ATO releases finalised guidance on the arm’s length debt test

17 August 2020

In brief

On 12 August 2020, the Australian Taxation Office (ATO) released its finalised guidance dealing with the application of the arm’s length debt test (ALDT) which applies as one of the options for determining deductibility of interest and other debt costs under Australia’s thin capitalisation rules.

Specifically, the following publications set out the ATO’s final views:

• final Taxation Ruling TR 2020/4 which provides the Commissioner’s views on key technical aspects of the ALDT, and
• final Practical Compliance Guideline PCG 2020/7 which provides guidance on the practical application of the ALDT as well as a risk assessment framework in respect of the ATO’s compliance approach.

With the above releases, the Commissioner continues to expand its public guidance on debt arrangements and thin capitalisation, confirming the ongoing strong focus on this topic to the taxpayer community. Common themes across these publications continue to be: the increased evidentiary burden required for taxpayers to support positions, the need to self-assess risk using these public guidelines, and an invitation to proactively engage with the ATO to obtain certainty and mitigate risk.

In detail

TR 2020/4 - Income tax: thin capitalisation - the arm's length debt test

TR 2020/4 replaces the only other previous guidance on the ALDT issued by the ATO (TR 2003/1). TR 2020/4, which is largely consistent with the draft ruling previously issued by the ATO in May 2019 (TR 2019/D2), clarifies the ATO’s perspective on points of legislative interpretation relating to the ALDT. The views expressed in the final ruling apply on both a prospective and retrospective basis.

Of particular note, TR 2020/4 continues to stress the evidentiary nature of the ALDT and the requirement for taxpayers to perform detailed analyses and prepare robust documentation to support the quantum of their debt under the ALDT. Our previous Insights article dated 8 April 2019 which considered the predecessor draft ruling provides detailed commentary on the ATO’s interpretation of the relevant legislative provisions and remains relevant given there are minimal substantive changes between the draft and final rulings.

PCG 2020/7 - ATO compliance approach to the arm's length debt test

PCG 2020/7 formalises the ATO position for taxpayers to self-assess their risk outcome in applying the ALDT to a financing arrangement, which may need to be disclosed to the ATO either through the Reportable Tax Position (RTP) Schedule, or upon specific request by the Commissioner (e.g., during a risk review). In addition, the PCG steps through the Commissioner’s views on how the ALDT should be applied on a practical basis. The PCG applies from 1 January 2019 (which is earlier than originally proposed by the earlier draft PCG 2019/D3 which had indicated it would apply from 1 July 2019), and while substantially similar to the comments in the draft PCG (see our Insights article dated 3 September 2019), there are some points of divergence.

Under PCG 2020/7, the ATO has refined its view that the application of the ALDT is seen as posing a “greater risk of non-compliance relative to other tests available under the thin capitalisation rules”, being a change from the draft guidance which suggested a “moderate to high risk of non compliance with the statutory requirements of the thin capitalisation rules”.

Similar to the draft PCG, the ATO has provided a risk assessment framework for self-assessing the “risk zone” applicable to a taxpayer’s ALDT position. The risk zone a taxpayer falls within dictates the level of perceived compliance risk and the corresponding level of resources dedicated by the ATO to review the position. The finalised PCG differs to the draft version on a few aspects - an expansion of risk zones to five categories (there were only three categories under the draft PCG) to provide greater differentiation of the risk levels for taxpayers who do not fit within a “low risk” zone, and the fact that the Commissioner will request the taxpayer to disclose the self-assessed risk score in its RTP Schedule (if a taxpayer is required to complete the Schedule).

Some key takeaways from the ATO’s risk framework and updated risk zones:

• There has been no change in the criteria to achieve a ‘white’ or ‘low risk’ zone outcome. The low risk zones remain narrowly defined. In addition, the ATO has helpfully made it clear in the final PCG that if a taxpayer falls within a low risk zone, it is not expected to prepare detailed ALDT documentation to meet the standard set out in the guidelines, with the only requirement being the need to prepare an analysis setting out satisfaction of the relevant criteria to achieve the low risk zone outcome.
• There has been a carve out of a new ‘low to moderate’ risk zone which is primarily based on an earlier concession (albeit not a separate rating zone category) in the draft PCG where there is an alignment of credit ratings of either the global group or the entity to that achieved by the notional Australian business with reference to an arm’s length debt amount.
• The ATO has also created a new ‘high risk’ category which covers any arrangements to the extent they are not analysed, documented and evidenced having regard to the prescriptive guidance found within the PCG, or which involve arrangements that have at least two of the following characteristics:
  • Cross-border related party debt comprises more than 50 per cent of the taxpayer’s debt capital;
  • Subordinated cross-border related party debt comprises more than 25 per cent of the taxpayer’s debt capital; 
  • Two years of positive earnings before interest and tax (EBIT) and negative profit before tax (PBT) during the previous five-year period

To the extent that taxpayers fall within the ‘high risk’ zone, the ATO has expressed that reviews of such arrangements are likely to be commenced as a matter of priority and that cases might proceed directly to audit, with less chances to resolve disputes through settlement or alternative dispute resolution.

• All other cases not falling in the white, low, low to moderate and high risk categories are assigned a medium risk rating.

It should be noted that a PCG is not a ruling on the application of the law. It provides a risk assessment framework and is indicative of the approach the ATO may take in reviewing ALDT positions, but a position that is ‘high risk’ under the PCG framework is not necessarily incorrect.

The takeaway

The taxpayer community continues to welcome guidance from the Commissioner around the area of cross-border financing. With respect to the ALDT, following the withdrawal of TR 2003/1, the finalised guidance represents the latest perspectives of the Commissioner around both the technical points and the practical application of the ALDT. It is important for taxpayers to consider this guidance and in particular self-assess their ALDT position in accordance with the framework set out under the PCG in order to ascertain the level of risk associated with their debt deductions position and the corresponding analysis and evidence required to manage an ATO review.