On April 5, 2019, the Australian Taxation Office
("ATO") published Draft Taxation Ruling TR 2019/D2
(Ruling) setting out the ATO's preliminary views on the
application of the arm's length debt test ("ALDT")
contained in the thin capitalization rules enacted in 2001. This
ruling can be found here.
The purpose of this Ruling is to provide interpretative
guidance on key technical issues that may arise in applying the
ALDT and is intended to have retrospective application.
In addition to TR 2019/D2, the ATO is planning to release a draft
practical compliance guideline which will provide
administrative guidance to taxpayers in applying the test.
This will include a schedule outlining risk indicators for the
application of the ALDT.
The Ruling, along with the planned draft practical compliance
guideline, will replace existing Taxation Ruling TR 2003/1 on
applying the ALDT. TR 2003/1 provides a suggested six step
methodology that could be used for determining an entity's
arm's length debt amount. TR 2019/D2 states that the six-step
methodology will not be replicated in the planned guideline and
instead will set out new guidance.
TR 2019/D2 reaffirms much of the guidance contained in TR 2003/1,
with a couple of notable additions. The first of these is the
relevance of shareholders in applying the ALDT. The Ruling asserts
that the subjective leverage preferences of shareholders should be
disregarded on the basis that an objective assessment is required
for the ALDT and neither the legislation nor the Explanatory
Memorandum refer to the shareholders of the entity. Curiously, the
factual assumptions under the legislation explicitly outline the
factors that are required not to be taken into account, and this
list does not include shareholder preferences. On this basis, an
argument can be made that shareholder preferences should not be
ignored.
The second area is the interaction between the ALDT and
Australia's transfer pricing rules of Subdivision 815-B. While
the arm's length debt test is the same as other arm's
length tests in that it postulates what separate enterprises
dealing at arm's length with each other would do, the Ruling
notes that there are important differences in the respective
statutory frameworks. In particular, application of the ALDT must
assume no guarantee, security or other form of credit support
(explicit or implicit) is provided by associates and that the only
business is the Australian business of the entity (i.e. excluding
holding of associate entity debt, controlled foreign entity debt or
controlled foreign entity equity). No equivalent requirement exists
in evaluating the arm's length conditions, including debt
amount, for transfer pricing purposes. Accordingly, the pricing of
a financing arrangement for transfer pricing purposes would not
necessarily be accepted as arm's length for the purposes of the
ALDT and vice-versa. For example, the construct of the hypothetical
Australian business and assumption of no credit support could
result in a higher interest cost under the ALDT than would apply
under the transfer pricing rules. This, in turn, would lead to
lower serviceability and hence a lower arm's length debt
amount.
Taxpayers relying on the ALDT should consider their positions in
light of the Ruling and draft compliance guideline once published
and review existing ALDT documentation in light of this new
guidance.
Comments on the Ruling are due by May 31, 2019.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.