Arm’s length debt test – New ATO position finalised

The ATO has simultaneously published two documents which now represent the ATO’s views on the application of the arm’s length debt test (“ALDT”) in determining borrowing capacity.

• TR 2020/4: thin capitalisation – the arm’s length debt test is now the ATO’s authoritative ruling on the ALDT though it focuses on key technical interpretative issues rather than setting out a practical approach.
• PCG2020/7: ATO compliance approach to the ALDT outlines the ATO’s compliance approach to the ALDT, and includes a colour-coded risk assessment framework.

Taxpayers who apply (or are considering applying) the ALDT in determining their maximum allowable debt for thin capitalisation purposes should consider both documents.

As mentioned in our earlier article, groups relying on the safe harbour debt amount that have been adversely impacted by COVID may wish to consider relying on the “simplified ALDT” approach which will be less onerous than a typical analysis.

ALDT within thin capitalisation regime

The ALDT is generally an under-utilised option under the thin capitalisation rules – with the vast majority of Australian multinational entities relying on the safe harbour debt amount.

Broadly, the ALDT requires a notional amount of debt to be determined (having regard to certain prescribed “factual assumptions” and “relevant factors” relating to the Australian business) that satisfies two requirements:

• the entity would reasonably be expected to have the notional amount of debt as addressed from the borrower’s perspective; and
• the notional amount of debt would reasonably be expected to have been provided to the borrower from the perspective of independent commercial lending institutions (“CLIs”).

As a general observation, the ATO is known to have had concerns about groups relying upon the ALDT due to a perception it has been misapplied – though it is an option which is statutorily available to taxpayers to rely upon subject to meeting the requirements. For some groups, it may become a necessity, if existing leverage is to be retained in the face of balance sheet pressure arising from COVID-19.

Taxation ruling on ALDT – TR 2020/4

This ruling largely reflects the same principles as set out by the ATO in its earlier draft ruling from August 2019. It again reaffirms that TR 2003/1 (which sets out a six-step approach to applying the ALDT) has been withdrawn and is replaced by a combination of TR 2020/4 and PCG 2020/7.

Some of the key points in this new ruling are as follows:

• The “would reasonably be expected to” tests require an objective assessment of the circumstances of a hypothetical reasonable borrower and CLI.
• If a borrower “could” take on more debt, this does not mean it “would” (as the legislation requires). A borrowing decision of the entity will be influenced by the overall cost of funding and the need to ensure an appropriate return to equity investors.
• Put another way, the ALDT does not allow identification of the highest debt amount that could possibly be taken on – the amount of debt must be probable.
• There are important differences between the arm's length principle as expressed in the transfer pricing rules and how it is expressed in the thin capitalisations rules. For example, for purposes of the ALDT,  the borrower should be considered on a standalone basis, without regard to its status as a member of a global group¹. For instance, any explicit or implicit parental support must be disregarded.
• The assessment of the ALDT (including factual assumptions and relevant factors) must occur annually and could change.

TR 2020/4 applies to years of income commencing both before and after its date of issue.

ATO compliance approach - PCG 2020/7

The primary purpose of PCG 2020/7 is to provide guidance to entities in applying the ALDT. Secondarily, it also provides a risk assessment framework that outlines the ATO's compliance approach to the ALDT depending on where a taxpayer falls within this framework.

The ATOs view in the PCG is that there are limited circumstances in which an independent Australian business would gear in excess of 60% of its net assets, outside specific industries. Therefore, where the ATO is concerned that either the arm’s length debt amount is too high or, from its own data and analysis, that the application of the ALDT is inappropriate, it will apply compliance resources to review a taxpayers assessment of the ALDT. 

Against this, it should be remembered that the statutory scheme allows taxpayers to choose which thin cap option provides them with the greatest borrowing capacity – and the ALDT is a legitimate option. Undoubtedly though, groups wishing to do so should engage in a considered analysis of the ALDT. For instance, it is quite clearly insufficient to simply provide evidence that a bank was prepared to lend the amount of debt drawdown.

PCG 2020/7 applies to years of income commencing on or after 1 January 2019².

Guidance in applying the ALDT

The guidance in PCG 2020/7 sets out what the ATO considers to be an appropriate approach to applying the ALDT.  However, it also states that such guidance represents a minimum standard with respect to the level of analysis and evidence the ATO expects of a comprehensive and robust analysis³.

