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Australia: ATO draft guidance, risk assessment and arm’s length debt test

Australia: Risk assessment and arm’s length debt test

The Australian Taxation Office (ATO) on 28 August 2019 released draft practical compliance guidance (PCG 2019/D3) setting out a risk assessment framework that outlines the ATO’s compliance approach to applying the arm’s length debt test (ALDT) as well as instances when the application of the ALDT will be considered “low risk.” The draft practical compliance guidance follows and builds on earlier guidance (TR 2019/D2) and provides an update and refreshes the ATO’s views regarding key technical issues pertaining to the ALDT.


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The ATO has invited comments on the draft practical compliance guidance up to 9 October 2019.

Read draft practical compliance guidance PCG 2019/D3


In the draft practical compliance guidance (which will have an effective date of 1 July 2019), the ATO outlines a vastly different and more detailed approach to applying the ALDT than what was previously outlined in TR 2003/1 (the prior ALDT ruling). The ATO makes it clear in draft practical compliance guidance that it sees “limited circumstances” when entities would gear in excess of 60% of net assets, and as such, it will generally view the ALDT as posing a “moderate” to “high risk” of non-compliance with the requirements of the thin capitalisation rules. For this reason, the draft practical compliance guidance considers a much more rigorous analysis is required when applying the ALDT as compared to the other thin capitalisation tests. 

The approach outlined in the draft practical compliance guidance represents the level of analysis expected by the ATO when applying the ALDT when the facts and circumstances do not fall within a “low risk” category.

The “low risk” scenarios put forward by the ATO are relatively limited, and although some degree of evidence and analysis is still required, it will allow eligible taxpayers a “short cut” in supporting a “low risk” outcome under the draft practical compliance guidance. These examples include:

  • Inbound taxpayers that operate solely in Australia, borrow debt from non-associates on an arm’s length basis, and receive no guarantees, security or other support from associates
  • Outbound taxpayers that are widely held on the ASX and can show that the notional Australian business would have the same credit rating as that applied to the group’s third-party debt
  • Regulated utilities in the electricity and gas industries, defined as entities with 70% or more of assets within the relevant regulated asset base (RAB), with net debt to RAB no greater than 70% and cash flow from operations interest cover ratio equal to or greater than 2.7 times during the relevant year

For taxpayers falling outside the “low risk” zone, a prescriptive and detailed approach is expected by the ATO when applying the ALDT (along with the use of “compelling evidence”). Although the analysis is not identical to a transfer pricing analysis, 

Expected considerations

The draft practical compliance guidance sets out a structured series of considerations that the ATO expects will be taken into account when undertaking an ALDT analysis. While the guidance provided in the draft practical compliance guidance is comprehensive, there are certain key steps:

  • Determine the notional Australian business—this requires consideration of and when relevant, adjustments for, key factual assumptions as outlined in the legislation.
  • Identify comparable companies to the Australian business—similar to a transfer pricing exercise, this requires a comparability and benchmarking analysis to be undertaken based on the functional profile of the Australian business. The purpose of this exercise is to identify a set of comparable companies which will be used to inform the term and conditions of debt that would reasonably be expected to have applied if the entities had been dealing at arm’s length and used to establish arm’s length ranges against which to test financial outcomes of the Australian business.
  • Adjustments to key terms and conditions of the relevant debt—using the comparability exercise above, the ATO notes that adjustments are to be made to reflect the Australian business under the relevant factual assumptions (including adjustments to exclude explicit or implicit support when provided by an associate, or adjustments to covenants).
  • Application of the borrower’s test—this is to be undertaken with reference to the comparability analysis undertaken or other relevant market data.
    • In this regard, prescriptive quantitative factors (including the profit of the Australian business, its return on capital, and its debt-to-equity ratio) are to be considered with reference to this data. Evidence (such as credit rating methodology guidance) is expected to be obtained regarding the relevant metric(s) applied to each factor and the relative weightings applied to these factors (or when this a lack of evidence, equal weightings are to be applied). When it is shown that the Australian business falls outside the arm’s length range or interquartile range determined for that factor, an adjustment to that range is expected.
    • Following this, prescriptive qualitative factors are also be considered with reference to relevant market data. These factors include the functional profile of the Australian business, the purpose of the debt, and the general state of the economy. A rating of “adverse” “neutral” or “supportive” is then applied for each qualitative factor. The ATO notes that when a qualitative factor is considered “adverse,” this may mean that the analysis undertaken for the quantitative factors should be with reference to the median of the range determined (as opposed to using an interquartile range).
  • Undertake a corroborative analysis using the Capital Asset Pricing Model (CAPM)—the ATO considers it best practice to test the outcomes of the capital structure of the Australian business against a return that hypothetical owners would expect for that same structure. A CAPM analysis is considered appropriate by the ATO to test the outcomes of the capital structure identified via the independent borrower test.
  • Application of the lender’s test—the ATO notes that this test should be done based on any adjustments or re-modelling that occurred under the borrower’s test. This aligns to the ATO’s views in TR 2019/D2, when the ATO has indicated that it consider the debt amount determined under the borrower’s test will typically be lower than what is determined for the lender’s test.

KPMG observation

At one level, it is expected the ATO’s detailed approach will be welcomed (and in this regard, responds to one of the Board of Tax’s recommendations from its previous review of the ALDT). The introduction of “low risk” scenarios, as well as clarity that the ATO will typically expect a detailed analysis to be done every three years with a roll-forward in interim years (when there are no material changes to the Australian business) is also viewed by tax professionals as being welcomed. Also, the ATO has not deviated from its earlier guidance that for ALDT (unlike Safe Harbour) purposes, taxpayers are not limited to the value of assets under AU-IFRS, which provides clarity for taxpayers.

Notwithstanding this, there are a number of practical and feasibility issues that may arise for taxpayers in satisfying the ATO’s expectations regarding the degree of analysis expected and, importantly, the level of supporting evidence. For example, the fact that interest rates on shareholder loans may need to be determined differently for transfer pricing and ALDT purposes may present some practical challenges.

It also remains to be seen as to whether the ATO’s views in TR 2019/D2, which influence the approach adopted in the draft practical compliance guidance (for example, the disregard of the entity’s position in the global group and the consideration of the return of “hypothetical owners”), will change based on feedback provided from industry. Given the approach currently proposed in the draft practical compliance guidance, tax professionals believe this appears to be unlikely.

Taxpayers need to consider their existing ALDT positions and analysis, and undertake a gap analysis to determine what additional evidence may be required having regard to the ATO’s increased expectations.

Read an August 2019 report prepared by the KPMG member firm in Australia

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