Managing the Australian Tax Office’s new arm’s-length capital structure requirement, pending new guidance

Last year, the Australian Parliament revised the tests within Australia’s thin capitalisation legislation so taxpayers could elect to determine a ‘maximum debt amount’ under the legislation.

At the same time, Parliament added a requirement that any debt amount must also be arm’s length under Australia’s transfer pricing principles. Hence, under the legislation, the net interest expense that a taxpayer could deduct was the lesser of the result of one of the three tests (a fixed ratio test, a group ratio test or a third-party debt test) and an arm’s-length debt amount.

The Australian Treasury did not provide any guidance as to how a taxpayer might support its debt amount under transfer pricing principles in the Explanatory Memorandum that accompanied the legislation, and the Australian Taxation Office (ATO) has yet to provide taxpayers with guidance in this area. The ATO has promised to provide such guidance, though it will be in the form of a Practical Compliance Guideline (PCG), which, based on commentary from the ATO, will “not provide advice or guidance on the technical interpretation or application of Australia's transfer pricing rules or other taxation provisions”.

The purpose of this article is to provide a brief overview of the current environment for intra-group financial transactions from an Australian transfer pricing perspective, given existing legislation and recent legal precedents, with a focus on how that environment might influence what the ATO might perceive to be an arm’s-length amount of debt.

Key points for taxpayers

Recent changes in Australian thin capitalisation legislation require most taxpayers with cross-border related-party debt to evaluate whether the total amount of debt assumed by the taxpayer is arm’s-length under transfer pricing principles
This test is in addition to the three new tests outlined in the thin capitalisation legislation
The ATO has yet to provide guidance on how taxpayers might support their capital structures as being arm’s length
Impacted taxpayers should consider how they will affirm that they have assumed an arm’s length amount of debt in advance of filing their 2024-2025 financial year tax returns.

Practical Compliance Guidelines (PCG): historical context as we await new guidance

Past PCGs have outlined the ATO’s compliance approach and have provided risk assessment guidelines towards a specific issue. The ATO has announced that it will release its PCG ‘in relation to the arm’s length amount of a debt interest for transfer pricing purposes’ in early 2025, so we expect to receive further updates soon.

In the meantime, taxpayers have had to second guess how they should demonstrate to the ATO that their capital structures are arm’s length, as well as potentially foreshadow which ‘litmus tests’ the ATO may incorporate into their planned PCG as a means of profiling a taxpayer’s tax risk and altering taxpayer behaviour.

As an example of the role of PCGs in the ATO’s administration of tax law, the ATO’s PCG on related-party financing, PCG 2017/4, highlights certain features of financial transactions that, in its view, merit additional scrutiny, including inbound loan transactions priced in excess of 0.50 per cent relative to the group’s parental cost of funds, subordinated debt, and loans that are not in the operating currency of the taxpayer. Transactions with these characteristics may be arm’s length, though they will likely receive additional ATO scrutiny.

This leaves a taxpayer with having to accept an increased risk of an ATO audit. Alternatively, the taxpayer may structure their arrangements to be ‘low risk’, though in the process assume other risks, such as the risk of increased overseas taxation authority scrutiny or the assumption of business risks that might otherwise be mitigated (e.g., borrowing or lending in Australian dollars (AUD) when, from a risk management perspective, a loan would optimally be denominated in another currency).

Evaluating debt amounts under transfer pricing principles

Australia’s transfer pricing provisions, which are contained in Subdivision 815-B of the Income Tax Assessment Act 1997, go beyond the price of an intra-group related-party transaction – they also consider whether the conditions of the transaction are arm’s length.

While the Organisation for Economic Co-operation and Development (OECD) Guidelines (see paragraph 1.141) indicate that a taxation authority should reconstruct a transaction only in exceptional circumstances, the ATO often reprices a financial transaction after imputing terms that it believes that it should have prevailed, almost as a routine part its review of a taxpayer’s transfer pricing.[1] Such changes may include altering the time to maturity, the credit priority, the amount, or other key terms that impact the rate on a loan.

Within the context of a financial transaction, its conditions may include its terms (or lack of certain terms) as well as the debt amount assumed by the taxpayer. While the ATO has provided taxpayers with guidance on the pricing of related-party debt going back to at least 1992, it has not provided guidance on how it might evaluate whether a debt amount is arm’s length under transfer pricing principles.

Australia’s legacy thin capitalisation legislation, which was in force between 2002 and last year, enabled taxpayers to elect to perform an ‘arm’s-length debt test’ (ALDT) to support their debt deductions under the thin capitalisation regime (Division 820).

