ATO releases finalised thin capitalisation ruling and compliance guidance

The Australian Tax Office has issued a finalised income tax ruling TR 2025/2 Income tax: aspects of the third party debt test in Subdivision 820-EAB of the Income Tax Assessment Act 1997 and Schedule 3 (examples - third party debt test compliance approach) to Practical Compliance Guidelines (PCG 2025/2 Restructures and the thin capitalisation and debt deduction creation rules - ATO compliance approach).

These releases are important for taxpayers who are considering whether to apply the third-party debt test under the thin capitalisation provisions. This decision not only impacts the debt deductions allowable to a taxpayer under the thin capitalisation provisions, but electing to apply the third-party debt test also removes the taxpayer from the application of the debt deduction creation rules.

Read our previous technical updates on the ATO’s finalisation of the guidance on new thin capitalisation and debt creation rules, and the enactment of the new Australian thin capitalisation rules.

TR 2025/2

TR 2025/2 was originally released in draft form as TR 2024/D3. The finalised version was published on 1 October 2025. The Commissioner has clarified some of the issues discussed in the draft ruling, and addressed concerns raised in submissions to the draft. The analysis in the ruling follows the order of the relevant provisions in the legislation:

Subsection 820-427A(2)

This subsection includes hedges and other instruments (such as interest rate swaps) that are treated as a debt deduction that may be subject to the third-party debt test. The provision has two parts: 

• The debt deduction must be directly associated with hedging or managing interest rate risk in respect of a debt interest 
• The debt deduction must not be referable to an amount paid, directly or indirectly, to an associate.

In particular, the Commissioner stresses that the hedges and swaps must relate to interest rate risk, and not be referable to an amount paid to an associate. This position has not changed from the draft ruling.

Paragraph 820-472A(2)(b) Associate

This paragraph contains the conditions that must be satisfied for a debt interest to qualify as third party debt. The first two conditions relate to the debt interests being issued to and held by parties that are not associates of the issuer. The Commissioner states that these conditions will be satisfied where:

• The taxpayer issued the debt interest to an entity that is not an associate. The Commissioner states where this condition is satisfied in relation to the income year in which the debt interest is issued, the condition will be satisfied in relation to subsequent income years in which the debt interest remains on issue 
• In relation to an income year, the debt interest is not held at any time in that year by an entity that is an associate of the issuer. The Commissioner states this condition is tested continuously throughout the period the debt interest is on issue. Where the debt interest is on issue for the whole income year, it must satisfy this condition for the entire year. Where the debt interest is issued for part of the income year, it will satisfy this condition if it has not been issued to an associate throughout the period it is on issue.

The Commissioner confirmed the position taken in the draft that debt interests will qualify as third party debt where they are issued to and held by parties that are not associates of the issuer in these circumstances.

Paragraph 820-427A(3)(c)

Recourse

An important condition in paragraph 820-427A(3)(c) is that the holder of the debt has recourse for payment of the debt to only Australian assets (subject to the minor and insignificant exclusion below). The Commissioner states this refers to the holder’s ability to recover amounts owed to it by the issuer. This test must be continuously applied throughout the term of the debt interest. 

The Commissioner has not changed the view expressed in the draft ruling. They agree that the ruling does not cover all possible factual situations, as expressed in submissions on the draft. However, they feel the guidance in the ruling is sufficient to assess the assets to which lenders have recourse. In particular, the ruling stresses that:

• The test is a practical question of fact based on the agreements and the legislation that may apply to the debt interest
• Having recourse does not require a default event, or for the holder of the debt to have enforceable rights of recourse. The consideration is the assets available in the event of default
• This is contrasted with security, which is a different concept, such that security assets may not be the same as default assets. 

The key change to the ruling is in relation to assets of an obligor group. In the draft ruling, a number of examples involved assets of obligor groups. Submissions on the draft stressed that the Commissioner’s view of the obligor rules as expressed in the examples was incorrect. The Tax Office has accepted that example 5, example 6 and example 8 were incorrect. These examples have been amended in the final ruling.

