ATO Issues Draft Guidance on the Thin Capitalization Arm’s Length Debt Test

On August 28, 2019, the Australian Taxation Office (ATO) published Draft Practical Compliance Guideline (PCG) 2019/D3 which provides administrative guidance to taxpayers in applying the arm’s length debt test (ALDT) contained in the thin capitalization rules. The PCG can be found here.

The Draft PCG follows the release of Draft Taxation Ruling (TR) 2019/D2 which provides interpretative guidance on key technical issues that may arise in applying the ALDT. TR 2019/D2 was discussed in the April 2019 issue of Duff & Phelps’ Transfer Pricing Times.

PCG 2019/D3 and TR 2019/D2, once finalized, will replace existing Taxation Ruling TR 2003/1 on applying the ALDT. The PCG will have effect from July 1, 2019.

The ALDT is typically only used when a taxpayer is unable to satisfy the safe harbour and worldwide gearing tests under the thin capitalization rules. It is the ATO’s view that it is uncommon for Australian businesses to be geared in excess of the safe harbour (60% of net assets) and accordingly the ALDT is more likely to be relied upon in an industry where it is common practice to operate with higher gearing levels at arm’s length. The example given in the PCG is regulated infrastructure entities, although our experience indicates that it is also not unusual for entities in the property industry or leasing industry to be highly geared (above the safe harbour).

The PCG provides a series of considerations for applying the ALDT that represents the “minimum standard expected of a comprehensive and robust arm’s length debt test analysis”. The detailed guidance will replace the suggested 6-step methodology for determining an entity’s arm's length debt amount set out in TR 2003/1 which has provided a structured approach to applying the ALDT to date.

The PCG also provides a risk assessment framework that outlines circumstances that the ATO identifies as low risk and therefore will generally not allocate compliance resources to examine the ALDT analysis. The criteria vary for inbound businesses, outbound businesses and regulated utilities. For example, in the context of inward investing entities, a low risk zone will typically be assessed where the entity receives debt funding solely from a commercial lender that is not guaranteed or supported by an associate, and the entity has no foreign operations. All other cases will fall within a medium-high risk zone.

Taxpayers relying on the ALDT should self-assess their risk zone and review their ALDT position going forward in light of this new guidance.

Comments on the PCG are due by October 9, 2019.

Simplified Transfer Pricing Record Keeping Options (STPRKO) for Loans

On other debt related matters, on September 11, 2019 the ATO released an update to PCG 2017/2 in respect of the STPRKO for related party loans, to provide 2.33% as the maximum interest rate for low-level inbound loans and the minimum interest rate for low-level outbound loans for the 2020 income year. This reflects a significant decrease from 3.76% for the 2019 income year.

This published rate is determined based on the average five-year yield on AUD-denominated bonds issued by Australian BBB- rated corporates for the two weeks prior to the commencement of each income year on July 1 (as sourced from Bloomberg).

Taxpayers relying on the STPRKO for loans should review their continued eligibility in light of the decrease in the safe harbour rate. Where they no longer qualify, taxpayers will need to prepare robust transfer pricing documentation satisfying the legislative requirements to support the interest rate adopted.

Read Transfer Pricing Times – September 2019

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