COVID-19 has had a pervasive effect on business and one of the most salient is its impact on a company’s cash flow and funding arrangements.
We have separately discussed general transfer pricing issues – here we consider the implications to Australian companies working capital management as well as new and existing long-term funding arrangements.
We also consider some opportunities for companies in pricing their intercompany funding arrangements that may no longer be able to rely on the safe harbour or worldwide gearing tests to determine their maximum allowable debt as a result of balance sheet impacts brought on by COVID-19.
As the discussion below sets out, some groups may now wish to consider applying the Arm’s Length Debt Test (“ALDT”) as an alternative to the safe harbour.
Cash flow management and intragroup funding
The Australian Government has already implemented several cash-flow measures to assist Australian business with their liquidity:
. Meanwhile, existing financing arrangements such as intragroup loans and external banking facilities will also be critical in supporting an entity’s financial requirements in the short-, medium-, and long-term.
Amid the coronavirus pandemic, the RBA announced an emergency rate cut in March and financial institutions are providing concessional payment terms to businesses as they negotiate short-term payment arrangements (backed by Government guarantee).
This has implications for existing intercompany financial arrangements including evaluation of:
the interest rate;
repayment schedule; and
advancement of additional funds.
Multinational groups may want to review the terms of the existing international related party financing arrangements. Given the current strain on business cash flow and concessions offered by commercial lending institutions, opportunities may exist to renegotiate the interest rates on existing lending arrangements consistently with approaches being taken by commercial lenders.
Similarly, opportunities may exist to re-evaluate or re-negotiate the repayment schedule on existing related party financing in line with current market (arm’s length) conditions. For example, extending the term of existing loans or temporarily deferring loan repayments may assist with managing cashflow.
Advancement of additional funds
The advancement of additional funds may be vital to support multinational group entities (including their Australian operations) in meeting their financial commitments. It is important that any new or extension of existing lending arrangements are evaluated to ensure they are consistent with current market (arm’s length) conditions (eg interest rate, term, currency, repayment schedule, security, priority). Additionally, a consideration could also arise as to whether a purported new loan could be recharacterised as equity under the transfer pricing reconstruction rules.
Furthermore, a review of the intercompany agreements which form the basis of the financing arrangement may need to be undertaken to determine the application of any force majeure clause. This may lead to a temporary suspension of certain obligations under a company’s contracts and agreements.
Changes to existing arrangements
Changes in policies or pricing may be defensible in the short-term in light of the current economic environment. However, any changes to intra-group policies are likely to be closely scrutinised by tax authorities regarding their start date and whether the change was made BC (Before COVID) or AD (After Disaster).
Businesses must be aware that while tax authorities are currently offering concessional administrative support and assistance, they will begin to scrutinise tax matters more closely as Governments feel their own cash flow pressures. There is widespread evidence of this occurring post-GFC. Therefore, any change in intragroup policy will be closely monitored and considered from a risk perspective.
We recommend that where taxpayers modify existing policies or develop new policies in response to COVID-19 that they are commercially and economically sound and are substantiated through robust documentation to ensure that any changes from the existing policies are validated and are at hand in the event of review.
ATO approach/concessions in relation to thin capitalisation
For the tax years encompassing the months of February/March 2020, some taxpayers may no longer be able to rely on the safe harbour or worldwide gearing tests to determine their maximum allowable debt as a result of balance sheet impacts brought on by COVID-19. These balance sheet impacts may be as a result of impairment of asset values or short-term draw downs on debt facilities as a direct result of COVID-19’s impacts on revenues.
The ATO has indicated it will provide some flexibility in their administration of the thin capitalisation rules. In this regard, the ATO has helpfully offered some free “tax advice” in relation to the safe harbour and worldwide gearing tests and also developed a concessional administrative approach for the arm’s length debt test (ALDT).
ATO “tax advice”: Safe harbour and worldwide gearing tests
The ATO is encouraging taxpayers to explore the use of alternative measurement periods in testing the suitability of the safe-harbour or worldwide gearing tests. For the purpose of calculating average values for thin capitalisation amounts, the selection of alternative valuation measurement periods may allow a degree of smoothing of values in situations where wide variations have occurred throughout the income year.
ATO administrative approach: “simplified” ALDT
Taxpayers who will otherwise need to rely on the ALDT for the relevant year, as a direct consequence of COVID-19, can expect the ATO will not dedicate compliance resources to reviewing the application of arm’s length debt test if the requirements set out below are met, other than to verify that the use of the ‘test’ was directly related to a COVID-19 reflex.
The requirements for the simplified ALDT approach include:
- The safe-harbour test would have been satisfied but for the COVID-19 related balance sheet impacts.
- It is still expected that the taxpayer will use best endeavours to apply all criteria of the arm’s length debt test.
- For entities which are classified as inward investing entities (and not also outward investing entities), no additional related party funding is received (other than short term (<12 months) debt facilities). In these instances, the ATO expects any new capital to be equity.
- The use of the ALDT by inward investing entities is not required because dividends were paid, thereby weakening the Australian balance sheet.
The ATO has also indicated that it will take a balanced approach to matters such as record keeping and timing of the creation of records for the purposes of the simplified ALDT. For example, while taxpayers should attempt to prepare documentation supporting the application of the ALDT, the ATO will not apply compliance resources to determine if the documentation satisfies the standards set out in draft PCG 2019/D3.
The ATO is also encouraging taxpayers whose economic circumstances are expected to persist over the longer term, and where the ALDT is likely to be relied upon beyond the income year that includes February/March 2020, to discuss their circumstances with the ATO.
For more information
If you have any questions or require further information, please contact Liam Delahunty, director of international tax and transfer pricing today.