Ref: AMK
7 November 2024
Mr Stephen Dodshon
Assistant Commissioner (a/g)
New Measures | Public Groups
Australian Taxation Office
By Email: stephen.dodshon@ato.gov.au
Dear Stephen
SUBMISSION: DRAFT PRACTICAL COMPLIANCE GUIDELINE PCG 2024/D3
1. Thank you for the opportunity to provide comments on the Draft Practical Compliance Guideline PCG 2024/D3 “Restructures and the new thin capitalisation and debt deduction creation rules - ATO compliance approach” (“PCG”).
2. Pitcher Partners specialises in advising taxpayers in what is commonly referred to as the middle market. Accordingly, we provide accounting and advisory services to taxpayers that would be impacted by the proposed changes to the debt deduction creation rules contained in Division 820 of the Income Tax Assessment Act 1997 (“ITAA97”).
3. We highlight that for the purposes of Division 30 of the Tax Agent Services Act 2009 (“TASA”), and in particular the amendments made by Tax Agent Services (Code of Professional Conduct) Determination 2024 (“the Determination”), many of the recommendations and suggestions contained in this submission will likely assist taxpayers in the middle market in complying with the debt deduction creation rules (“DDCR”) contained in Subdivision 820-EAA and reducing the potential exposure that such taxpayers will have in relation to the DDCR. While this may result in a conflict of interest for the purposes of Section 20 of the Determination, we highlight that we have tried to ensure that our comments and suggestions contained in this submission are balanced and consistent with the policy principles and intention of the DDCR provisions as we understand them
4. We understand that the ATO is in a difficult position that requires appropriate guidance to be provided in relation to the operation of the DDCR provisions, being a set of very complex provisions to interpret and apply in practice. We also understand that these provisions can also be interpreted in an extremely broad manner and that ascertaining
low and high risk cases is a difficult exercise for the ATO, advisors and taxpayers . Accordingly, our collective comments contained in this document are not intended to be a criticism of the PCG, but instead are intended to provide constructive feedback to assist in developing principles that may assist taxpayers in the middle market and their compliance with the DDCR provisions.
LITTLE OR NO LOW RISK OPTIONS FOR MIDDLE MARKET
5. We are extremely concerned with the current version of the PCG for middle market taxpayers. Due to the different types of structures that middle market taxpayers utilise (e.g., partnerships and discretionary trusts),we believe that the PCG offers little or no viable low risk restructure options for those taxpayers in the middle market
6. We believe that the document currently does not appear to recognise that the majority of middle market taxpayer groups: (a) operate using discretionary trusts that cannot be funded by “trust capital”; (b) receive loans from companies in the group that require interest to be charged under Division 7A; and (c) cannot form tax consolidated groups due to their entity and ownership structure The current version is drafted in a manner that only recognises corporate groups and only provides examples on how corporate groups may be able to restructure their affairs in a low risk manner
7. Furthermore, in respect of (c), while a restructure to form a tax consolidated group may help to reduce intragroup Australian debt that is recognised by the system, the PCG does not recognise this as an option that would be considered low risk. Accordingly, we believe that almost all of the low risk examples provided cannot be utilised by taxpayers in the middle market.
8. In our view, this will have two very significant implications.
8.1. The first is that middle market taxpayers that conduct business operations will be at a significant disadvantage compared to their competitors in the large business market. Without options to restructure to address thin capitalisation or DDCR issues due to the change in legislation, related party debt deductions will very likely be denied permanently for such groups At the same time, related party interest income on that debt will continue to be assessable income which can result in a significant increase in taxable income and the cost of funding for such Australian groups in the middle market (where there is no economic gain for the Australian group)
8.2. The second is that a middle market taxpayer that is aware of these issues before commencing business, or that receives appropriate advice to that affect, could establish a new group that reduces the overall risk of both thin capitalisation and DDCR applying A new group could be established optimally from the outset. For example, intragroup debt issues could be managed by establishing a new tax consolidated Australian group encompassing all new corporate entities, owned by one or more discretionary trusts that have made a family trust election. This structure would remove intragroup debt from being included within the thin capitalisation regime and would not likely be subject to either Part IVA or section 820-423D.