The PCG devotes 30 pages to describing its approach, including:

• How to construct the notional Australian business having regard to all factual assumptions;
• How to determine arm’s length terms and condtions with respect to any debt interests that would reasonably be expected to have applied if the entity and the CLIs had been dealing at *arm’s length with each other;
• How to determine an amount of debt the notional Australian business would reasonably be expected to borrow and CLIs would reasonably be expected to lend having regard to all relevant factors; and
• Providing a worked example (although caveated by the ATO saying that the example does not reflect the detailed level of analysis or evidence required⁴).

Where there is insufficient evidence presented to the ATO to support an entity’s arm’s length debt amount, the Commissioner may seek to amend the entity’s assessment to substitute an alternative debt amount.

The “low risk” zone in PCG 2020/7 will not include many groups as it broadly comprises (i) inbound debt solely from unrelated parties which is not guaranteed by a related party, (ii) debt issued by ASX-listed entities; and (iii) debt issued by regulated utilities groups.

At the other end of the spectrum, the “high risk” zone includes entities that have no performed an ALDT consistently with the guidance provided in the PCG or there are arrangements with two or more of the following:

• cross-border related party debt comprises more than 50% of the notional Australian business' debt capital
• subordinated cross-border related party debt comprises more than 25% of the notional Australian business' debt capital
• two years of positive (unadjusted) earnings before interest and tax (EBIT) and negative profit before tax (PBT) during the previous five-year period.

Significantly, entities falling within the “high risk” zone are not eligible to enter the ATO’s Advance Pricing Arrangement (APA) program. Further, the ATO has also indicated it is likely to use its formal powers for information gathering ⁵.

In between, the “medium risk” zone is only available to taxpayers that have performed an ALDT consistently with the guidance provided in the PCG and where facts and circumstances pertaining to the high-risk zone are not present.  However, even in such cases, the ATO says it may apply compliance resources to review a taxpayer’s ALDT analysis.

Practically, if the ALDT is applied on related-party debt (or third-party debt with a related-party guarantee), the position will automatically be considered at least medium (provided it is not “high risk”) irrespective of the debt quantum or gearing level. The ATOs reasoning behind this approach is that because an ALDT assessment requires a robust and complex analysis, it, therefore, poses a high risk of non-compliance.

RSM Insights

PCG 2020/7 adopts a one size fits all approach as no consideration is given to whether the relevant entity is a small-medium multinational enterprise (SME) or a significant global entity (SGE).  As such, a significant compliance burden could arise for SMEs seeking to apply the ALDT in the way described in the PCG.

The range of low-risk arrangements is narrow and the majority of taxpayers seeking to apply the ALDT are likely to fall in categories where the ATO states it will apply compliance resources to review their position.

In this respect, entities that perform an ALDT consistently with the guidance provided in the PCG should be mindful that they are unlikely to be rated lower than “medium risk”.  As such, the likelihood of ATO compliance activity cannot be disregarded. 

By contrast, entities that do not perform an ALDT consistently with the guidance provided in the PCG will be rated “high risk” and can expect ATO compliance activity to be commenced as a matter of priortiy. This is particularly important for taxpayer’s required to complete a Reportable Tax Position schedule.

This does not mean that taxpayers' reliance upon the ALDT is unsupportable and the ALDT cannot be utilised. However, it does mean that taxpayers should anticipate potential ATO review and maintain robust evidence to support their reliance upon the ALDT. The PCG shows how the ATO expects this be done.

Reliance upon the ALDT, therefore, becomes a matter of risk appetite.

At a level of detail, the potential need to perform different arm’s length analyses under the thin capitalisation rules and the transfer pricing rules adds to complexity and will increase compliance costs.

Finally, early balancers who have lodged income tax returns for the year ended 31 December 2019 and have relied upon the ALDT should review their positions in light of PCG 2020/7.

HOW CAN RSM HELP?

If you have any questions regarding the Arm's Length Debt Test, please contact your local RSM tax expert.

^1. By contrast, membership of a global group was a relevant factor for purposes of the hypothetical independent entity in the transfer pricing rules considered in Chevron Australia Holdings Pty Ltd v Commissioner of Taxation [2017] FCAFC 62 at [62].

^2. Six months earlier than was indicated in the PCG 2019/D3.

^3. PCG 2020/7, paragraphs 13 and 51.

⁴. Ibid, paragraph 185.

⁵. Section 353-10 of Schedule 1 to the Taxation Administration Act 1953.