Minor and insignificant

One of the more controversial views in the draft ruling related to the minor and insignificant exclusion, where recourse can be to non-Australian assets where those assets were minor and insignificant. Despite submissions arguing the Commissioner’s view in the draft ruling was too restrictive, the Tax Office has reiterated this position in the final ruling.

Australian assets

The final ruling provides a more detailed analysis of what constitutes an Australian asset. The Commissioner notes that Australian real property is an Australian asset, and the discussion clarifies the position on membership interests. In particular, they state that membership interests will be Australian assets where the non-Australian assets are minor and insignificant. However, membership interests in entities that have foreign permanent establishments are not Australian assets.

The Tax Office has added an example which demonstrates the interaction between minor and insignificant and paragraph 820-427A(4)(b). Whilst recourse to non-Australian assets that are minor or insignificant is permitted under paragraph 820-427A(3)(c), recourse to membership interests in entities that hold non-Australian assets is not permitted, even if those assets are minor or insignificant, in accordance with paragraph 820-427A(4)(b).

All or substantially all/Australian commercial activities

The submissions to the draft ruling noted that the Commissioner’s view of all or substantially all was too narrow, and that the expression means more than just minimal or nominal, as had been indicated by the Commissioner in the draft ruling. The Tax Office has removed reference to a minimal or nominal amount in the final ruling. However, they otherwise maintain the views expressed in the draft ruling.

The submissions also noted issues with the references to commercial activities in connection with Australia. There was confusion regarding reference to capital management activities, and this has been removed from the final ruling. Additional guidance has also been provided to assist in determining what commercial activities are in connection with Australia.

The Tax Office maintains its view that the payment of dividends and the return of capital do not constitute commercial activities in connection with Australia. However, they confirm that refinancing debt that was used to find commercial activities in connection with Australia will satisfy the provisions where that relationship between the debt and the use of the funds is maintained.

Credit support rights

There are a number of comments on the application of specific provisions relating to credit support rights. Generally, the Commissioner has restated the position expressed in the draft ruling. There were concerns raised about example 18 in the draft ruling, which related to associate subsidiaries and obligor groups. That example has been deleted from the final ruling, and replaced with example 19, which the Tax Office believes better explains subparagraph 820-427A(5)(a)(i).

In addition, the Tax Office noted the following in relation to submissions into the draft ruling:

• The development concessions - the Tax Office was asked to provide more examples in relation to the development concession. No change has been made, although there is an additional example included in Schedule 3 to PCG 2025/2
• Conduit financing - guidance is outside the scope of the ruling
• Interaction with Division 230 - guidance is outside the scope of the ruling
• Tax consolidated groups - guidance is outside the scope of ruling.

PCG 2025/2

The majority of PCG 2025/2 was finalised in September 2025. At the time of publication, the Tax Office noted they had withheld the compliance approach to the third-party debt test, which was to be contained in Schedule 3 to the guidelines. Schedule 3 was withheld to be finalised and jointly released with TR 2025/2. Schedule 3 has been finalised and issued, and it should be read in conjunction with TR 2025/2.

Example 29	Formerly example 20 in the draft - removing recourse to foreign assets from obligor group - no change.
Example 30	Formerly example 21 in the draft - removing recourse to foreign assets from obligor group - no change.
	Former example 22 - is foreign bank account an Australian asset - example deleted from final version, noting TR2025/2 clarifies what is an Australian asset.
Example 31	New example - amending the terms of a credit support agreement to be limited to support during development phase only.
Example 32	Former example 23 - additional comment, taxpayer amends the terms of the loan so there is no recourse to interest in a controlled foreign corporation (CFC).
Example 33	New example - small asset holding, minor or insignificant non-Australian assets less than 1 per cent of all recourse assets - agree to remove these assets from recourse in loan agreement, or potentially dispose of these assets.
Proceeds used to fund commercial activities only	New discussion - new example 34 - trust distribution to investors, trust ceases the practice of using debt facility to finance trust distribution, governance documents amended to cease use of debt facility.
Example 35	Formerly example 24 in the draft - removing margin on project finance (back-to-back) - no change.
Example 36	Formerly example 25 in the draft - creating separate intercompany loans - no change.
Example 37	Formerly example 26 in the draft – back-to-back lending facility - amendment of intercompany loan conditions and close out internal swap - new analysis of compliance activity.