9. We do not believe that this should be the outcome of the guidance for middle market taxpayers that will be subject to the DDCR, especially those that are caught by virtue of only being within he rules due to the exception in section 820-37 being ignored.
CONSISTENCY WITH SENATE REPORT STATEMENTS
10. We also do not believe that this outcome is consistent with the statements made by the ATO that were contained in the February 2024 Senate Report titled “Government Amendments to Treasury Laws Amendment (Making Multinationals Pay Their Fair Share-Integrity and Transparency) Bill 2023” . In that report, the ATO is quoted as stating the following:
we're really mindful that taxpayers will need to manage the transition from the current thin capitalisation regime to the proposed new thin capitalisation regime on passage of the bill, and this may well require restructuring of existing financing arrangements. We're also mindful that there are some concerns within the stakeholder groups about whether that position is consistent with restructuring might fall foul of integrity rules, not just in the measure itself but also more generally. What I'll say about that is that, as a general principle, the ATO would not be looking to apply integrity rules in the proposed new law or elsewhere where taxpayers are restructuring their arrangements as a means of seeking to comply with the underlying intent of the new law. This is an approach we have taken in the past. [emphasis added]
11. As demonstrated by this submission, we do not believe that the ATO have appropriately articulated the integrity risk for middle market taxpayers. We also do not believe that the ATO has provided principles that allow middle market taxpayers to assess whether a restructure would be considered low risk where a restructure is implemented to comply with the underlying intent of the new law.
12. In addition, due to the view contained with respect to Division 7A in the PCG, we highlight that almost all of the examples provided in the PCG cannot be utilised by a taxpayer in an Australian group that is predominantly is structured using discretionary trusts. We discuss this further below.
LOW RISK SCENARIOS
Section 820-37 groups that are not SGEs
13. In our meeting with the ATO on 30 October 2024, we highlighted that, in many cases, an Australian Group of entities may be outside of the thin capitalisation provisions due to the application of section 820-37 (the 10% rule). Where this is the case, we do not understand why such groups would be considered high risk from a DDCR restructuring perspective. We note that this is different to whether they are considered high risk from a DDCR perspective.
14. As a starting point, we believe that there would be very few cases where “debt dumping” could occur for such a group that has minimal foreign assets. We understand that the ATO is concerned with groups that satisfy the 10% rule that are “very large” taxpayers as compared to those that are not. We believe that the PCG should therefore separate the identification of these two groups.
15. This could be done by identifying a group of smaller taxpayers, for example, a taxpayer that is not a member of an SGE and is one that otherwise satisfied the 10% rule. In such a case, restructuring that removes the application of the DDCR should generally be considered low risk.
16. If this threshold is not acceptable, we would like to understand the types of larger groups that the ATO are concerned with We believe it should be possible to distinguish between the low risk and high risk case based on the size of the relevant group or entity.
17. We request that the ATO consider this potential option. If there are risks with this option that we have not otherwise identified, we would welcome the opportunity to discuss this option further with the ATO.
High level principles for determining a low risk arrangement
18. In addition to the potential option raised above, we believe it should also be possible to formulate high level principles to identify low risk cases for entities within the middle market. Again, we believe that this could be potentially restricted to those that are not members of an SGE We note that this option would not be limited to outbound groups and could be applied by inbound groups.
19. From our meeting with the ATO on 30 October 2024, we broadly understand that one of the ATO’s concerns with debt restructuring is obtaining an understanding of the relationship between the relevant entities and foreign entities (either inbound or outbound entities) within the broader group We understand that this is to assist with determining whether the debt restructure involves a case of “debt dumping” or overgearing in Australia (as compared to the international structure).
20. On this point, the PCG appears to identify “debt dumping” as the key risk that is targeted by the DDCR, especially in relation to third-party debt. Third party debt dumping is recognised in the EM as a risk in the Supplementary Explanatory Memorandum at paragraphs 1.31 and 1.43.
