Thin Capitalisation & Debt Deduction Creation Rules: A Quick Guide For Private Groups
If your business claims debt deductions – such as interest on loans – it’s essential to understand whether the thin capitalisation rules or the newer Debt Deduction Creation Rules (DDCR) apply to you.
What Are the Thin Capitalisation Rules?
Thin capitalisation rules are designed to prevent excessive debt funding in businesses. They may limit the amount of debt deductions you can claim by reference to:
- your adjusted tax earnings (Earnings-Based Test), or
- the amount of eligible third-party debt you hold (Third-Party Debt Test).
These rules aim to ensure entities don’t artificially inflate deductions by over-leveraging. With recent reforms broadening their scope, private groups that previously fell outside the net may now find themselves captured.
Introducing the Debt Deduction Creation Rules (DDCR)
From 1 July 2024, the DDCR adds an additional layer of scrutiny. These rules disallow certain debt deductions arising from related-party financing arrangements – particularly where debt is used for:
- acquisitions of assets from associates
- transactions involving associate entities
- funding distributions, dividends or shareholder payments
- wholly domestic arrangements using related-party loans
Importantly, the DDCR can apply to current and historical arrangements, meaning previous transactions may now trigger a denial of deductions.
While this was introduced some time ago, it’s important to check your lodgements to ensure you are compliant.
Don’t Rely on Outdated Exemptions
A common mistake is assuming exemptions still apply. Misinterpretation often arises where businesses fail to consider associate entities, pushing them above key thresholds such as the $2 million de minimis exemption.
If you rely on an exemption, it’s critical to reassess eligibility each year. Many private groups have incorrectly assumed they fall outside the rules, only to face amended assessments later.
Consequences of Getting It Wrong
Non-compliance is a red flag for the ATO. Errors can lead to:
- denial of debt deductions
- amended tax returns and tax shortfalls
- penalties and interest
- increased ATO scrutiny of related-party arrangements
Five Tips to Get It Right
- Review all funding arrangements and discuss the thin capitalisation and DDCR implications with your adviser.
- Complete the International Dealings Schedule if the rules apply to you.
- Include all associates when determining whether you fall under the $2 million threshold exemption.
- If you’ve used related-party debt (e.g., Division 7A loans), revisit these arrangements – DDCR may apply even to older transactions.
- Maintain detailed, accurate records to support your positions.
As the rules evolve, careful annual review is the best way to protect your business and avoid costly surprises. Why not speak to your trusted tax adviser to ensure your business is doing the right thing?
