Key income tax developments in Australia - August 2020

ATO approach to the arm's length debt test contained in the thin capitalisation rules

On 12 August 2020, the ATO published Taxation Ruling TR 2020/4 and Practical Compliance Guideline PCG 2020/7 dealing with the application of the arm's length debt test contained in the thin capitalisation rules in Division 820 of the ITAA 1997. 

For both outward investing and inward investing non-authorised deposit-taking institutions (non-ADIs), the arm's length debt test is one of the options for determining the maximum allowable debt, constituting the limit on an entity's level of gearing for tax purposes (beyond which interest and other debt deductions may be denied under Australia’s thin capitalisation rules). 

Both publications, read in conjunction, replace former Taxation Ruling TR 2003/1 (notwithstanding there has been no legislative changes which would imply an alternative approach was required). Notably, the six-step method for determining an entity's arm's length debt amount in the former TR 2003/1 has not been replicated in either document.  Furthermore, TR 2020/4 applies retrospectively and prospectively, although it will not apply to taxpayers to the extent that it conflicts with the terms of a settlement of a dispute agreed to before 12 August 2020.  

With respect to its retrospective application, TR 2003/1 is not considered to be a "public ruling" (consistent with the terms of TR 2003/1), such that taxpayers whose arm's length debt amount was higher under TR 2003/1's six step methodology may not legally be able to rely on TR 2003/1 if the ATO were to successfully challenge the quantum of permissible debt (although it may be administratively binding on the ATO).

TR 2020/4 clarifies the ATO's view on the interpretation of key technical issues that are critical for applying the arm's length debt test. In particular, the following guidance is provided in the ruling:

• The arm's length debt test is a statutory test that requires the determination of a notional amount of debt to be arrived at after taking into account the facts and circumstances legislatively prescribed to exist.  Whether those facts and circumstances are in fact correct is irrelevant to the operation of the arm's length debt test.
• The meaning of the phrase "would reasonably be expected" is critical to applying the arm's length debt test and requires an objective assessment of the "probable" amount based upon evidence rather than a "prediction of a possible level of debt".  In other words, falling within a range of possible debt is not sufficient where a taxpayer is not able to demonstrate that the level of debt would be probable where the legislative prescribed facts and circumstances obtained.
• An amount that a borrower 'would' borrow is distinguishable from an amount the borrower 'could' borrow. The debt amount a borrower 'would' reasonably be expected to have will be influenced by other factors particular to the borrower including the overall cost of funding and the need to ensure an appropriate return to equity investors. The amount that a borrower could borrow is what the commercial lender would lend. 
• Consequently, the arm's length debt amount is a notional amount that has regard to the factual assumptions and relevant factors prescribed by law - it is not sufficient for taxpayers to rely on the fact that debt is in fact provided by an arm's length party as support for it satisfying the arm's length debt test.
• Usefully, the ATO has acknowledged that it may be reasonable for taxpayers to determine the arm's length debt amount in the light of the actual value of assets (e.g., the market value), as distinct from the accounting value (among other considerations).  
• Proper records must be prepared by an entity seeking to apply the arm's length debt test. A failure to keep the records legislatively required may result in the imposition of a penalty. However, this will not disallow the entity from relying on the arm's length debt test as the maximum allowable debt for the relevant income year, provided all other requirements are satisfied.

PCG 2020/7 provides guidance on applying the arm's length debt test and includes a risk assessment framework that outlines the ATO's compliance approach to applying the test. Consistent with other recent PCGs on financing issues, PCG 2020/7 also contains a colour-coded risk framework which highlights the limited circumstances in which the ATO considers taxpayers would be able to rely on the arm's length debt test and be considered "low risk".  The risk area a taxpayer falls in determines the ATO's perceived compliance risk, and is meant to act as an indication of the level of resources that will be deployed by the ATO to review the position.  In addition, taxpayers may be required to disclose whether they have self-assessed the risk rating of their application of the arm's length debt test (e.g., as part of a review), and will be required to disclose that position if they are required to be complete a Reportable Tax Position Schedule.