21. We have tried to provide a number of examples in this submission that demonstrate situations where debt restructuring should not amount to a high risk case of debt dumping. If the ATO agrees with us on these examples, we believe that these examples could help to develop high level core principles to identify cases of restructures that should be considered low risk. As a starting point, criteria could be based on the low risk principles contained in PSLA 2018/7, paragraph 18, dealing with hybrid mismatch restructures
22. We have attempted to modify those criteria and have included additional criteria to help identify what we believe would be low risk cases in relation to DDCR restructures. We note that this is likely to be a good starting point, and we would welcome an opportunity to work with the ATO on developing these criteria. As noted earlier, these principles first assume that the relevant entities are not members of an SGE group. Our initial proposed principles for consideration are as follows.
22.1. Identify a group of entities that are within the same controlled associate entity group or same family trust elected group and are Australian resident entities of that group. This group is referred to as the Australian Group
[This step is to identify entities in the Australian Group that may be effected by the restructure steps].
22.2. Identify the original arrangement prior to the restructure. The original arrangement prior to the restructure should not have attracted the application of Part IVA.
22.3. Identify the replacement arrangement that will occur from the restructure. The replacement arrangement on a stand-alone basis should not attract the application of Part IVA (arrangement viewed without regard to the original arrangement or restructure steps).
22.4. The restructure and replacement arrangement should be effected in a straightforward manner, explicable only by an objective of eliminating or reducing levels of intragroup debt between entities within the Australian Group
[It is important that the restructure results in a reduction of intragroup debt deductions or intragroup levels of debt].
22.5. The restructure should not result in a reduction in the overall net asset position of the Australian Group as a whole.
[A reduction in the overall net asset position would be indicative of an arrangement that substitutes “equity” of the Australian Group with further debt in the Australian Group and thus would indicate that debt dumping may have occurred].
22.6. The restructure:
22.6.1. Should not the result in an increase in the overall third-party debt of the Australian Group (as compared to the debt of the Australian Group prior to the restructure); or
[This step is to identify the risk that there may be third-party debt dumping, subject to the following step].
22.6.2. Results in an increase in the overall third-party debt of the Australian Group, but the Australian Group can evidence that either: (a) there is no related reduction in third-party debt for any foreign entity that is related to the Australian Group; or (b) the third-party debt is not used to fund (directly or indirect) foreign investments or foreign operations
[This step is to identify acceptable new third party debt that occurs as part of the restructure].
APPLICATION OF THE PROPOSED PRINCIPLES TO THE PCG EXAMPLES
23. We have tested these high level principles to the Examples 12 to 19 contained in the PCG. Appendix B contains a summary of this testing.
24. We note that the application of these proposed principles results in the same classification for those examples as compared to the PCG. That is, only Examples 18 and 19 are identified as not being considered low risk. Accordingly, we believe that the application of the proposed principles could provide an outcome consistent with the existing restructure examples contained in the PCG.
APPLICATION TO COMMON SCENARIOS FOR THE MIDDLE MARKET
Overview
25. This section provides a number of basic examples that use an outbound structure that is otherwise excluded from the thin capitalisation provisions due to the 10% rule (being a common structure in the middle market). The proposed low risk restructure principles contained in paragraph 22 above are applied to the restructures in those examples to test whether the restructures would be considered low risk in such a case.
26. We believe that these examples can assist in providing a starting point for further discussions with the ATO in order to develop appropriate low risk safe harbours for taxpayers in the middle market. We refer to Appendix A which provides a diagrammatical structure for each of the examples below.
27. We note that all of the restructure examples below are theoretical and are not restructure examples that we are aware of that have occurred in practice However, we believe that these would likely be realistic restructuring options that would be considered in practice for middle market taxpayers Accordingly, we believe that these would be relevant examples for appropriate consideration and comment by the ATO.
Example 1: Intragroup debt restructuring
28. In Example 1, Bco and Cco are part of the same wholly owned group of entities (Australian Group) Cco is an operational entity that runs an active business in Australia. Cco also owns a foreign subsidiary (CFC) that satisfies the s 820-37 exception. The CFC was originally funded by retained earnings of Cco and through bank debt in the foreign jurisdiction.
