What is the third party debt test
The ‘third party debt test’, is an elective test that supplements the earnings-based tests.
Under the third party debt test, the amount of the debt deductions of an entity for an income year that is disallowed is the amount by which the entity's debt deductions exceed the entity's third party earnings limit for the income year.
An entity's third party earnings limit for an income year is the sum of each debt deduction of the entity for the income year that is attributable to a debt interest that satisfies the third party debt conditions in relation to the income year. Broadly speaking, a debt interest only satisfies the third party debt conditions if it is issued to and held by an unrelated third-party and certain other conditions are met.
If an amount is disallowed under the third party debt test, then (as with all other tests) each individual debt deduction is disallowed in the same proportion that the total disallowed amount represents to the total debt deductions of the entity for the income year.
The third party debt test is designed to be narrow, to accommodate only genuine commercial arrangements relating only to Australian business operations. It is not intended to accommodate all debt financing arrangements that may be accepted as current practice within industry.
Who can make a choice to apply the third party debt test
General class investors and financial entities can choose to apply the third party debt test. A choice to use the third party debt test for an income year must be made:
- in the approved form
- on or before the earlier of the following days
- the day the entity lodges its income tax return for the income year
- the day the entity is required to lodge its income tax return for the income year
- a later day allowed by the Commissioner.
Some general class investors are deemed to have made a choice to apply the third party debt test. To determine if you are deemed to have made a choice to apply the third party debt test, refer to Deemed choice to use the third party debt test.
If an entity is taken to have made a choice to use the third party debt test for an income year, then that entity cannot make a choice to use the group ratio test, and any existing choice to use the group ratio test in relation to that income year is automatically revoked and taken to never have been made.
Third party earnings limit
The amount of an entity’s debt deductions for the income year that is disallowed under the third party debt test is the amount by which the entity’s debt deductions exceed the entity’s third party earnings limit for the income year.
An entity’s 'third party earnings limit' is the sum of each deduction of the entity that is attributable to a debt interest issued by the entity that satisfies the third party debt conditions in relation to the income year.
Specific adjustments have been included for hedging arrangements. For these purposes, debt deductions of an entity are taken to be attributable to the debt interest if they are both:
- directly associated with hedging or managing the interest rate risk in respect of the debt interest
- not referrable to an amount paid, directly or indirectly, to an associate entity of the entity.
This rule is intended to only cover conventional 'interest rate swap' arrangements between unrelated parties.
Third party debt conditions
A debt interest issued by an entity satisfies the ‘third party debt conditions in relation to an income year if the following conditions are satisfied:
- The entity is an Australian entity.
- The entity issued the debt interest to an entity that is not an associate entity of the entity.
- The debt interest is not held at any time in the income year by an entity that is an associate entity of the entity.
- Disregarding recourse to minor or insignificant assets, the holder of the debt interest has recourse for payment of the debt to which the debt interest relates only to
- Australian assets held by the entity that issued the debt interest, or
- Australian assets of another Australian entity that is the member of the obligor group in relation to the debt interest, or
- membership interests in the entity that issued the debt interest (unless the entity has a legal or equitable interest, directly or indirectly, in an asset that is not an Australian asset).
For the purposes of this condition, Australian assets that are rights under or in relation to a guarantee, security or other form of credit support, are generally excluded unless otherwise specified.
- the entity uses all, or substantially all, of the proceeds of issuing the debt interest to fund its commercial activities in connection with Australia but not:
- any business carried on through an overseas permanent establishment, or
- holding any associate entity debt, controlled foreign entity debt or controlled foreign entity equity
For the purposes of third party debt conditions:
- a modified definition of ‘associate entity’ is used which is based on a thin capitalisation control interest of 20% or more, unless otherwise specified
- an entity that has entered into a cross-staple arrangement with another entity is treated as an associate entity of that other entity and any conduit financier that other entity is itself an associate entity of.
Recourse to Australian assets
Generally, recourse available to the holder of the debt interest cannot extend beyond the Australian assets held by the issuer of the debt interest, membership interests in the borrower and Australian assets of other Australian entities that are members of the obligor group in relation to the debt interest. In substance, this requires that Australian borrowers support their third party debt levels with Australian assets of Australian entities in order to include all debt deductions related to that debt in its third party earnings limit. This complements the requirements for the funds to be used in Australian commercial activities.
In most circumstances where the Australian borrower's associated foreign entities (such as global parent entities or offshore treasury entities) provide recourse to a lender to assets other than membership interests in the borrower, no debt deductions related to that borrowing will be included in the third party earnings limit.
