By Dr. Harold McClure, New York City
Tax authorities have relied on a variety of approaches to limit interest deductions, including challenges to intercompany interest rates under the arm’s length standard and thin capitalization rules.
The Australian Taxation Office (ATO) has approached the issue of thin capitalization with its arm’s length debt test. The ATO published guidance under TR 2020/4 and PCG 2020/7 on August 12.
Under the new Australian rules, the maximum allowable debt is the greatest of a safe harbor debt amount, a worldwide gearing debt amount, or an arm’s length debt amount. The safe harbor allows debt to be 60 percent of the enterprise’s assets.
Under the new Australian rules, the maximum allowable debt is the greatest of a safe harbor debt amount, a worldwide gearing debt amount, or an arm’s length debt amount. The safe harbor allows debt to be 60 percent of the enterprise’s assets.
Gearing refers to the amount of an enterprise’s assets that are financed by debt versus equity, so the second criteria would limit the percent of the Australia assets that are financed by debt to the debt-to-asset ratio of the worldwide multinational.
Oil and gas multinationals such as Chevron and Exxon tend to have modest debt to asset ratios, but other extractive enterprises such as fracking companies and mining multinationals may rely on an extensive amount of debt financing.
Action 4 of the OECD/G20 base erosion and profit shifting (BEPS) initiative suggested a group ratio rule defined as the ratio of third-party expenses relative to operating profits for the multinational.
The BEPS group ratio rule differs from a worldwide gearing debt approach as it must consider the borrower’s interest rate as well as its return to assets. We will note this distinction below in an illustration based on the massive Gorgon project in Australia.
Action 4 of the BEPS initiative also suggested a fixed ratio rule that would limited interest expenses to a specified percent of operating profits, such as 30 percent.
The ATO notes that an independent Australian business would incur debt in excess of 60 percent only in a limited number of circumstances.
The ATO also recognizes that companies in a few sectors, such as regulated utilities, have high debt to asset ratios. APA Group is Australia’s largest natural gas infrastructure business and provides electricity as a regulated utility. Its liabilities represent approximately 75 percent of its assets.
Arm’s length debt test
The Australian guidance considers many factors to determine whether an extensive amount of debt financing would be warranted under the arm’s length debt test.
The guidance notes there is no single approach to satisfy this test as it depends on the facts and circumstances of the borrowing entity.
The guidance sets forth two basic questions. The borrower’s test asks what amount of debt would the entity reasonably be expected to have. The lender’s test asks what would independent commercial financial institutions reasonably be expected to lend that amount to the entity under terms and conditions that would reasonably be expected if the lenders and the entity were dealing at arm’s length.
The guidance sets forth two basic questions. The borrower’s test asks what amount of debt would the entity reasonably be expected to have. The lender’s test asks what would independent commercial financial institutions reasonably be expected to lend that amount to the entity under terms and conditions that would reasonably be expected if the lenders and the entity were dealing at arm’s length.
The guidance suggests an analysis of these tests should be performed. This analysis should include the nature of the Australian business, the contractual terms of any borrowings, and an analysis of the credit rating of the borrower.
The analysis might also present the extent of financing by similar companies in the same sector of the Australian borrowing entity.
In an earlier MNE Tax article, we addressed chapter 9 of the United Nations Practical Manual on Transfer Pricing for Developing Countries. This chapter discussed both the pricing of intercompany loans as well as the thin capitalization issues.
The UN transfer pricing manual notes that one way that tax authorities may limit intercompany interest deductions is to recharacterize debt as equity. This approach seems to be at the heart of the “accurate delineation of the transaction” discussions in the OECD transfer pricing guidelines on financial transactions.
While the UN transfer pricing manual noted this accurate delineation of the transaction concept, its focus was more on the approach in the guidance developed as a result of Action 4 of the OECD/G20 base erosion and profit shifting (BEPS) plan, which proposed fixed ratio and group ratio rules.
The ATO approach is to propose to limit the extent that assets can be financed by debt and to scrutinize intercompany interest rates under the arm’s length standard.
Our earlier discussion also focused on the interest rate issue and closed with an illustration based on Australia’s Gorgon project.
The Gorgon gas project is a natural gas project in Western Australia which involves a massive amount of intercompany financing. Affiliates for Exxon and Royal Dutch Shell each have 25 percent stakes in this project, and several minor players have shares that approximate 2.5 percent of the projects. An Australian affiliate of Chevron has a share that is nearly 47.5 percent of this project.
Our illustrative example assumed that the total assets for these entities is AUS $60 billion, which is financed by $40 billion in intercompany debt.
If the interest rate on this debt were 5 percent, then interest deduction would be AUS $2 billion per year. If the return on these assets is 10 percent, operating profits would be AUS $6 billion, which would imply that interest deductions would represent 33.33 percent of operating profits.
The ATO could limit the interest deduction to 30 percent of operating profits in a couple of ways. Our earlier discussion suggested that the ATO could argue that the arm’s length interest rate should be only 4 to 4.5 percent.
The ATO might also question whether the Australian business would have incurred more than AUS $3.6 billion in debt under arm’s length debt test. Even if the ATO accepted the 5 percent interest rate, limiting debt to the safe harbor where allowable debt would represent 60 percent of assets would lower interest deductions from $2 billion to $1.8 billion.
Multinationals with Australian affiliates that incur extensive debt face two challenges from the ATO. The traditional challenge is the need to document that an intercompany interest rate is consistent with the arm’s length standard. The other challenge is the need to document the debt to asset ratio satisfies Australia’s thin capitalization rules.
It’s nice. Responding to BEPS Action No. 4, Indonesia also since 2016 issued Regulation of The Minister of Finance No.169/PMK.010/2015 about Determination of Corporate Taxpayer’s Debt to Equity Ratio for Income Tax Calculation Purposes to Limit Base Erosion via Interest Deduction .The maximum debt to equity ratio is four to one (4:1).