29. Cco has borrowed an amount from Cco to fund its Australian operations. None of the borrowing relates to its foreign equity or foreign operations. For the purpose of this example, assume that the loan from Bco to Cco funded transactions that would otherwise meet the requirements of s.820-423A(2) or (5).
30. Where DDCR applies, interest income to Bco would be assessable, but interest deductions to Cco would be denied under the DDCR. This would result in a permanent tax cost to the Australian Group and would place the Australian Group at a significant disadvantage as compared to large public corporate groups operating in the same market (unless Cco restructures its financing)
31. The Australian Group considers a restructure to comply with the DDCR provisions and to reduce overall intragroup debt or intragroup debt deductions The Australian Group considers four different options to restructure. All of these options have a similar economic effect to the overall Australian Group
31.1. Option 1 – Repayment of debt from retained earnings: Cco will use existing retained earnings to repay all of the debt to Bco There is no change to the overall assets nor liabilities of the Australian Group. This would be considered low risk by virtue of Examples 12, 13, 15, 16 and 17 of the PCG. Under this option, interest would no longer be deductible nor assessable to the Australian Group This option would likely meet all of the principles outlined in paragraph 22.
31.2. Option 2 – Interest free loan: Bco turns the loan into an interest free loan to Cco While not covered by the PCG, we believe that this should be considered low risk as there is no overall change to the assets nor liabilities of the Australian Group and the same result occurs as compared to Option 1. This option should also meet all of the principles outlined in paragraph 22
31.3. Option 3 – Intragroup dividend to fund repayment: Bco pays a dividend to Aco, which is used by Aco to introduce new share capital to Cco, which is used to repay the debt to Bco. This option may be used where Option 1 is not possible (i.e. Cco does not have retained earnings). In this option, Cco is simply repaying debt from equity capital raised, this would be similar to Example 16 and should be considered low risk. This option should also meet all of the principles outlined in paragraph 22
31.4. Option 4 – Formation of a tax consolidated group: Finally, Aco could form a tax consolidated group with Bco and Cco. Under the single entity rule, the DDCR should have no application. Furthermore, the simple choice of forming a tax consolidated group should not result in Part IVA applying. This option should also be considered low risk. This option should also meet all of the principles outlined in paragraph 22
32. We note that this first example is intended to be a basic case used to demonstrate what we believe should be regarded as low risk options from a DDCR perspective. As outlined above, we believe that these four options should meet the high-level principles at paragraph 22 when applied to this basic example
Example 2: Intragroup debt with existing third party debt
33. This second example is the similar to Example 1, however assume the loan from Bco was originally funded from a loan from XYZ Bank.
34. In this example, Bco must charge interest to Cco, otherwise interest deductions on the loan from the XYZ Bank to Bco may be denied under section 8-1 (i.e., as the loan needs to be used for income producing purposes) Accordingly, this means that Option 2 is unlikely to be available in this case (as the outcome would be the same as DDCR applying).
35. It is also unlikely that Option 3 (dividends used to fund repayments) from Example 1 could be used in this example as the original funding of the loan from Bco was sourced from the XYZ Bank.
36. However, it is possible that Option 1 (repayment by Cco from its retained earnings) and Option 4 (formation of a tax consolidated group) could be used. As outlined in Example 1, these two options should meet the high level principles outlined in paragraph 22
37. In this example, another option (Option 5) could involve the novation of the third-party bank debt from Bco to Cco While a debt factoring arrangement is considered high risk in the PCG (Example 18), we note that applying a novation of debt to this example does not share in the same risk factors as Example 18 That is, given that this option would reduce intragroup debt and intragroup debt deductions, this option can be distinguished from Example 18.
38. Provided that Cco can otherwise meet the requirements contained in paragraph 22 (and especially those contained in paragraph 22.6 in respect of the third-party debt), we believe that this additional option should also be regarded as low risk.