The ATO issued a taxation ruling (which was binding on the Commissioner of Taxation and represented the ATO’s interpretation of a given tax law), TR 2003/1, which outlined a ‘six-step process’ for evaluating whether a given taxpayer’s debt/equity mix was supportable under the ALDT. These steps required the taxpayer to define its Australian business in functional and financial terms and subsequently adjust the pricing of any existing debt arrangements to be on arm’s-length terms (disregarding any form of parental credit support). The taxpayer subsequently had to determine the maximum amount that its Australian business could borrow from the perspective of an independent borrower (i.e. based upon its profitability) and from an independent lender (based on its credit metrics). The arm’s-length debt amount was the lesser amount resulting from the two tests of borrowing capacity and profitability.

In 2020, the ATO modified its guidance by replacing TR 2003/1 with another taxation ruling (TR 2020/4) to provide updated interpretative guidance on key technical issues that may arise in determining an entity’s arm’s length debt amount.

While the conditions hypothecated under Division 820 differ from those in Subdivision 815-B (including the need to define an ‘Australian business’ and to adjust for any potential parental credit support), the past guidance provides a potential starting point for taxpayers to evaluate whether their capital structure is arm’s length. This framework also benefits from the fact that it has been employed by taxpayers and their advisors and evaluated by the ATO for over twenty years.

An ‘independent lender’/‘independent borrower’ framework might provide a useful starting point for taxpayers and for the ATO to evaluate a taxpayer’s debt/equity mix. However, there are certainly taxpayer circumstances that are demonstrably arm’s length, but that do not easily fit into such a framework. For example, real estate projects in their construction phase, projects in natural resource sectors in their development phase, and other investments where cash flow and/or profitability may be impaired with a view by equity investors towards long-term gains do not easily submit to many analyses, particularly those that focus on results in a given tax year.

The issue of what constitutes an optimal debt/equity mix has been of interest to finance academics for over sixty years. Modigliani and Miller (M&M) published their first joint paper on the topic in 1958, when they concluded (based upon certain restrictive and, in practice, unrealistic assumptions) that corporations should be indifferent between issuing debt and equity. However in a subsequent paper in 1963, they incorporated the impact of deductibility of interest into their analysis and concluded that this deductibility made debt generally less expensive to issue than equity. Since M&M, academics have developed at least ten additional theories of how firms arrive at their debt/equity mix (including approaches that do not directly rely upon interest deductibility). Some of these theories that go beyond M&M’s pioneering work will likely be relevant when supporting taxpayer capital structures.

Mylan Australia: A significant anti-avoidance ruling

Last year, the ATO lost a significant anti-avoidance (Part IVA) case against Mylan Australia in which, among other arguments, the ATO asserted that the taxpayer should have financed its acquisition of a pharmaceutical business entirely with equity at the Australian level.[2]

Among its reasons for asserting this position, the “Commissioner stated that the 100% equity scenario would also have been attractive on the basis that there would be no risk that it would be set aside under Pt IVA”. The primary judge in the case noted that there are a number of commercial reasons why a taxpayer might decide to finance itself (at least in part) with debt over equity.

In its decision impact statement relating to the case, the ATO reaffirmed that “this decision does not disturb our view that, depending on the relevant facts and circumstances, Part IVA may apply to 'debt push-down' schemes”. It also noted that the decision depended upon the facts of the case and that the case was decided under legacy legislation (for context, the ATO had also brought a transfer pricing case against Mylan. While the ATO did not disclose why it did not pursue transfer pricing, it should be noted that the loan facility to Mylan’s Australian business was priced at, if not below, the parental cost of funds).

The Mylan case highlights the ATO’s sensitivity to highly-leveraged taxpayers, including those with introduced debt that results from a corporate acquisition. The primary judge in the Mylan case affirmed many of the non-tax reasons why a taxpayer might prefer debt over equity, which may assist some taxpayers in arguing that their debt amount is appropriate.

The role of passive association and parental credit guarantees

ATO stances on ‘passive association’ and parental credit guarantees, which the ATO has used as a means to narrow any differential between a parental cost of funds and the rate at which an Australian business might receive related-party funding, also have significant implications for the amount of debt that an obligor may assume at arm’s length.

The ATO’s argument in connection with ‘passive association’ is that it is not appropriate to view the credit quality of the subsidiary of a multinational on a pure stand-alone basis (i.e. without the possibility of parental credit support), as market participants may assign a ‘credit uplift’ to account for the fact that a parent may provide contingent credit support to one of its subsidiaries, even without the legal obligation to do so.

Citing general ratings guidance (typically solely from Standard & Poor’s), the ATO often seeks to equalise the credit quality of a parent and its Australian business on inbound loans. In some instances, based upon the ATO’s application of ‘passive association’ arguments, one might be left with the belief that intra-group credit risk is a fiction and that a parental credit rating is a group attribute. Significantly, to the extent that the ATO makes such arguments, it also has implications for the amount of debt that can be assumed by the subsidiary of a multinational.

