By Leslie Prescott-Haar & Stefan Sunde, TP EQuilibrium | AustralAsia LP
The Australian Tax Office on 4 June released Taxation Determination 2019/10 which deals with the interaction between the debt and equity rules in Division 974 of the Income Tax Assessment Act 1997, and the transfer pricing rules in Subdivision 815-B of the Income Tax Assessment Act 1997.
The Taxation Determination applies to income years commencing on or after 29 June 2013, which aligns with the commencement of Subdivision 815-B.
TD 2019/10 confirms that the debt/equity rules in Division 974 do not limit the operations of the transfer pricing rules and that the debt/equity rules apply to classify financing arrangements as either debt or equity by reference to the arm’s length conditions, not the actual conditions.
This is on the basis that Subdivision 815-B explicitly states that nothing in the income tax legislation limits the operation of the transfer pricing rules other than the provisions of Subdivision 815-B (refer Section 815-110(1)).
The Taxation Determination also provides three examples to illustrate the implications of arm’s length conditions, for purposes of the debt/equity and transfer pricing rules.
These examples are briefly outlined below.
Outbound interest-free loan
The first example considers an instance where an Australian parent company provides a loan to a distressed foreign subsidiary, whereon interest will not accrue until such time as the foreign subsidiary resumes a profit-making position.
Under such circumstances, the outbound loan would not satisfy the debt test as the foreign subsidiary does not have a non-contingent obligation to pay interest on the loan.
The loan would instead satisfy the equity test because the Australian company’s receipt of interest on the loan is contingent on the economic performance of its subsidiary.
Thus, any interest received by the Australian parent would be non-assessable, non-exempt income under Subdivision 768-A of the Income Tax Assessment Act 1997.
Had arm’s length conditions operated, the ATO deems that there would be a loan with interest that would have accrued from the commencement of the loan, and hence would give rise to additional Australian interest income.
Discretionary interest payments
The second example considers an instance where a foreign parent makes a loan to its Australian subsidiary.
The inbound loan carries no obligation to pay interest; however, the Australian subsidiary can, at its sole discretion, pay interest on the loan, accruing at a rate of 10% per annum, but which is non-cumulative.
Again, the inbound loan would not satisfy the debt test as the Australian subsidiary does not have an effectively non-contingent obligation to pay interest.
The loan would instead satisfy the equity test because it carries a right to pay at the discretion of the Australian subsidiary.
Had the arm’s length conditions operated, the foreign parent would have made a loan to the Australian subsidiary with interest on the outstanding principal accruing periodically, with an obligation to pay at the end of the term, and the ATO would deem an interest withholding tax liability on the interest assumed to have been charged.
Start up interest-free loan
The third example considers an outbound interest-free loan made by an Australian parent to a foreign subsidiary. The subsidiary is in the exploration stage of a mining business, and would not have been able to obtain third-party debt financing from an unrelated party.
Under arm’s length conditions, the ATO argues that the Australian parent would have made a capital contribution to its subsidiary, rather than a loan.
However, as there is no transfer pricing benefit under the arm’s length conditions, Subdivision 815-B does not operate, and the classification of the arrangement as a debt interest is not affected, as the ATO would not deem interest income to the Australian parent.
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