The general prohibition on recourse to credit support rights
Under the third party debt conditions, recourse to Australian assets that are rights under or in relation to a guarantee, security or other form of credit support is generally prohibited unless the right is any of the following:
- a right that provides recourse, directly or indirectly, only to one or more Australian assets of the borrower or another member of the obligor groups (unless those rights are otherwise prohibited)
- a right that would not be expected to allow the lender or another entity to have recourse for payment of the debt against an associate entity of the entity that issued the tested debt interest
- a right that relates wholly to the creation or development of a CGT asset that is (or is reasonably expected to be) either
- land situated in Australia (including an interest in land, if the land is situated in Australia)
- moveable property situated, or to be situated, on land situated in Australia, and that is (or is reasonably expected to be) relevant to the income producing use of the land and situated on the land for the majority of its useful life
- offshore renewable energy infrastructure (within the meaning of the Offshore Electricity Infrastructure Act 2021) situated, or to be situated, in a declared area (within the meaning of that Act) for the majority of its useful life
- offshore electricity transmission infrastructure (within the meaning of the Offshore Electricity Infrastructure Act 2021) that is directly related to offshore renewable energy infrastructure meeting the above criteria.
For the purposes of determining whether a right relates wholly to the creation or development of a CGT asset, disregard the extent (if any) to which the right relates incidentally to another matter.
Conduit financing conditions
Additional rules allow for 'conduit financer' arrangements to satisfy the third party debt conditions in certain circumstances. Such arrangements are generally implemented to allow one entity in a group to raise funds on behalf of other entities in the group. This can streamline and simplify borrowing processes for the group. However, debt interests issued under such arrangements ordinarily would not satisfy the third party debt conditions.
In the context of the third party debt test, conduit financer arrangements exist where an entity (the 'conduit financer') issues a debt interest (the 'ultimate debt interest') to another entity that is not an associate entity (the 'ultimate lender'). The conduit financer then on-lends the proceeds of the ultimate debt interest to one or more associate entities (each a 'borrower', and each on-loan being a 'relevant debt interest') on largely the same terms as the ultimate debt interest.
The 'conduit financing conditions', and the modifications to the third party debt conditions under section 820-427B of the ITAA 1997 that apply when the conduit financing conditions are satisfied, are designed to enable both the relevant debt interest and the ultimate debt interest to satisfy the third party debt conditions in these types of conduit financing scenarios, provided certain conditions are met.
Relevant debt interest which satisfies the conduit conditions.
A relevant debt interest satisfies the conduit financing conditions in relation to an income year if:
- the conduit financer issues a debt interest (the 'ultimate debt interest') to an entity (the ‘ultimate lender’) that is not an associate entity of the conduit financer
- an entity that is an associate entity of the conduit financier (the 'borrower') issues a debt interest (the 'relevant debt interest') to the conduit financer
- the amount loaned under the relevant debt interest was financed by the conduit financer only with proceeds from of the ultimate debt interest
- the terms of the relevant debt interest, to the extent those terms relate to a cost incurred by the borrower in relation to the relevant debt interest, are the same as the terms of the ultimate debt interest, to the extent those terms relate to such costs incurred by the conduit financer in relation to the ultimate debt interest (the 'same terms' requirement). However, for these purposes, the following terms are disregarded
- terms of a debt interest to the extent that those terms relate to the amount of the debt
- terms of the ultimate debt interest that have the effect of allowing the recovery of reasonable administrative costs of the ultimate lender that relate directly to the ultimate debt interest
- terms of a relevant debt interest issued to the conduit financer that have the effect of allowing the recovery of reasonable administrative costs of the conduit financer that relate directly to the relevant debt interest
- terms of a relevant debt interest that have the effect of allowing the recovery of costs of the conduit financer that are a debt deduction of the conduit financer and are treated as being attributable to the ultimate debt interest under subsection 820-427A(2) of the ITAA 1997 (concerning interest rate swap arrangements)
- terms of a relevant debt interest that have the effect of allowing the recovery of costs of a borrower that are a debt deduction of the borrower and are treated as being attributable to another debt interest under subsection 820-427A(2) of the ITAA 1997.
- the conduit financer and the borrower are Australian entities
- the conduit financer and the borrower apply the third party debt test.
Modified definition of ‘associate entity’
A modified definition of ‘associate entity’ also applies for the purpose of the third party debt test. In determining whether an entity is an associate entity of another entity, disregard the requirement in subsections 820-905(1) and (2A) that the entity is an 'associate' of the other entity (unless only paragraph 820-905(1)(b) applies) and the references to 'an associate interest of 50% or more' are treated as:
- for the purposes of paragraph 820-427A(5)(b) — a reference to a TC control interest of 50% or more
- for the purposes of any other provision within the third party debt test method — a reference to a TC control interest of 20% or more
- Subsection 820-860(3) is treated as applying for the purposes of determining whether the entity is an associate entity of the other entity.
For more information, see modified associate entity definition.