Example 3: Intragroup debt (Division 7A loan)
Overview
39. In this third example, a company in the Australian Group (Bco) provides a loan to Trust C that runs the Australian operations. Trust C also holds an interest in the CFC. All background facts are the same as Example 1, except that Trust C is substituted for company Cco, where Trust C is a discretionary trust.
40. As the loan is from Bco to a trust (Trust C), the intragroup loan is subject to Division 7A. Accordingly, if interest is not charged on the loan, the loan will result in a deemed dividend under section 109E. Accordingly, Option 2 (interest free loan) would not be available in this case.
41. As a trust does not have retained earnings, Option 1 (repayment from retained earnings) and Option 3 (dividend to fund repayment) would not be available to Trust C. Furthermore, a discretionary trust generally cannot form part of a tax consolidated group and so Option 4 is also unlikely to be possible.
42. As outlined in our submission, this example demonstrates that many of the low risk restructuring options that would be available to large business and corporate groups would not be available to middle market taxpayers operating through trusts. Accordingly, if the application of the DDCR results in interest being assessable to Bco and non-deductible to Trust C (in an example like this), the cost of funding for private groups would increase substantially as compared to a large business taxpayers or corporate taxpayer operating in a similar market (for example a group covered by Example 1). We believe that this would place taxpayers in the middle market at a competitive disadvantage unless additional options for restructure are regarded as low risk.
Additional options for consideration for Example 3
Option 6: using third party bank debt
43. Under this option, the Australian Group would look to introduce third party debt into Trust C that would enable Trust C to repay Bco.
44. We note that while there is an increase in overall third-party debt of the Australian Group, the Australian Group can evidence in this case that: (a) there is no reduction in third-party debt for any foreign entity that is related to the Australian Group; and (b) the third-party debt is not used to fund (directly or indirect) foreign investments or foreign operations.
45. We note that this option would be the least preferable option (from a financial perspective) to the Australian Group, as it would involve the Australian Group making interest repayments to a third party (which would result in a reduction in cash flow and net assets of the Australian Group over time, as compared to a Division 7A loan which retains the cash flows within the Australian Group). However, we note that this option would likely be preferable to having the DDCR apply to intragroup debt in this case.
46. Accordingly, we believe that a restructure of debt to introduce third-party debt should not be regarded as “debt dumping” and should be regarded as low risk in this example
Option 7: Rollover assets using Subdivision 122-A rollover
47. This additional option would allow the trust (Trust C) to dispose of all of its assets to a wholly owned corporate entity (Cco), via a Subdivision 122-A rollover. As a part of the rollover of assets, the loan from Bco would also be rolled into Cco (i.e. the loan would be assumed by Cco) This restructure could allow Trust C to be replaced by Cco and could help to eliminate the need for a Division 7A loan. Essentially, this option allows a trust group to corporatise to manage the impact of the DDCR on Division 7A loans.
48. Accordingly, once this option has been implemented, the structure of the Australian Group would be broadly similar to that contained in Example 1. That is, the rollover of Trust C to Cco would provide access to Option 1 to Option 3 We note that the group would not qualify for Option 4 (tax consolidated group) as the parent entity of Cco is different to Aco. However, please see Example 4 for this additional restructure.
49. We highlight that this Option 7 introduces an additional step as part of the restructure, being the rollover concession under Subdivision 122-A. Under the principles proposed at paragraph 22, ignoring DDCR, the restructure steps are fairly straightforward and should not otherwise attract Part IVA if they were viewed on an isolated basis.
50. We believe that this alternative restructure should be considered a low risk arrangement.
Example 4: Consolidating the Australian entities
51. Example 4 follows from Example 3, where the shares in Cco are then rolled under Aco using a Subdivision 124-M rollover (Option 8). This allows the Australian Group to form a tax consolidated group. Accordingly, in addition to using the restructure in Example 3, this additional step would provide access to Option 4 (tax consolidated group) whereby the loan between Bco and Cco would not be recognised for income tax purposes. Again, this option would facilitate the corporatisation of trusts in the group.
