The thin capitalisation rules set a limit on the amount of debt that can be used to finance an entity’s Australian operations. The interest expense of an entity on the average adjusted debt amount that exceeds this threshold is denied for tax purposes. One of the tests under the thin capitalisation rules to determine an entity’s maximum allowable debt amount is the arm’s length debt test (ALDT). The ALDT focuses on determining the notional amount of debt the Australian business would reasonably be expected to have, and what independent commercial lenders would reasonably be expected to lend at arm’s length.
The Australian Taxation Office (ATO) has recently finalised the Taxation Ruling (TR 2020/4) and the Practical Compliance Guideline (PCG 2020/7) on the ALDT. The earlier Taxation Ruling (TR 2003/1) has been withdrawn.
Unlike its predecessor, the TR 2020/4 is a public ruling and is legally binding. It provides interpretive guidance on technical issues that may arise while undertaking the ALDT. The TR 2020/4 does not include the six-step methodology, which was included in the earlier ruling. Rather, TR 2020/4 focuses on considering all the factual assumptions and relevant factors listed in Division 820 of Income Tax Assessment Act 1997 to determine the arm’s length debt amount.
The ruling confirms the ALDT is an annual test, however, it allows certain instances where prior year ALDT analysis may be broadly relied upon in the current year. The ruling also notes the option to rely on the ALDT is not a decision that is binding and irrevocable once made. This potentially allows for reconsideration of the applicability of ALDT in situations where the thin capitalisation safe harbour test was initially relied upon.
PCG 2020/7 provides administrative guidance to taxpayers in applying the ALDT and applies to all income years commencing on or after 1 January 2019. It provides a risk assessment framework that outlines the compliance approach of the ATO to an application of the ALDT. The PCG 2020/7 also provides detailed guidance on the application of ALDT, including a structured series of considerations that are essential in producing a robust ALDT analysis.
The PCG 2020/7 includes the following five risk zones:
The white zone includes arrangements that have been reviewed by the ATO or the ATO has agreed to the ALDT outcome of a taxpayer. Taxpayers are encouraged to engage with the ATO to assess if their low-risk ALDT could potentially fall under this zone.
The green zone represents a “shortcut” method to determine the arm’s length debt amount. ALDTs which fall in this zone are not expected to be supported by documentation or analysis meeting the standards set out in the PCG 2020/7. However, documentation will be required to support the applicability of this risk zone.
All the following factors should be present in the case of an inward investing entity:
All the following factors should be present in the case of an outward investing entity:
All the following factors should be present in case of specific entities operating in the regulated utilities industry:
An ALDT will be considered to fall in the blue risk zone if it falls under the following circumstances:
Arrangements are considered to fall in the yellow risk zone if:
Arrangements are considered to fall in the red risk zone if:
The ATO considers the application of the ALDT as high risk requiring greater compliance resources. It has included the requirement to disclose the self-assessed risk rating under PCG 2020/7 in the Reportable Tax Position (RTP) Schedule. Taxpayers who are unable to or choose not to apply the PCG 2020/7 will also be required to disclose this in the RTP Schedule. We can expect increased compliance reviews based on the disclosure in the RTP Schedule.
The ATO considers PCG 2020/7 to represent the minimum standard expected of a comprehensive and robust ALDTs undertaken from 1 January 2019. As such, it is important for all taxpayers to consider the application of the finalised ruling and the compliance guideline in all ALDTs undertaken going forward.
If you need any advice relating to transfer pricing, please get in touch directly with these members of our Tax Advisory team:
Keerthiga Sharma, Manager, Tax Advisory (Sydney)
Anthony Patrk, Partner, Tax Advisory (Sydney)
John Baillie, Senior Partner, Tax Advisory (Melbourne)
Trevor Pascall, Senior Partner, Tax Advisory (Brisbane)
 TR 2020/4 Income tax: thin capitalisation - the arm's length debt test
 PCG 2020/7 ATO compliance approach to the arm's length debt test
 TR 2003/1 Income tax: thin capitalisation - applying the arm's length debt test