The following key views were expressed by the ATO in the guidelines:  

• There are very limited circumstances in which an entity would apply the arm's length debt test. In practice, the test is typically only used by very highly-geared entities that are unable to satisfy the safe harbour and worldwide gearing tests (such as certain regulated infrastructure entities). As a consequence, an application of the arm's length debt test is seen as posing a greater risk of non-compliance than the safe harbour and worldwide gearing debt tests. 
• The risk framework can be summarised as follows:

Risk Zone	Facts and Circumstances	ATO Treatment
White	Arrangements already reviewed and concluded.	No review other than to confirm ongoing consistency with the agreed/determined approach.
Low	For inward investors: the entity receives debt funding solely from a commercial lending institution/s that is not an associate of the entity; the entity and the actual lender/s must have been dealing at arm's length with each other in relation to the debt interests such that the debt is considered to be on arm's length terms and conditions or the entity has received part or all of its debt funding on back-to-back terms from an associate; the entity operates an Australian business only and has no foreign operations, for example, no foreign permanent establishments or controlled foreign entity equity; 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 investors:   the entity is a widely-held publicly-listed entity on the Australian Securities Exchange; 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 determined by an internationally-recognised credit rating agency and encompasses the entire global group's operations. For entities operating a regulated utility business: has a net debt to Regulated Asset Base (RAB) leverage equal to, or less than 70%, during the relevant year; and has a cash flow from operations (CFO) interest cover ratio equal to, or greater than, 2.7 times, during the relevant year.	No review other than to confirm you have satisfied the necessary criteria to fall within the low risk zone.
Low to Moderate	In the following circumstances: where the global group is publicly rated on third-party debt that is on arm's length terms and conditions and the notional Australian business would achieve the same credit rating on the basis of its arm's length debt amount; or an inward investing entity is owned by a consortium of foreign investors (each with no more than a 20% direct or indirect interest) and the public credit rating of the entity based on the entity's third-party debt (that is, on arm's length terms and conditions) is equivalent to the credit rating of the notional Australian business on the basis of its arm's length debt amount; and no other facts or circumstances pertaining to the high risk zone are present.	The ATO will actively monitor your arrangements using available data and will review arrangements by exception. Alternative dispute resolution (ADR) might be effective in resolving any areas of difference.
Medium	Arrangements that are not eligible for 'white', 'low' or 'low to moderate' risk zones, facts and circumstances pertaining to high risk zone are not present and, application of the arm's length debt test consistent with this Guideline.	The ATO may apply compliance resources to review your arm's length debt test in circumstances such as where:  the ATO is concerned, from their own data and analysis, that your circumstances do not justify use of the arm's length debt test to sustain an amount of debt capital in excess of the safe harbour or the arm's length debt amount is otherwise too high; your debt capital is subject to a broader review by the ATO in relation to provisions not addressed in this Guideline. Depending upon the outcome of the ATO's review, ADR might be effective in resolving any areas of difference, however in some instances it is anticipated that cases will proceed to review or audit.
High	Application of the arm's length debt test that is not consistent with the Guideline, or arrangements that have two or more of the following characteristics: 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.	Reviews are likely to be commenced as a matter of priority. Cases might proceed directly to audit. You will not be eligible to access the advance pricing arrangement program. The ATO is likely to use formal powers for information gathering. Practically, it will be more difficult to resolve disputes through settlement or ADR.

It should be noted that following the reduction of the safe harbour debt amount from a debt/equity ratio of 3:1 to 3:2 (from 1 July 2014), more taxpayers operate in industries where ordinary commercial gearing ratios exceed those permissible under the safe harbour debt amount.  It is likely that some of these taxpayers will be relying on the arm's length debt amount to ensure debt deductions are not denied under the thin capitalisation regime.