Overall, the examples provide some guidance on the potential compliance activity in this area during the transitional period. The ATO have indicated that they will review the examples and their position regarding compliance, and they may consider extending this beyond the transitional period.

Tax Office releases thin capitalisation election form

The Tax Office has issued guidance regarding the form they require taxpayers to prepare when making an election under the thin capitalisation provisions to use a method other than the fixed ratio test. The form is available via the Tax Office website.

The choices

Under the thin capitalisation provisions, taxpayers have the choice of three methods to calculate their deductible/non-deductible interest amounts. The default method for calculating these amounts is the fixed ratio test. Where the taxpayer decides to apply this method, no election is required.

The alternative methods under the thin capitalisation provisions are:

• The group ratio test
• The third-party debt test.

The choice must be made annually. This means that taxpayers must consider their thin capitalisation position each year, and if necessary, make a new election each year.

The choice must be made:

• On or before the earlier of:
  • The day on which the taxpayer lodges its income tax return for the relevant year; or
  • The due date for lodgement of the income tax return for the relevant year; or
• A later day as allowed by the Tax Office.

Where a choice is made by the taxpayer, they must complete this election form and retain it with the income tax return. It is not necessary for this return to be lodged with the Tax Office.

Who can make a choice?

The first step in the process is determining whether you need to make the election. Where the taxpayer satisfies the de minimus rules for thin capitalisation, including the 90 per cent Australian asset threshold, the thin capitalisation provisions do not apply for that particular income year, and no election is necessary.

Where the taxpayer is a general class investor, outward investing financial entity (non-ADI) or inward investing financial entity (non-ADI) for the relevant income year, they can make the election, and if they chose to do so, they must complete the election form.

Where the taxpayer is an outward investing financial entity (non-ADI) or an inward investing financial entity (non-ADI) for the relevant income year, they are only entitled to elect to use the third-party debt test.

What are the implications of making a choice?

Fixed ratio test deferred deductions

Where a taxpayer has previously chosen to apply the fixed ratio test, and under that test deductions have been disallowed, that taxpayer may have carried forward deductions to be applied in future years. These deductions may be available for up to 15 years to be applied where the taxpayer continues to apply the fixed ratio test, and it has excess debt capacity.

Where a choice is made to apply either the group ratio test or the third-party debt test, those carried forward deductions are forfeited. 

Debt deduction creation rules

Where a taxpayer chooses to apply the third-party debt test in a particular income year, the debt deduction creation rules, contained in Subdivision-EAA of the Income Tax Assessment Act 1997 will not apply to the taxpayer for that particular income year.

Deemed choices

Where a taxpayer is making a choice under the thin capitalisation provisions, they also need to be mindful that their choice may impact other related parties (or be impacted by choices made by other related parties).

Specifically, general class investors will be deemed to have made a choice under the third-party debt test where they, or any associate member of their obligor group makes the choice to apply the third-party debt test. Alternatively, where taxpayers are operating cross-staple arrangements, and one of those taxpayers has made the choice to apply the third-party debt test, all parties to the arrangement are deemed to have made the choice to apply the third-party debt test.

Extensions of time to make a choice

The legislation states the Commissioner may grant an extension of time to make the choice of which method to apply. The Tax Office has stated that applications should be made in writing, providing the following:

• Taxpayer's name and ABN
• The relevant income year
• Details of why the choice was not made by the due date and why the extension should be granted
• The thin capitalisation designation of the taxpayer (e.g. general class investor)
• What choice is being made under the thin capitalisation provisions.

