Australian Transfer Pricing Alert:

ATO explains its expectations for the application of Arm’s Length Debt Test

16 September 2019

On 28 August 2019, the Australian Taxation Office (ATO) issued Draft Practical Compliance Guideline 2019/D3 – ATO compliance approach to the arm’s length debt test (the PCG). This PCG provides a risk assessment framework outlining the ATO’s compliance approach to the application of the Arm’s Length Debt Test (ALDT) [PCG 2019/D3]. The ALDT may be applicable to taxpayers where, under the Thin Capitalisation rules, the Safe-Harbor Debt Amount is breached and as a result, debt deductions are denied. In these instances, the ALDT may allow a taxpayer to assess its Arm’s Length Debt Amount and rely on this amount to support higher debt deductions.

Similar to other PCGs, the ATO provides taxpayers with a clear colour coded risk assessment framework. The PCG provides insight into whether the arrangement is likely to be high on the ATO radar and whether the ATO resources are likely to be allocated for additional review or follow up. It also provides insight into the types of arrangements that may be considered low risk.

Helpfully, this PCG also provides some practical guidelines on the application of the ALDT as well as what level of analysis and evidence the ATO expects based on the level of risk.

The PCG (when finalised) along with recently published TR 2019/D2 [BDO Taxpayer Alert] replaces historic guidance (Taxation Ruling TR 2003/1 – Income tax: thin capitalisation – applying the arm’s length debt test) and will come into effect from 1 July 2019. The PCG will apply to analyses undertaken for income years beginning on or after 1 July 2019, irrespective of when the arrangement was entered into.

Risk Framework

The PCG prescribes three risk zones as summarised at a high level below. In practice, many companies will fall within the medium/high risk zone, and will therefore require a robust analysis to comply with the ATO’s expectations.

Zone

Type of entity

Details

Consequences

White

Arrangements already reviewed and concluded by the ATO.

No review other than to confirm ongoing consistency with the agreed/determined approach

Low

Inward investing entity (i.e. an Australian entity that is controlled by a foreign entity or a foreign entity affected by thin capitalisation provisions)

The debt funding is from a commercial institution (unrelated party) without a guarantee, security or other credit support of any kind from other associates.

The entity also operates an Australian only business and has no foreign operations.

No review but to confirm key criteria is satisfied.

Where it is evidenced that the criteria is met, the entity may take its adjusted average debt to be its arm’s length debt amount.

Outward investing entity (i.e. Australian controlled entity)

The entity is a widely held publicly listed entity on the Australian stock exchange and is not also an inward investing entity. If officially assessed by the credit rating agency, the credit rating of the Australian business would have been the same.

Regulated utility business

The entity must have at least 70% of its total assets as regulated assets.

Further must have a net debt to regulated asset leverage equal to or less than 70%, and a cash flow from operations interest cover ratio equal to or greater than 2.7 times.

Medium - High

All arrangements that are not green

The ATO may apply resources to review the ALDT arrangement. 

Practical Application

The PCG provides updated guidance as to the ATO’s expectation on the practical application of the ALDT. In particular, there is an emphasis on the provision of evidence and robustness of the analysis required to be undertaken, as well as additional detail likely to be required by the ATO. It is clear that the ATO is seeking to increase the level of support that taxpayers outside of the green zone need to maintain when applying the ALDT.  Specifically, on a practical level, the PCG highlights the following key areas to consider when performing the test:

  • The creation of a hypothetical stand-alone Australian business;
  • Importance of a detailed functional analysis and selection of robust comparables;
  • Role of a credit rating;
  • The qualitative and quantitative factors which should be considered; and
  • The need for a corroborative analysis (such as for example Capital Asset Pricing Model).

The approach outlined in the PCG represents the minimum standard expected in performing an ALDT. Therefore, analysis which fails to address the factors outlined by the ATO will likely be considered technically insufficient to support a debt to equity ratio exceeding 60% under the Thin Capitalisation safe harbour. 

Next Steps

Taxpayers relying on the ALDT need to undertake specific actions -

  • Self-assessment financing arrangements to determine their applicable risk zone;
  • Confirm whether the ALDT application adopted takes into account the key areas of consideration identified within the new guidance;
  • Be prepared for potential ATO scrutiny of the ALDT position by ensuring that self-assessment, ALDT analysis and supporting evidence is well documented; and
  • Some (albeit limited) taxpayers may find the application of ALDT is more straightforward if the arrangement falls within the green zone.

Please reach out to your BDO transfer pricing or tax advisor to assist in identifying how the PCG may apply to your operations.