Australian thin capitalisation reforms - Are you prepared?

This article has been brought by Quantera Global in partnership with DFDL.

“When one door closes, another opens…” Alexander Graham Bell famously said. Perhaps an example of this is the proposed changes to statutory debt limits under Australia’s thin capitalisation rules (originating in last year’s Federal Budget), which is scheduled for debate in the House of Representatives this week.

The proposed amendments were introduced into the House of Representatives on 17 July 2014, and include, among other measures:

Increasing the safe harbour capital limit for Authorised Deposit Taking Institutions (“ADIs”) from 4 per cent to 6 per cent of risk weighted Australian assets;
Reducing the safe harbour debt limit for general entities (non-ADI) from 3:1 to 1.5:1 on a debt-to-equity basis (that is, from 75% to 60% of adjusted Australian assets);
Reducing the safe harbour debt limit for financial entities (non-ADI) from 20:1 to 15:1 on a debt-to-equity basis;
Allowing inward-investing entities to access the worldwide gearing test (basically enabling an entity to gear up its Australian operations to the gearing level of the global group); and
Increasing the ‘de minimis’ threshold from A$250,000 to A$2 million of debt deductions per annum.

These changes are to apply to income years commencing on or after 1 July 2014.

The tightening of the safe harbour limits could trigger a denial of debt deductions for taxpayers with current levels of debt in excess of the safe harbour ratio. At the same time, this opens the door for taxpayers to use the ‘Arm’s Length Debt Test’ (“ALDT”) as an alternative to the safe harbour test. The ALDT is available as a fall-back to taxpayers who may fail the prescribed safe harbour test but for whom gearing levels are otherwise commercially justified or acceptable.

Naturally, there is a concern that reliance on the ALDT to support interest deductions will result in an increase in compliance costs for taxpayers. The good news is that the Board of Taxation (“BoT”) is currently undertaking a review of the ALDT with a view to making it easier for businesses to comply with and for the Australian Taxation Office (“ATO”) to administer. This should help alleviate the impact of the reduction in the safe harbour debt limit for many businesses, particularly those in industries that are generally able to support higher levels of debt funding (such as the property and infrastructure industries). The BoT is expected to provide its recommendations to the Government by December 2014.

In a twist of fate, the changes to the safe harbour limits could herald the arrival of long overdue simplification measures for the application of the ALDT.

Multinational entities that currently use the safe harbour test should carefully review their existing debt levels and consider whether the ALDT can be used to support debt levels for income years beginning on or after 1 July 2014. Where the ALDT can be relied on, this will need to be properly documented in line with ATO guidance by the time of lodging the tax return.

We welcome and support action by the Australian Government to make the ALDT easier to comply with and administer. In any case, while we acknowledge that use of the ALDT will create some additional paperwork for taxpayers, in our view this should not be significantly greater than the burden that currently exists in respect of the application of the new transfer pricing rules which require an analysis of the arm’s length conditions of related party debt arrangements, including the amount of debt held. We consider that compliance with the ALDT can largely be addressed within the existing requirements for dealing with transfer pricing.

On the topic of arm’s length conditions for related party debt arrangements, energy company Chevron Australia is appealing against transfer pricing assessments issued by the ATO in a 13 day trial in the Federal Court of Australia (Chevron Australia Holdings Pty Ltd v Commissioner of Taxation (No 2) [2014] FCA 707) scheduled to begin on 29 September 2014. At issue is whether the interest paid on a loan of US$2.45 billion advanced to Chevron Australia Holdings Pty Ltd (“CAHPL”) by its US subsidiary, ChevronTexaco Funding Corporation (“CFC”), exceeded the arm’s length consideration.

The ATO is claiming more than A$280 million in tax for the 2004 to 2008 years of income based on the transfer pricing rules under Division 13 of the ITAA 1936 and Subdivision 815-A of the ITAA 1997. The ATO is arguing that CAHPL would not have been able to borrow the funds from an independent party dealing at arm’s length on the actual terms of the loan agreement, or it would not have been able to borrow the full principal amount having regard to the stand-alone credit rating of CAHPL. In either case, the ATO argues that CAHPL would have paid a lower amount of interest if it had been dealing with an independent party, and that the interest actually paid in excess of this arm’s length amount should be disallowed.

The case is the first big court battle between the ATO and a taxpayer over the pricing of inter-company debt and underscores the need for taxpayers to consider the arm’s length nature of the terms and quantum of their loans, not just the pricing.