It is clear that the ATO considers that the arm's length debt test is likely to be able to be utilised by taxpayers in very few circumstances – particularly for outward investing entities (where the low risk zone requires the entity to be publicly listed on the ASX, for example).  

For taxpayers who have relied on TR 2003/1, consideration should be given to reviewing their historical tax positions, given that that document is not a public ruling, and the ATO intends to apply TR 2020/4 retrospectively. 

The ATO's approach to risk-rating taxpayers who utilise the arm's length debt amount may mean taxpayers should reconsider the strength of their arm's length debt amount position, or alternatively to consider their position under the worldwide gearing debt amount.

Finally, it is worth noting that the ATO has previously announced (in April 2020) that it will not be directing compliance resources to taxpayers which rely on the arm's length debt test in respect of income years which include February or March 2020 where those taxpayers have been directly affected by COVID-19 (e.g., where COVID-19 has resulted in asset impairments or increased borrowing to provide liquidity).  There are a range of requirements that need to be satisfied for this administrative concession to be available, including that the taxpayer would have satisfied the safe harbour debt test but for the impact of COVID-19 on the entity's balance sheet, no additional related party debt has been provided (in the case of inward investing entities), no dividends have been paid, and the taxpayer uses best endeavours to apply all the criteria contained in the arm's length debt test.  

Arrangements involving interposed offshore entities to avoid interest withholding tax 

On 14 August 2020, the ATO released Taxpayer Alert TA 2020/3 addressing arrangements involving interposed offshore entities to avoid interest withholding tax. The ATO announced that it is reviewing arrangements that typically display the following features:

• an Australian resident flow-through trust with one or more non-resident investors; 

• the non-resident investor holds its interest in the resident trust through an interposed offshore entity (usually in a third jurisdiction which is a low or no tax jurisdiction and which is not part of the Australian tax treaty framework);
• the interposed offshore entity (being a beneficiary of the Australian flow through trust) is financed in part or in whole by (usually, related-party) debt;
• the interest rate on the debt is at a significant premium to referrable third-party debt, or the lending entity's cost of funds (and the arrangement would usually fall outside the 'green zone' referred to in PCG 2017/4);
• the resident trust derives Australian-sourced income and makes distributions to the interposed beneficiary; and
• the interposed beneficiary deducts the interest expense against the Australian income it receives from the trust.

An example of a scenario the ATO is concerned about is as follows:

 

The ATO is concerned that arrangements with these features may be entered into to avoid interest withholding tax liabilities, as compared to (for example) related party debt being provided to the Australian trust. The ATO considers some of these structures display some or all of the following features:

• There appears to be no commercial rationale other than tax reasons to support the interposition of a non-resident beneficiary and/or the jurisdiction of that beneficiary.
• There appears to be no commercial rationale other than tax reasons why the debt used for Australian business purposes should be borne by the non-resident beneficiary.
• The effective tax rate on Australian-sourced income is minimal or zero.
• The beneficiary's capital structure maximises debt deductions under the thin capitalisation rules in Division 820 of the ITAA 1997.

The ATO is currently reviewing these arrangements and engaging with taxpayers who have entered into or are considering entering into these arrangements.

Taxpayers who enter into these types of arrangements will be subject to increased scrutiny, and refunds claimed by taxpayers may be withheld until assurance is obtained concerning the relevant structures.

If you have entered into, or are contemplating entering into, an arrangement of this type, detailed consideration should be given to the Taxpayer Alert in the light of your particular circumstances.

Cross-border related party financing arrangements and related transactions

On 12 August 2002, the ATO published Practical Compliance Guideline PCG 2017/4DC2, which is a draft consolidated PCG which contains a new draft schedule (Schedule 3) relating to cross-border interest free loans.

In general, the ATO considers that there is a high transfer pricing risk with outbound interest-free loans between related parties. As may be expected, this is because loans are not generally provided by independent parties on an interest-free basis. Based on the current draft, an outbound interest-free loan would generally qualify with an amber (high risk) or red (very high risk) rating under this guideline.

