Contributed by David Bond, Director and Julian Pinson, Director, Greenwoods & Herbert Smith Freehills
On 5 April 2019, the ATO released draft Taxation Ruling TR 2019/D2 providing updated guidance on the “arm length debt test” (ALDT) in the thin capitalisation provisions.
When finalised, TR 2019/D2 will apply retrospectively and replace the ATO’s previous ruling on the ALDT, namely Taxation Ruling TR 2003/1. TR 2003/1 is not a “public ruling” but instead is only providing guidance. This provides flexibility for the ATO to change their position in TR 2019/D2.
The ATO is also proposing to issue a Practical Compliance Guide on the operation of the ALDT but will have stated that they will not replicate the six-step methodology in TR 2003/1.
Under the thin capitalisation provisions, a taxpayer’s debt deductions are reduced to the extent that its “adjusted average debt” exceeds its “maximum allowable debt”. In this regard, “maximum allowable debt” is the greater of the following:
- safe harbour debt amount
- worldwide gearing debt amount, and
- arm’s length debt amount.
With the reduction in the safe harbour debt amount from 75% to 60% of adjusted assets, more taxpayers have sought to rely on the ALDT.
In May 2013, the Board of Taxation (BOT) was asked to review the application of the ALDT and reported to Government in December 2014. The BOT recommended legislative changes in relation to the treatment of credit support and that the ATO provide additional guidance including a tax risk integrity framework.
Two limbs — borrower and commercial lender perspectives
The draft ruling emphasises the two tests in determining the ALDA, namely the lower of:
- the amount the borrower would reasonably be expected to have borrowed, and
- the amount commercial lending institutions would reasonably be expected to have loaned.
The draft ruling reinforces the requirement of the ALDT to apply these dual tests, and puts taxpayers on notice of the importance of assessing the amount that a borrower may be willing to borrow. The amount a borrower may be willing to borrow may be less than the amount commercial lenders may be willing to lend.
Would reasonably be expected
Both tests require an assessment of the amount which “would reasonably be expected”. The draft ruling suggests that this requires a standard higher than a prediction of the possible level of debt and calls for a prediction of the expected level of debt based on evidence.
The ALDT puts the onus on the taxpayers to provide evidence of the capital structure that would be adopted by hypothetical taxpayer based on the factual assumptions and relevant factors.
Annual test and measurement periods
The legislation requires that the ALDA be assessed “throughout the income year”. This requires at least an annual reassessment of the ALDA, and if circumstances change during the year, it could require an assessment of the ALDA at different times during the year.
This retesting requirement is inconsistent with lending practice where a lender will generally be unable to change the amount loaned during the term of a loan (in the absence of a breach of debt covenants). The retesting requirement also creates a significant compliance burden for taxpayers.
The BOT identified the compliance burden imposed by the annual testing requirement and recommended that the ATO apply an administrative approach of only requiring an annual reassessment where there was a material change in the taxpayer’s circumstances, the terms of the debt, or the business environment.
Where there are changes in the Australian business or the debt markets during a year, the TR 2019/D2suggests that it may be appropriate to determine the ALDA for different periods and then average these amounts.
Hypothetical Australian business
The ALDT allows only the taxpayer’s Australian business to be considered in applying the ALDT. This requirement applies as follows:
- Inward investing entities — the hypothetical Australian business includes only the commercial activities connected with Australia and excludes any associate entity debt.
- Outward investing entities — the hypothetical Australian business includes only the commercial activities connected with Australia and excludes any business carried on through a foreign permanent establishment, any associate entity debt, controlled foreign debt, or controlled foreign equity.
- The Australian business can include transactions with foreign entities such sales, management fees, and royalties.
For example, where an Australian outward investing entity has borrowed based on its global assets, the hypothetical Australian business requirement leads to an assessment of the amount that would have been borrowed in the absence of those foreign operations.
Relevance of shareholders
The draft ruling asserts that the subjective capital structure and leverage preferences of the shareholders are not relevant in applying the ALDT on the basis that the ALDT requires an objective assessment.
However the alternative view is that neither the legislative provisions nor the Explanatory Memorandum to the Bill which introduced the ALDT refer to the entity’s shareholders. The ALDT includes a list of characteristics and facts that are explicitly required to be ignored, and this list does not include shareholder preferences. On this basis, it should be possible to consider shareholder preferences.
Values of assets in applying the ALDT
The draft ruling confirms that the ALDT is not restricted to the accounting values of the assets of the Australian business. Instead the assets can be viewed as they would be viewed by a commercial lender, who is likely to consider the market value of an asset rather than its book value.
Commercial lending institutions
The term “commercial lending institution” is not defined in the relevant legislative provisions. The draft ruling confirms that the term includes not only banks and ADIs but also other markets whose commercial activities involve the provision of debt capital, such as the bond market.
The ALDT includes an assumption that any form of credit support provided by associates is disregarded. This clearly applies to explicit credit support but the draft ruling suggests that it also applies to implicit support where a lender may consider a member of a multinational group to have less credit risk as a result of their membership of the multinational group.
The BOT considered this issue and highlighted the practical difficulties in assessing the extent to which implicit credit support impacts the amount that could be borrowed from arm’s length lenders. The BOT recommended that the ALDT be amended so that implicit support not be excluded in applying the ALDT. To date, this recommendation has not been actioned and would seem to be resisted by the ATO.
Weighting of factors
The factual assumptions and the relevant factors must all be taken into account but may have different weightings. The draft ruling confirms the importance of providing support for the weightings adopting in applying the ALDT.
If a taxpayer wants to rely on the ALDT, it is required to prepare documentation of its calculation of the ALDA by the time it lodges its income tax return. This documentation must include the calculation of its ALDA together with details of the factual assumptions and relevant factors.
If a taxpayer fails to comply with this documentation requirement, it may be subject to an administrative penalty but will not be precluded from relying on the ALDT.
Interaction with transfer pricing rules
The draft ruling discusses the fact that although the ALDT and the transfer pricing rules both consider the arm’s length principle, they are each based on different statutory frameworks.
For example under the ALDT, an entity must assume that no credit support has been provided by associates and that its only business is its Australian business. There are no equivalent assumptions for the purposes of applying the transfer pricing rules under Subdiv 815-B of ITAA 1997.
Therefore the ALDA for the purposes of the ALDT may be different to the arm’s length capital structure for transfer pricing purposes.
For example, a taxpayer may have taken a conservative position on the interest rate applied to a loan in order to reduce the risk of the ATO assessing there to be a transfer pricing benefit. However in assessing the ALDA, the taxpayer would not be able to use that same interest rate in determining it’s ALDA. Instead an arm’s length rate must be used and that interest rate may be higher and so could reduce the ALDA.
The draft ruling provides clarification of some technical issues but also includes some differences to the ATO’s previous guidance in TR 2003/1. There remain some practical concerns, such as those raised by the BOT review. Hopefully these concerns will be addressed in the ATO’s forthcoming practical compliance guidance.
In the meantime, taxpayers should review their previous ALDT calculations and assess their consistency with the guidance in the draft ruling.
[This article was originally published in CCH Tax Week on 3 May 2019. Tax Week is included in various tax subscription services such as The Australian Federal Tax Reporter and CCH iKnow. CCH Tax Week is available for subscription in its own right. This article is an example of many practitioner articles published in Tax Week.]