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