As ‘passive association’ arguments decrease the differential between the rate at which a parent might borrow and a subsidiary might borrow equivalent funds from third parties, the focus that a third-party lender might place on the subsidiary to perform on a given loan based upon its own financial resources decreases and therefore the amount that a subsidiary of a multinational might be able to borrow from the third parties may increase. Much as the ATO argues that it may be appropriate to reduce the interest rate on a related-party loan, it may also be appropriate to increase the amount of debt that the borrower can obtain from third parties to the extent that third parties view the parent as an ‘implicit guarantor’ of the loan.

Parental credit guarantees in practice: Chevron Australia and Singtel Optus

While ‘passive association’ arguments may narrow the differential between a parental credit rating and the estimated credit quality of one or more of its subsidiaries, the ATO has successfully argued in two recent transfer pricing cases involving Chevron Australia and Singtel Optus for outcomes that equalised the credit quality of an Australian subsidiary with that of its parent, separately from the application of ‘passive association’ principles.

In the case of Singtel Optus, the primary judge argued that the “overarching consideration is that the enterprises in the hypothetical should generally have the characteristics and attributes of the actual enterprises. Giving effect to this consideration requires [the parties]…to be treated as a member of a group,” (Singapore Telecom Australia Investments Pty Ltd v Commissioner of Taxation [2021] FCA 1597, paragraph 320). The judge subsequently imputes a parental credit guarantee to the Australian business for nil consideration, disregarding the emphasis that most other jurisdictions would place on the requirement that the two parties act as if they were independent.

This interpretation of the arm’s-length standard is arguably inconsistent with Article 9 of the OECD Model Tax Convention, which focuses on the parties being ‘independent’ and not members of a common group. The most recent version of the OECD Guidelines highlight the impact of the Australian interpretation of the arm’s-length standard when they cite the need to attribute a credit guarantee fee to an intra-group credit guarantee – a consideration that appears to have been overlooked in Singtel Optus.

While the imputation of a parental credit guarantee may decrease the rate at which a subsidiary borrows, it may also increase the amount that the subsidiary can borrow. One would therefore infer that in cases where the ATO might impute a parental credit guarantee, it is appropriate to account for the fact that potential creditors will not consider the credit quality of the subsidiary in isolation but will also evaluate the impact of the (imputed) parental credit guarantee. In some instances, one might expect that this could lead to outcomes where a subsidiary could arguably be nearly entirely debt funded, at least under transfer pricing principles.

ATO Documentation Requirements

The ATO has relatively high expectations for the documentation of cross-border related-party transactions, which are outlined in Subdivision 284-E and Taxation Ruling TR 2014/8. These requirements will extend to analyses that support a taxpayer’s debt/equity mix. In practice, a number of factors will likely impact the resources that taxpayers devote to documenting and supporting their capital structures, including the amount of related-party debt assumed by an Australian business, its leverage relative to local functionally comparable firms, its credit and profitability metrics, the terms of the intra-group debt, and the risk profile of the transaction, based upon ATO PCG guidance.

Anticipating new practical guidance

One can sympathise with the individuals tasked at the ATO with providing “practical guidance in relation to the arm’s length amount of a debt interest for transfer pricing purposes”.

Financial managers as a group do not seem to determine their firms’ optimal capital structure based upon a single approach, with a number of theories, each potentially providing part of the story. Recent Australian tax court decisions, while serving to narrow the differential between the estimated credit quality of an Australian business relative to that of its parent, may have the unintended effect of increasing the amount of debt that the taxpayer can otherwise in theory borrow, using the ATO’s own arguments and recent Australian court interpretations of the arm’s-length principle. The recent revisions to the thin capitalisation legislation arguably made the compliance environment for Australian corporates – and for the ATO – more complex, subjective, and challenging.

We look forward to reviewing the ATO’s guidance.

How taxpayers can prepare

As we await further guidance from the ATO on arm's-length capital structures, taxpayers should stay proactive and review their current debt arrangements, ensuring they align with the latest legislative changes and transfer pricing principles.

In the meantime, taxpayers might consider taking the following steps in advance of the ATO’s anticipated release of its PCG guidance:

Reviewing how financial transactions are currently incorporated into existing transfer pricing documentation
Conducing a preliminary analysis of the firm’s capital structure, including an analysis of its financial metrics from the perspective of a lender and an independent equity investor, with further potential adjustments for other factors that might impact the analysis
Evaluating how the ATO and other relevant taxation authorities might view existing and proposed financial transactions with a view towards anticipating sources of potential tax risk
We recommend that, at a minimum, an analysis needs to be completed to support the position adopted in the taxpayer’s corporate income tax return. Therefore, 31 December year-end taxpayers need to address their positions as soon as possible.

How BDO can help

Regardless of the release date for the ATO’s planned guidance, taxpayers will still have the burden to document their intra-group financial transactions, including their pricing, their terms, and the amount of debt assumed, given that the revisions to the Thin Capitalisation legislation are currently in effect.

If you need any assistance, contact our team of expert transfer pricing advisers.