Thin Capitalisation - Arm’s length Debt Test – PCG 2019/D3

11 October 2019


The ATO has now provide the following guidance on the application of the Arm’s Length Debt Test (ALDT) in the thin capitalisation rules:

  • Draft Tax Ruling TR 2019/D2 – issued on 5 April 2019
  • Draft Practical Compliance Guideline PCG 2019/D3 (the PCG)

The submission dates for these documents has now closed and it is unlikely that there will be material changes to either document.


Observations

  • The ATO makes it clear that it sees the ALDT as only applying to a narrow range of taxpayers. 
  • The ATO has cast the low risk green zone narrowly and warned taxpayer’s outside the green zones that they can expect ATO scrutiny of any ALDT claims.
  • Tax Ruling TR 2019/D2 and PCG 2019/D3 provide detailed guidance on how the ATO expects the ALDT to be applied but represents a significant narrowing of its interpretation of the ALDT compared to now withdrawn Tax Ruling TR 2003/1. 
  • In the context of this detailed guidance we have included below a high level summary of the guidance to assist in understanding the key elements in applying the ALDT.
  • The ATO guidance makes it clear that taxpayers wanting to apply the ALDT will need to invest in analysing and documented the application of the ALDT to their debt arrangements and in particular the commerciality of their capital structures.
  • Unlike the other PCG’s the ATO does not offer documentation concessions to those in the green zone.


Outline of PCG 2019/D3

PCG 2019/D3 includes two key sections:

  • Risk assessment framework for the ALDT
  • Guidance on applying the ALDT


Risk Assessment framework

The PCG outlines specific categories of taxpayers which qualify for the green low risk zone, with all other taxpayers allocated to the moderate to high risk zone. 

These risk categories are illustrated in the table below.  It is expected that relatively few taxpayers will qualify for the green zone and the broad message from the ATO is that they consider most taxpayers seeking to rely on the ALDT as being moderate to high risk.

Type of entity

Third party debt only

Related party debt

Regulated Utilities  

70% regulated assets & other metrics

   


Other

   

Inbound

 

Only Australian business

  • No group credit support
 


Australian & Foreign businesses

   

Outbound

Publicly Listed & Australian business credit rating = Group credit rating

   


Other

   

It can be seen from the table above that the green zones are very narrow.  This is illustrated in the following comments in the PCG[1]:

“The ATO has found that there are limited circumstances in which an entity would gear in excess of 60% of its net assets.”

Guidance on application of ALDT

Factual Assumptions

The PCG considers each of the factual assumptions under the ALDT and provides the following guidance:

Factual assumption

Guidance

Only Australian business

  • Start with accounting information used for tax return
  • Adjust to exclude non-Australian assets and liabilities

Based on actual business

  • Australian functions, assets and risks only
  • Exclude foreign functions, asset and risks

Nature of assets & liabilities as they were during the year

  • Also considers assets and liabilities not on the balance sheet
  • Starting point is book values
  • Can use other values but need support for these values

In same circumstances as actually occurred

  • Exclude actual debt and related expenses
  • Ignore entities position as a member of global group (i.e. ignore implicit credit support)

Ignore credit support provided by associates

  • Ignore explicit credit support
  • Ignore implicit credit support

 

Quantitative factors

The PCG also considers each of the relevant quantitative relevant factors required to be considered under the ALDT. 

Each of the quantitative factor should be assessed from both the borrower and lenders perspective and a weight attached to each factor.  This is summarised below:

Quantitative factors

Guidance

Weight

Assessed dollar value

Capacity to meet liabilities

Borrower

  • Interest cover ratio, after tax profit, and cashflows
  • Within range of comparable third party borrowers

Lender

  • Meets arm’s length covenants on debt serviceability
  • Meets metrics of independent lenders on debt serviceability

x%

 

 

 

x%

$XXX

 

 

 

$XXX

Accounting profit

Borrower

  • Within range of profitability of comparable third party borrowers

Lender

  • Meets arm’s length covenants
  • Meets metrics of independent lenders on profitability

x%

 

x%

$XXX

 

$XXX

Return on capital

Borrower

  • Within range of return on capital of comparable third party borrowers

Lender

  • Meets arm’s length covenants
  • Meets metrics of independent lenders on return on capital

x%

 

x%

$XXX

 

$XXX

Debt to equity ratios

Borrower

  • Within range of D/E ratios of comparable third party borrowers

Lender

  • Meets arm’s length covenants
  • Meets metrics of independent lenders on of D/E ratios

x%

 

x%

$XXX

 

$XXX

 

Qualitative factors

The PCG also considers each of the qualitative relevant factors required to be considered under the ALDT.  For each of the qualitative factors, each factor should be assessed from both the borrower and lenders perspective and assessed as adverse (to be avoided), neutral or supportive, as summarised below:

Qualitative factors

Guidance

Adverse

Neutral

Support-ive

Functions assets and risks

  • Don’t consider the financial risk preference of the entity
  • Characterisation of Australian entity relevant for credit assessment, e.g. healthcare services provider should use credit rating methods for healthcare industry

 

X

 

Terms and conditions of the actual debt capital

  • Compare to arm’s length terms and conditions

 

X

 

Assets available as security

  • In some industries the availability of security will set a cap on borrowing capacity (e.g. value of commercial property)

 

X

 

Purpose for which scheme of debt capital entered into

  • Commercial reason for debt funding , e.g. fund capital expenditure.
  • If commercial reason not readily explainable will be difficult to support ALDA

 

X

 

Debt to equity ratios

  • Compare to whole of entity (not just Australian business)
  • Compare to associates undertaking similar activities
  • Difficult to support a debt to equity ratio higher than global group

 

X

 

Commercial practices in the industry[2]

  • Australian markets preferred
  • Comparables based on transfer pricing principles, and adjusted if required

 

X

 

Method of financing commercial activities (outward investors only)

  • Compare financing of taxpayers overseas and Australian business
  • If overseas business over-capitalised the Australian business may be under-capitalised

 

X

 

General state of Australian economy

  • Consider whether state of economy is impacting financing, e.g. recession
  • Explain any impact with evidence

 

X

 

All of the above factors at the time debt capital actually issued which is still on issue

  • Assess whether there has been a material change since the year of issue of the debt capital
  • Less analysis is required when there has not been a material change (+/- 10%)

 

X

 

 

 Requirement for annual testing

  • TR 2019/D2 reinforces the requirement for annual testing of the ALDT even where financing arrangements have not changed.
  • However PCG 2019/D3 provides that the ATO will accept a lower level of testing in later years  where there has not been any material change to the notional Australian business or its financing

 

[1] At paragraph 11.

[2] In Australia or comparable markets elsewhere

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Authors

David Bond

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Julian Pinson

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Cameron Blackwood

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