The thin-capitalisation regime addresses the maximum allowable debt an entity can obtain, before the entity’s interest and other debt deductions are reduced. The maximum amount of deductible debt can be calculated through three methods; one of which is the Arm’s Length Debt Test (“ALDT”).

On 5 April 2019, the ATO released Draft Taxation Ruling, TR 2019/D2 to clarify how entities should utilise the ALDT (“the ALDT Draft Ruling”). This ruling applies retrospectively.

The ALDT Draft Ruling at a glance

  • The proposed ALDT continues to enable taxpayers with special leverage requirements (those over and above the 1.5:1 debt/equity thin capitalisation safe harbor) to have access to deductible debt funding, provided this leverage is “reasonable”.
  • The ALDT draft ruling replaces the existing six-step methodology contained in TR 2003/1. Further, a Practical Compliance Guideline (PCG) will be issued to provide further clarification regarding the key aspects raised within the Draft Ruling.
  • The ALDT should be an annual test and its documentation should be prepared by the time the entity lodges its income tax return in order to avoid administrative penalties.

Who is impacted?

  • ‘Inward investing entities’ – Australian entities, investments or permanent establishments that are foreign controlled; and
  • ‘Outward investing entities’ – Australian controlled entities with international operations.

What has changed?

The clarification on the two limbs of the ALDT

The ALDT Draft Ruling suggests that considering the circumstances, the amount an entity “could borrow” may be different to the amount the entity “would actually borrow”. As a result, when applying the ALDT, entities will be required to estimate:

  • the amount an independent lender would be willing to provide to the taxpayer; and
  • the amount it “would be reasonably expected” for the taxpayer to borrow.

Where a discrepancy exists between the two amounts, the Arm’s Length Debt (ALD) amount will be the lower of the two tests.

What does "would reasonably be expected“ mean?

The ALDT Draft Ruling clarifies what the ATO deems as "reasonably expected". This is not seeking to identify the highest debt amount possible but rather the amount most probable.

In light of this, the ATO calls for a practical and justifiable prediction based upon evidence, including:

  • the entities’ financial performance and financial statements; and  
  • the commercial and industry practices adopted by independent parties.

Other relevant changes

  • Methodologies outside the values determined for accounting purposes can be considered to determine the relevant assets and liabilities when conducting an ALDT. In particular, those based on industry practice.
  • When pricing intercompany arrangements, varying results may arise depending on which methodology is adopted. Under the ALDT Draft Ruling, when calculating the ALD amount, related party implicit and explicit credit support should be disregarded (likely increasing the price of intercompany debt). In contrast, under the existing transfer pricing guidelines, parental support should be considered for intercompany debt pricing purposes (in most instances reducing debt pricing).
  • The ALDT Draft Ruling requires that in estimating the ALD amount for the Australian entity, the investment objectives of shareholders are disregarded. This could be challenging, as it would be difficult to imagine a scenario where shareholder objectives are divorced from the management policies of the Australian entity.
  • Whilst the ALDT continues to be a tool available to support debt deductions, Labor’s proposed multinational tax package considers the elimination of the thin-capitalisation safe harbour threshold and the ALDT. In the event of the election of a Labor government in this year’s federal election, the ALDT may no longer be available.

What should you do?

  • Revisit your past ALDT positions and ensure that these are still valid, under the new guidance pre and post-federal election;
  • Ensure that ALDT calculations and documentation are prepared on a yearly basis and before the tax return; and
  • Identify any discrepancies between the pricing of debt under the ALDT Draft Ruling and the transfer pricing rules.

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