ATO releases final guidance on the arm’s length debt test

24 August 2020

The thin capitalisation rules set a limit on the amount of debt that can be used to finance an entity’s Australian operations. The interest expense of an entity on the average adjusted debt amount that exceeds this threshold is denied for tax purposes. One of the tests under the thin capitalisation rules to determine an entity’s maximum allowable debt amount is the arm’s length debt test (ALDT). The ALDT focuses on determining the notional amount of debt the Australian business would reasonably be expected to have, and what independent commercial lenders would reasonably be expected to lend at arm’s length.

The Australian Taxation Office (ATO) has recently finalised the Taxation Ruling (TR 2020/4[1]) and the Practical Compliance Guideline (PCG 2020/7[2]) on the ALDT. The earlier Taxation Ruling (TR 2003/1[3]) has been withdrawn.

Taxation Ruling TR 2020/4

Unlike its predecessor, the TR 2020/4 is a public ruling and is legally binding. It provides interpretive guidance on technical issues that may arise while undertaking the ALDT. The TR 2020/4 does not include the six-step methodology, which was included in the earlier ruling. Rather, TR 2020/4 focuses on considering all the factual assumptions and relevant factors listed in Division 820 of Income Tax Assessment Act 1997 to determine the arm’s length debt amount.

Key aspects of TR 2020/4

  • Higher standard of proof

The ruling states the standard of the ALDT is higher than a prediction of a possible level of debt and requires the determination of the arm’s length debt amount that is probable or reasonably likely, based upon evidence. Under the borrower’s test, the maximum level of debt amount should be based on what the borrowing entity “would” borrow, rather than the amount that it “could” borrow. In other words, while the borrowing entity may have capacity to take on additional debt, it does not mean that it would do so in all circumstances.

  • Relevant factors and factual assumptions

While the ruling requires consideration of all factual assumptions and relevant factors, it notes certain factors may not have a material impact on the arm’s length debt amount. Similar to the methodology adopted by credit agencies or commercial lending institutions, the ruling allows weighting to be given to each factor to determine the arm’s length debt amount.

  • Value of asset

The ruling allows consideration of asset values different to their accounting values, depending on commercial practises adopted by independent parties in the industry.

  • Annual test

The ruling confirms the ALDT is an annual test, however, it allows certain instances where prior year ALDT analysis may be broadly relied upon in the current year. The ruling also notes the option to rely on the ALDT is not a decision that is binding and irrevocable once made. This potentially allows for reconsideration of the applicability of ALDT in situations where the thin capitalisation safe harbour test was initially relied upon.

Practical Compliance Guideline PCG 2020/7

PCG 2020/7 provides administrative guidance to taxpayers in applying the ALDT and applies to all income years commencing on or after 1 January 2019. It provides a risk assessment framework that outlines the compliance approach of the ATO to an application of the ALDT. The PCG 2020/7 also provides detailed guidance on the application of ALDT, including a structured series of considerations that are essential in producing a robust ALDT analysis.

The PCG 2020/7 includes the following five risk zones:

Risk Zone

Treatment by the ATO

White

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

Green (Low risk)

No review other than to confirm the necessary criteria to fall within the low risk zone are satisfied.

Blue (Low to moderate risk)

Actively monitor such arrangements and review arrangements by exception.

Yellow (Medium risk)

Potentially apply compliance resources to review the ALDT in certain circumstances.

Red (High risk)

Reviews are likely to be commenced as a matter of priority and cases may proceed directly to audit.

White zone

The white zone includes arrangements that have been reviewed by the ATO or the ATO has agreed to the ALDT outcome of a taxpayer. Taxpayers are encouraged to engage with the ATO to assess if their low-risk ALDT could potentially fall under this zone.

Green (Low risk)

The green zone represents a “shortcut” method to determine the arm’s length debt amount. ALDTs which fall in this zone are not expected to be supported by documentation or analysis meeting the standards set out in the PCG 2020/7. However, documentation will be required to support the applicability of this risk zone.

