these are very limited and are in general, limited to rights which are confined to recourse against Australian assets. 

Despite this, to the extent that the credit support right allows for recourse against an associated foreign entity, regardless of the nature of the assets to which recourse is given, the exclusions will not apply. Moreover, the ATO has included a new interpretation in the Ruling that credit support rights are unlikely to ever be considered minor or insignificant assets for the purposes of 820-427A(3)(c).

This presents significant challenges for the property and infrastructure industry for instance, given the common commercial practices that have historically been relied upon. 

Concluding comments

While the ATO guidance on the TPDT is welcome, the conditions required to be met for taxpayers and their associates to rely on this elective method are extensive. The rules are highly complex and there are still areas of uncertainty notwithstanding the release of the Ruling. It has been and will continue to be extremely challenging for businesses, even in asset-intensive sectors, to rely on TPDT given the narrow application and interpretation by the ATO of many of the TPDT conditions.  

For example, as mentioned above, any deductions that do not meet the conditions of the TPDT are permanently denied in full and cannot be carried forward, so there is a risk in electing into this method given its complexity. 
Similarly, if an entity elects to use the TPDT, its associates are also deemed to have chosen this test which may result in consequences for joint venture partners contexts which may not be feasible for many groups. 

Another challenge is where existing projects have been historically funded by related party debt – any deductions denied in previous years under the default fixed ratio test method are also permanently lost. In the recently published PCG 2025/2, the ATO only provided a limited number of examples it considers to be low risk where a taxpayer replaced related party debt with third party debt. The ATO also set out high risk examples for entities that restructure their existing financing arrangements to put themselves into a position to rely on the TPDT. 

Ultimately, the TPDT presents a challenge for taxpayers to meet all the requisite conditions to rely on this method. This is consistent with what we are seeing in the market terms of the number of taxpayers seeking to rely on the TPDT.

In short, the TPDT is not a panacea for highly leveraged industries such as infrastructure and property and construction due to its complexity and continuing areas of uncertainty, notwithstanding the finalisation of TR 2025/2 and PCG 2025/2. 

We view that choosing to rely on the TPDT can be fraught with complexity. Notwithstanding, much of the complexity that arises can be managed with appropriate planning, advice, and guidance and there are, of course, other options availability under the new thin capitalisation regime depending on the nature of a groups’ operations, structure, and financing requirements.