Australia provides arm’s length debt test guidance

By Leslie Prescott-Haar & Stefan Sunde at TP EQuilibrium AustralAsia

The Australian Tax Office on 28 August, released its awaited draft guidance contained in Practical Compliance Guideline 2019/D3, on applying the arm’s length debt test contained in Division 820 of the Income Tax Assessment Act 1997, Australia’s thin capitalization statutory provisions.  

It is noted that taxpayer application of the arm’s length debt test is currently a key focus of the Australian Tax Office.

Once finalised, the guidance will have effect from 1 July.

While not the focus of this article, the authors note that this PCG guidance should be read in conjunction with, in particular, draft Taxation Ruling 2019/D2 Income tax: thin capitalisation – the arm’s length debt test, which replaces Taxation Ruling 2003/1. 

In addition to draft OECD guidance in respect of finance transactions, and Australian / international case law relating specifically to controlled financial transactions, the authors draw readers’ attention to various other Australian Tax Office rulings and guidance as may be applicable to a financial transaction, in particular Practical Compliance Guideline 2017/4 .

With such developments, the taxation treatment of financial transactions in Australia has become complex and challenging to navigate, notwithstanding the Australian Tax Office’s stated intention to simply provide guidance to multinationals.

Regrettably, more recent guidance does not expressly address Australian requirements of arm’s length terms and conditions for financial transactions under Subdivision 815-B (the transfer pricing provisions), nor the more fundamental question of debt versus equity classification of financial arrangements under the accurate delineation provisions of the OECD Guidelines. 

Choosing to apply the arm’s length debt test

The arm’s length debt test is one of the statutory provisions available to determine an entity’s maximum allowable debt for Australian thin capitalisation purposes.

The test can be used when an entity does not satisfy the safe harbour and worldwide gearing tests and, in such case, the test must be applied on an annual basis.  Hence, annual testing could result in a debt amount that was supportable in the initial income year, but not supportable in subsequent periods.

The arm’s length debt test, where satisfied, allows entities to support debt deductions for commercially sustainable debt levels in excess of that otherwise allowable under the thin capitalisation provisions.

 The definition of debt includes both commercial third party, and related party debt. However, the Australian Tax Office is of the general view that related party debt significantly increases an entity’s tax risk profile.

The Australian Tax Office notes that the application of this materially detailed and arguably complex test is at taxpayers’ discretion, and not relevant for the vast majority of taxpayers which would not gear in excess of 60% of net assets. The Tax Office guidance states that most arm’s length debt analyses are unlikely to support gearing in excess of 60% of net assets in any event. 

Applying the arm’s length debt test is dependent on the facts and circumstances of a particular business, acknowledged by the Australian Tax Office, and further reinforcing the need for robust quantitative and qualitative analysis, as well as thorough documentation thereof.  

In this regard, the options available to the borrower and the optimal capital structure for the Australian business must be addressed. However, the test itself is not a transfer pricing analysis, while it draws on transfer pricing-type analyses, nor does it necessarily reflect an outcome consistent with the arm’s length conditions under Subdivision 815-B.

The arm’s length debt analysis must be conducted from the perspectives of both the borrower and commercial lender, and must satisfy both perspectives. If the arm’s length amount of debt determined from the commercial lender’s perspective is less than that from the borrower’s perspective (or visa versa), the lesser arm’s length debt amount computed shall be the determining debt amount.

As stated by the Australian Tax Office, the analysis undertaken and documented must support the conclusion that the relevant debt amount (on arm’s length terms and conditions) would ‘reasonably be expected’ under the borrower’s test and the independent lender’s test.

The Practical Compliance Guideline’s designated compliance approach, broadly, operates in a manner similar to other self-assessed risk ratings approaches recently released by the Australian Tax Office. That said, as alluded to above, the Tax Office generally views application of the debt test as having at least a moderate if not high risk of non-compliance.

Risk Zones

Three separate risk zones have been identified: white (no risk), green (low risk), and yellow (medium to high risk).

As for other similar guidelines, white zone categorisation is typically satisfied where the transactions are covered by advance pricing agreements, reviews undertaken post 1 July 2019 leading to low risk ratings, settlements, or court decisions, or a proactive approach to the Australian Tax Office by the taxpayer which reaches agreement on low risk.

To otherwise be categorised in the green low risk zone, taxpayers must satisfy all relevant criteria as either inward debt recipients, outward debt funders, or special conditions as a regulated utility business. The regulated utility business category may be expanded over time.

For inward debt recipients, the following must be satisfied:

• the entity receives debt funding solely from a commercial lending institution(s) that is not an associate of the entity, dealing at arm’s length; and
• the entity operates an Australian business only and has no foreign operations; and
• the entity is not an associate entity of another Australian entity that is an outward investor; and
• the entity receives no guarantee, security or other form of explicit credit support from an associate.

For outward debt funders, the following must be satisfied:

• the entity is a widely held publicly-listed entity on the Australian Securities Exchange; and
• the entity is an outward investing entity (and not also an inward investing entity); and
• it can be shown that the entity’s notional Australian business would have the same issuer credit rating as the actual entity did in fact have, where the entity’s actual rating has been assessed in accordance with the criteria of an internationally recognised credit rating agency and encompasses the entire global group’s operations.