Inward low risk zone

All the following factors should be present in the case of an inward investing entity:

  • The entity’s debt is solely from a commercial lending institution on an arm’s length basis, or the entity’s debt is partly or completely from an associate on back-to-back terms as a third-party loan.
  • The entity operates an Australian business only and has no foreign operations.
  • The entity is not an associate entity of another Australian entity that is an outward investor.
  • The entity receives no guarantee, security or other form of explicit credit support from an associate.

Outward low risk zone

All the following factors should be present in the case of an outward investing entity:

  • The entity is a widely-held publicly-listed entity on the ASX.
  • The entity is not also an inward investing entity.
  • The entity’s notional Australian business has the same issuer credit rating as the actual entity, where the entity’s actual rating has been determined by an internationally-recognised credit rating agency and encompasses the entire global group’s operations.

Regulated utilities low risk zone

All the following factors should be present in case of specific entities operating in the regulated utilities industry:

  • Has a net debt to regulated asset base leverage equal to, or less than 70%, during the relevant year.
  • Has a cash flow from operations interest cover ratio equal to, or greater than, 2.7 times, during the relevant year.

Blue (Low to moderate risk)

An ALDT will be considered to fall in the blue risk zone if it falls under the following circumstances:

  • The global group is publicly rated on third-party debt that is on arm’s length basis and the notional Australian business would achieve the same credit rating on the basis of its arm’s length debt amount, or
  • An inward investing entity is owned by a consortium of foreign investors (each with no more than a 20% direct or indirect interest) and the public credit rating of the entity based on the entity’s third-party debt (that is, on arm’s length terms and conditions) is equivalent to the credit rating of the notional Australian business on the basis of its arm’s length debt amount, and
  • No other facts or circumstances pertaining to the high-risk zone are present.

Yellow (Medium risk)

Arrangements are considered to fall in the yellow risk zone if:

  • Arrangements are not eligible to fall within the “white”, “green” or “blue” risk zones.
  • Facts and circumstances pertaining to the high-risk zone are not present.
  • The application of ALDT is consistent with PCG 2020/7.

Red (High-risk)

Arrangements are considered to fall in the red risk zone if:

  • The application of the ALDT is not consistent with the PCG 2020/7, or.
  • Arrangements have two or more of the following characteristics:

- Cross-border related party debt comprises more than 50% of the notional Australian business’ debt capital.

- Subordinated cross-border related party debt comprises more than 25% of the notional Australian business’ debt capital.

- Two years of positive (unadjusted) earnings before interest and tax and negative profit before tax during the previous five-year period.

The ATO considers the application of the ALDT as high risk requiring greater compliance resources. It has included the requirement to disclose the self-assessed risk rating under PCG 2020/7 in the Reportable Tax Position (RTP) Schedule. Taxpayers who are unable to or choose not to apply the PCG 2020/7 will also be required to disclose this in the RTP Schedule. We can expect increased compliance reviews based on the disclosure in the RTP Schedule.

The ATO considers PCG 2020/7 to represent the minimum standard expected of a comprehensive and robust ALDTs undertaken from 1 January 2019. As such, it is important for all taxpayers to consider the application of the finalised ruling and the compliance guideline in all ALDTs undertaken going forward.

If you need any advice relating to transfer pricing, please get in touch directly with these members of our Tax Advisory team:

Keerthiga Sharma, Manager, Tax Advisory (Sydney)

Anthony Patrk, Partner, Tax Advisory (Sydney)

John Baillie, Senior Partner, Tax Advisory (Melbourne)

Trevor Pascall, Senior Partner, Tax Advisory (Brisbane)

[1] TR 2020/4 Income tax: thin capitalisation - the arm's length debt test

[2] PCG 2020/7 ATO compliance approach to the arm's length debt test

[3] TR 2003/1 Income tax: thin capitalisation - applying the arm's length debt test