The TPDT, introduced by the 2024 Treasury Laws Amendment, replaces the arm’s length debt test for general investors and financial entities with a simpler, more streamlined method.
The Australian Taxation Office (ATO) has issued Taxation Ruling TR 2025/2 (effective 1 October 2025), addressing the third-party debt test (TPDT) for thin capitalisation purposes.
Additionally, the ATO has finalised Schedule 3 of Practical Compliance Guideline (PCG) 2025/2, guiding restructures undertaken in response to the thin capitalisation and debt deduction creation rules.
The third-party debt test (TPDT) for thin capitalisation purposes
The TPDT was introduced by the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share—Integrity and Transparency) Act 2024 (Act). The TPDT replaces the arm’s length debt test for general class investors and financial entities. It is designed to be a simpler and more streamlined test to apply and administer than the arm’s length debt test, which operated based on valuation metrics and a ‘hypothesised entity comparison’. Its design reflects that the earnings-based rules may not work appropriately for asset-heavy sectors with long depreciation periods, such as the infrastructure and property sectors.
In general terms, the TPDT limits an entity’s gross debt deductions for an income year to an amount equal to the sum of its debt deductions for that year that are attributable to debt interests issued to unrelated entities and used to fund its Australian operations. The TPDT may allow debt deductions in excess of those otherwise available under the earnings-based tests. However, the TPDT is designed to be narrow and is not intended to accommodate all third-party debt financing arrangements.
A critical condition of the TPDT is that the holder of the debt interest has recourse for payment of the debt only to the Australian assets of the issuer or an Australian entity that is a member of the “obligor group”. Assets that are rights under or in relation to a guarantee, security or other form of credit support are generally not permitted and will lead to failure of this condition unless certain limited exceptions apply. This condition is designed to ensure that independent commercial lenders determine the level and structure of debt finance they are prepared to provide an entity based only on its Australian assets. Another condition of the TPDT is that the issuer must use the proceeds of issuing the debt interest to fund its commercial activities in connection with Australia.
An entity will generally be able to claim its debt deductions in full if all the debt interests it issues satisfy the TPDT. That is, the TPDT will not disallow any part of its debt deductions. To the extent an entity’s debt deductions are attributable to debt interests that do not satisfy the TPDT, they are effectively disallowed.
The TPDT includes ‘conduit financing’ rules that allow debt deductions attributable to on-loans between related parties in certain circumstances. These rules are outside the scope of this Ruling.
A choice to use the TPDT may result in certain associate entities being deemed to have made the same choice. If an entity is deemed to have made a choice to apply the TPDT in relation to an income year, it is not permitted to make a choice to apply the group ratio test in relation to that year, and any choice it has made to apply the group ratio test for that income year is revoked and taken not to have been made.
Clarification on the definition of “Australian assets”
The final Ruling and Schedule 3 of the PCG offer further clarification on the definition of “Australian assets,” which is relevant to the TPDT.
The term ‘Australian assets’ is not defined for the purposes of paragraph 820-427A(3)(c) and therefore takes on its ordinary meaning in the context it appears. The adjective ‘Australian’ is defined to mean something ‘of, or relating to Australia’. ‘Assets’ are resources available for future economic benefit or service potential, such as real property, machinery, inventory, cash, securities and intangible items like patents, trademarks and goodwill.
Additionally, the term Australian assets is intended to capture assets that are substantially connected to Australia, and the following assets are not intended to be covered assets that are attributable to the entity’s overseas permanent establishments or assets that are otherwise attributable to the offshore commercial activities of an entity.
Apart from minor or insignificant assets, the TPDT limits recourse for payment of the debt to which the debt interest relates only to Australian assets in order to prevent entities from using offshore assets to inflate borrowing capacity (and therefore Australian debt deductions) beyond what the entity’s Australian assets would support.
However, for intangible assets, the guidance outlines several factors to consider when determining whether an intangible asset qualifies as an Australian asset.
Intangible assets like licences, contractual rights, and IP require special consideration since they lack physical location. Their classification as Australian assets depends on factors such as the parties’ location, governing law, use in Australian business, legal situs, and whether payments are backed by Australian assets.