For regulated utility business, it must be satisfied that the entity:

• has a net debt to regulated asset base leverage equal to, or less than 70%, during the relevant year; and
• has a cash flow from operations interest cover ratio equal to, or greater than 2.7 times, during the relevant year.

Failure to satisfy a low risk categorization does not carry the presumption of a failure to comply with Australian tax law. However, entities which fall outside the white and green zones can anticipate greater compliance resources to be applied by the Australian Tax Office to review their arrangements.

Extensive guidance is then provided in respect of applying the arm’s length debt test for self-assessment of the risk rating, based on a three-step process, summarised below.  It is noted that for various taxpayers, such risk rating will be disclosed on the Reportable Tax Positions form filed with the income tax return.

Step 1: The notional Australian business

As a first step in performing the arm’s length debt test, the tested borrower must be appropriately categorised as a notional Australian business, focusing on its Australian operations only. Thus, a stand-alone entity without regard for foreign activities or influences must be constructed, thus:

1. The impact of foreign ownership or business interests must be removed, including assets owned overseas; and
2. The impact of associated entity debt must be removed; and
3. The impact of foreign credit or guarantee support must be removed.

Thus, in constructing a notional Australian business, only those commercial activities conducted by the Australian business, in Australia, should be accounted for.

Step 2: Arm’s length terms and conditions

Comparables selection

Drawing on transfer pricing principles, a search for comparable uncontrolled companies should be carried out. Such should leverage the process outlined in the 2017 OECD Transfer Pricing Guidelines, and can reflect either broad or narrow search criteria, as required to satisfy an appropriate level of comparability to the notional Australian entity, but should focus on independent entities operating in the same industry in Australia, or comparable jurisdictions if there is insufficient Australian information.  For regulated industries, overseas regulated markets are not considered comparable.

The search should be comprehensively documented.

Terms and conditions that would reasonably be expected

It must then be established that the borrowing has been undertaken under arm’s length terms and conditions, with respect to the notional Australian business. In this regard, credit rating agency guidance and a careful assessment of key covenants of the debt agreement may be important to consider.

Arm’s length terms and conditions between the notional Australian business and the hypothetical commercial lender could differ from those terms and conditions between the actual borrower and lender, including even those concluded as ‘arm’s length’ under a general transfer pricing analysis. Accordingly, taxpayers cannot assume that a financing arrangement that is arm’s length for transfer pricing purposes is appropriate to rely on without undertaking analysis to ensure compliance with the arm’s length debt test.  

The extent to which adjustments are required to satisfy arm’s length terms and conditions will depend on the extent to which the actual lending’s terms and conditions are not commensurate with that identified as arm’s length between the notional Australian business and commercial lender.

Step 3: Consideration of all relevant factors

The high standard of analysis required under the arm’s length debt test means that all relevant factors should be considered in determining an arm’s length amount of debt from the perspectives of both the borrower, the notional Australian business, and the commercial lender. The objective of the test is to determine an amount of debt the notional Australian business would reasonably be expected to borrow, and commercial lending institutions would reasonably be expected to lend, on arm’s length terms and conditions, throughout the income year.

A series of both quantitative and qualitative factors has been included in the guideline, which taxpayers should be prepared to consider and document for each income year. Such quantitative factors include:

• The entity’s capacity to meet all its liabilities;
• The profit of the entity in relation to the Australian business;
• The return on capital of the Australian business; and
• The debt to equity ratio of the Australian business.

Further qualitative factors have been outlined:

• The functions performed, assets used and risks assumed;
• The terms and conditions of the debt capital the entity actually had;
• The nature of, and title to, any assets attributable to the Australian business available as security;
• The purposes for which the schemes for debt capital had actually been entered into;
• The debt to equity ratios of the entity, the Australian business, each associate entity that engages in commercial activities similar to the Australian business and each entity in which a direct or indirect interest is held;
• The commercial practices adopted by independent parties in the industry;
• The way in which the entity financed its commercial activities;
• The general state of the Australian economy throughout that year; and
• All of the above factors existing at the time the entity last entered into debt capital that remains on issue throughout that year.

Taxpayers can then attribute justified weightings to the factors above, or weigh relevant contributing factors equally.

The Australian Tax Office has suggested that qualitative factors be assessed as either adverse, neutral, or supportive of the notional Australian business’ borrowing position. In respect of qualitative factors, an arm’s length range of comparable data should be computed, and an assessment of the borrowing made thereon.

The Australian Tax Office accepts that where there are no changes year-on-year in respect of the notional Australian entity, and wider conditions under assessment, the prior income year’s assessment should be deemed appropriate. A degree of change of less than 10% should be applied.

The Practical Compliance Guideline concludes with an example of an arm’s length debt tested assessment carried out for a regulated utility business.

-Leslie Prescott-Haar – Managing Director, TP EQuilibrium AustralAsia

-Stefan Sunde – Manager, TP EQuilibrium AustralAsia