There are some exceptions to this, such as where the transfer pricing regime would regard it as appropriate to treat the interest free loan as an equity contribution. In order to reduce the amber/red risk classification, taxpayers will generally need to being able to show that one of the alternatives in each of the following are satisfied:

(a) It can be evidenced that either:

• The rights and obligations of the provider of funds are effectively the same as the rights and obligations of a shareholder; or
• The parties had no intention of creating a debt with a reasonable expectation of repayment and, therefore, did not have the intent of creating a 'debtor–creditor relationship'; and

(b) It can be evidenced that either:

• The intentions of the parties are that the funds would only be repaid or interest imputed at such time that the borrower is in a position to repay; or
• The borrower is in a position where it has questionable prospects for repayment and is unable to borrow externally. 

Although the approach to related party interest free outbound loans may be expected, the updated draft PCG is a demonstration that the ATO's simplified approach to risk classifying financial arrangements is here to stay.  And since taxpayers may be required to provide risk weightings to the ATO as part of compliance reviews or in Reportable Tax Schedules (subject to the operation of legal professional privilege), taxpayers should prepare to defend positions where they do not fall within low-risk categories.

OECD hybrid mismatch rules - targeted integrity rule

On 8 July 2020, the ATO published Law Companion Ruling LCR 2019/D1 regarding the hybrid mismatch targeted integrity rule in Subdivision 832-J of the ITAA 1997. This draft ruling has been reissued to take into account the amendments to the targeted integrity rule (and other provisions impacted by the rule's hypothetical operation), contained in Parts 1 and 3 of Schedule 1 to the Treasury Laws Amendment (2020 Measures No. 2) Act 2020.

By way of background, the targeted integrity rule affects financing structures in which an entity in a low tax jurisdiction (10% or less tax rate) or resident in no tax jurisdiction is interposed as lender between the foreign parent and the Australian borrower.  Where the integrity rule applies, deductions for interest payments on the financing arrangement or payments on derivative financial arrangements are disallowed.  For example, the targeted integrity rule may apply to the following simplified example:

 

 

 

The rationale for the integrity rule was to target financing structures which were considered to circumvent more "traditional" hybrid structures.  However, this is not a requirement for the operation of the integrity rule (e.g., it also applies where it was done with a principal purpose of obtaining a deduction, rather than circumventing the anti-hybrid rules), such that it has much broader application than these circumstances.

Broadly, the amendments:

• clarify that the entity that is entitled to a deduction in respect of the payment (disregarding the operation of the targeted integrity rule) does not have to be the entity that is making the payment.  This is intended to clarify the Commissioner's view that (for example) the fact the payer may be a subsidiary of a tax consolidated group does not mean the provisions do not apply (since the head company is entitled to a deduction);
• specify that a deduction (the later year deduction) will not be permitted where a deduction has been disallowed in an earlier income year (under section 832-180 or section 832-530) if, under certain assumptions, the targeted integrity rule would have denied a deduction in respect of a payment (upon which the entitlement to the later year deduction has its basis) in that earlier income year.  This is to overcome an issue that had arisen where a deduction would have been denied under the anti-hybrid measures, but subsequently become available in a subsequent year as a result of the amount being taxed in that year (for example);
• specify that the targeted integrity rule can apply in the same income year in which there is a deducting hybrid mismatch (to the extent that the deduction component of that mismatch has not been 'neutralised' by the deducting hybrid mismatch rule); and
• clarify that state and municipal taxes can be taken into account in working out the rate of foreign income tax that applied to the payment.

It is proposed that this Ruling, when finalised, will be effective from 1 January 2019.

The anti-hybrid measures continue to be an area of complexity for taxpayers – and although the measures are often explained by reference to specific arrangements that are structured to take advantage of different jurisdictions' tax regimes, they can have much broader application.  Taxpayers with complex cross-border financing arrangements should review those arrangements in the light of the measures, including the recent amendments.

Authors: Vivian Chang, Partner; Steve Whittington, Senior Associate.