The ATO has issued draft guidance formalising its view confirming the tax debt equity rules cannot limit the operation of the transfer pricing rules in respect of cross border related party funding.
On 31 October 2018, the Australian Taxation Office ('ATO') released Draft Taxation Determination TD 2018/D6 (TD 2018/D6) which reviews the relationship between Division 974 (debt-equity rules) and Subdivision 815-B (transfer pricing rules) of the Income Tax Assessment Act 1997 ('ITAA 97') in respect of international related party financing arrangements.
TD 2018/D6 confirms that the debt-equity rules will not limit the operation of the transfer pricing rules. Furthermore, the ATO also re-confirms its view that nothing in the income tax legislation limits the application of the transfer pricing rules.
Once finalised, TD 2018/D6 will apply retrospectively to income years commencing on or after 29 June 2013 (the date on which Subdivision 815-B began to operate). Taxpayers who rely on the draft document will be protected from penalties and interest, should there be changes once it is finalised.
BDO recommends that taxpayers who have existing related party cross border arrangements (especially ones with the elements of both debt and equity), closely review those arrangements, as TD 2018/D6 may affect the resulting debt-equity classification.
TD 2018/D6 provides three examples that illustrate the ATO’s view on the transfer pricing rules in relation to debt-equity characterisation of financing arrangements.
Example 1: Outbound loan to a distressed subsidiary
An Australian resident company provides a loan to its distressed foreign subsidiary. The interest on this loan accrues subject to the company making a profit.
Using this example, the ATO concludes that there is disparity between conclusions under Division 974 (i.e. where the arrangement satisfies classification of equity) and transfer pricing rules (i.e. where that arrangement is classified as debt with the need to accrue the notional arm’s length interest from the start of the arrangement).
Therefore, as the application of the transfer pricing rules results in a transfer pricing benefit, the outbound loan will be treated as a debt interest, and assessable income (rather than non-assessable non exempt income).
Example 2: Inbound discretionary interest loan
A foreign company provides a loan to an Australian subsidiary and there is no obligation to pay interest on the loan. The Australian subsidiary can, if it wishes to, pay interest on the loan at its sole discretion.
Under Division 974, this arrangement would be classified as an equity interest. Based on the ATO’s commentary in TD 2018/D6, under the transfer pricing rules, the arrangement would be classified as a debt interest, with the need to accrue the notional arm’s length interest with the corresponding interest withholding tax (WHT) payable. The focus of the application of the Australian transfer pricing rules is on the potential underpaid WHT, resulting in the transfer pricing benefit.
Example 3: Outbound interest-free loan
An Australian company provides an interest free loan to its foreign mining subsidiary, which is in the exploration phase and is not capable of raising finance from the unrelated parties.
Using this example, Division 974 classifies the arrangement as debt and the transfer pricing rules classify the arrangement as equity with no interest imputed. This is a positive message, as based on this example alone, it is clear that the ATO accepts that some financing arrangements will effectively be classified as 'quasi' equity with no interest accruing.
It should be noted that the differences between Example 1 and Example 3 are subtle, but the two examples result in different conclusions and consequences for the respective taxpayers.
Although arguably not inconsistent with the views previously expressed by the ATO, the retrospective application of TD 2018/D6 creates the need for taxpayers to review not only future, but also historical arrangements. Taxpayers are therefore specifically encouraged to review the following arrangements:
- All interest free outbound cross border related party debt arrangements
- Inbound interest free cross border related party debt arrangements for possible WHT underpayments (especially but not limited to taxpayers with carry forward or current losses)
- Cross border related party debt arrangements with both debt and equity elements including thin capitalisation arrangements.
BDO note that ATO guidance on interest free loans is imminent and will form a key piece of the puzzle that will practically drive the interaction between the debt equity rules and transfer pricing rules.
Please reach out to your local BDO transfer pricing contact to discuss your arrangements and potential risk mitigation strategies that might be suitable for you.