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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.