52. As there are multiple steps undertaken to put the Australian Group in a position to form the tax consolidated group (inclusive of Cco), this would unlikely be covered by the “choice” exclusion contained in section 177C However, assuming that there are no tax advantages associated with the multiple rollovers (i.e. loss benefits or pushdown ACA benefits), we do not believe that the dual rollover should attract the anti-avoidance provisions in this case (i.e., being a condition of the proposed principles in paragraph 22)
53. This example would therefore provide the ability for a trust group to convert to a corporate group in order to facilitate the refinancing of Division 7A loans that would otherwise exist and otherwise be subject to the DDCR. Accordingly, we believe that this example is consistent with all of the principles outlined in paragraph 22 and (in our view) should be regarded as being a low risk arrangement.
Example 5: Separating the Australian and foreign business operations
54. Example 5 is an expansion of Example 2 and Example 3. Utilising a Subdivision 122-A rollover, it allows Trust C to rollover assets separately to either Cco and Dco, ensuring that the foreign business assets are separated from the Australian business assets and operations (Option 9). This allows intragroup loans and third party debt to be properly quarantined. Essentially this can allow the group to properly quarantine assets and liabilities for DDCR purposes.
55. Once the rollover restructure is complete, Cco could borrow from a third-party financier to repay intragroup debt. To the extent that there is no intragroup debt between Cco and Dco, this example allows for an appropriate quarantining of debt and the foreign operations. We believe that this option should make it easier to demonstrate that the debt is appropriate for the Australian operations and should not be regarded as debtdumping in Australia. We believe that this option should meet all of the requirements as outlined in paragraph 22 (and accordingly demonstrates a low risk restructure arrangement)
Example 6: Removing intragroup debt via intragroup dividends
56. This example considers the structure from Example 3 after completing Option 7 (i.e. a Subdivision 122-A rollover). An additional option available to the group (Option 10), could allow Bco to pay a fully franked dividend to Aco, which in turn pays a fully franked dividend to Trust A, which is then distributed to Cco. Cco can utilise the dividend to repay its loan to Bco.
57. This option enables the group to place “equity” in the entity (Cco) that requires the funding and removes or reduces intragroup debt and intragroup debt deductions in the Australian Group (by repaying the loan from Bco) Essentially, there is no change to the overall asset structure of the group but allows the group to appropriately capitalise each entity in order to remove intragroup debt. Accordingly, we believe that this example should meet all of the conditions in paragraph 22 and therefore should be considered a low risk option for taxpayers in the middle market.
Example 7: Amending a cash pooling arrangement
58. This example looks at the cash pooling example contained in the PCG (Example 4). Essentially in the PCG example, the cash pooling arrangement requires the relevant cash pool leader to pay interest under the arrangement to the third-party financier.
59. It is possible, under a cash pooling arrangement, to require the cash pool participant to pay the interest charge of its notional loan under the cash pool. This option reduces the overall debt cost to the pool participant (as the amount of interest is reduced by the groups balance in the pool).
60. Where this occurs, the payment of the debt deduction will be directly to the third-party financier which should not be taken to a debt deduction covered by subsection 820423A(2)(e) or 820-423A(5)(e) Essentially, the end result is that the cash pooling arrangement (as modified) would result in the cash pool participant economically receiving an interest free loan from the other cash pool participants, reducing its overall debt cost. We believe that this option should be regarded as a low risk option for restructuring within the DDCR provisions. We also note that this restructure should meet all of the conditions in paragraph 22
61. As an aside, we believe that modifications of a simple nature like this should be regarded as low risk restructures. We do not believe that modifications to a legal document to comply with the thin capitalisation provisions or the DDCR should be considered high risk (unless the arrangement prior to the modification was itself high risk).
We again appreciate your time in considering our submission. We would welcome an opportunity to discuss this further with you. Please contact me on (03) 8610 5170 or at alexis.kokkinos@pitcher.com.au at any time to organise a meeting to discuss this further
Yours sincerely
A M KOKKINOS Executive Director