Revoking an election

The legislation also states that the Commissioner may allow taxpayers to revoke an election they had previously made. There is a form that must be lodged to revoke an election. The application must be made no later than four years after the original choice was made or due to be made.

Revoking an election will impact the calculation of allowable interest deductions for the relevant taxpayer. It may also impact the application of the debt deduction creation rules, and may further impact any related parties who were impacted by group elections. These implications need to be carefully considered.

What about 2024 and 2025?

The Tax Office noted that decisions were made by taxpayers in relation to the election in the 2024 and 2025 years, even though the definitive Tax Office position on the operation of the third-party debt test was unresolved. The Tax Office recognised that once the draft ruling and PCG were finalised, taxpayers may need to make or change their initial choice. The draft ruling and PCG have now been finalised. The Tax Office is allowing taxpayers to amend their choices in relation to the third-party debt test for 2024 and 2025. Taxpayers should revisit the decisions they have previously made in relation to the third-party debt test in the context of the draft and finalised positions. 

Extension of time to make a choice

Where taxpayers have not made a choice, and decide that they should have elected to apply the third-party debt test, the Tax Office states it will generally be appropriate to grant an extension in the following circumstances:

• Taxpayers relied on Draft TR 2024/D3 and Schedule 3 of Draft PCG 2024/D3 and decided to not make a choice to use the third-party debt test for the 2024 or 2025 income year
• The Tax Office’s views as expressed in those drafts have changed in the final advices
• The change in the Tax Office’s view results in an increase in the taxpayer’s third party earnings limit for the 2024 or 2025 income year
• The taxpayer lodges a request for extension to make the choice within 6 months of the publication date of the final releases.

Extension of time to revoke a choice

The Tax Office states that it will generally be appropriate to grant a request to revoke an election in the following circumstances:

• Taxpayers relied on Draft TR 2024/D3 and Schedule 3 of Draft PCG 2024/D3 in good faith and decided to make a choice to use the third-party debt test for the 2024 or 2025 income year
• The Tax Office’s views as expressed in those drafts have changed in the final advices
• The change in the Tax Office’s view produced an adverse outcome under the third-party debt test for the 2024 or 2025 income year.
• The taxpayer lodges a request to revoke the choice within six months of the publication date of the final releases.

It is important to note references by the Tax Office to concessions to lodge or revoke elections in relation to the 2024 and 2025 income years refer specifically to the third-party debt test. There is no specific reference to the group ratio test.

The concessions allowing companies to apply for an extension of time to make elections, or to revoke elections are available for six months from the publication date of the final ruling and PCG. As noted above, the final versions were published on 1 October 2025. Taxpayers therefore have six months from that date to make a choice, and if necessary, approach the ATO. 

BDO comment

The finalisation of these Tax Office releases is an important step for taxpayers who are contemplating making the election to apply the third-party debt test. Those decisions were forced upon taxpayers without access to the Tax Office’s finalised views on the operation of the various conditions under the test. Now that the ruling and guidance documents have been finalised, taxpayers can now make decisions knowing the Tax Office’s position.

This is important as the decision to make the election is an annual task, and taxpayers should review their thin capitalisation position each year as part of the compliance process.

More importantly, given decisions for the 2024 and 2025 years have been made without access to the Tax Office’s final position, taxpayers should revisit the decisions they have already made in 2024 and 2025 to ensure they provide the optimal tax result. As noted, it is possible for taxpayers to revisit and change those decisions for 2024 and 2025. However, the decision and the application to the Tax Office must be made no later than 60 days after the final ruling and guidance documents were published. As these were published on 1 October 2025, the clock is now ticking. 

We recommend you revisit your decisions as a matter of urgency, and consult your BDO contact to assist with the review process and to prepare any applications to the Tax Office that may become necessary.