In light of the ATO's ongoing focus on cross border debt, it's understandable that the ATO has withdrawn its existing guidance on the Arm's Length Debt Test (ALDT) in TR 2003/1 and that TR 2020/4 and PCG 2020/7 have been issued.

The revised guidance in TR 2020/4 has both prospective and retrospective application. PCG 2020/7 has effect for income years commencing on or after 1 January 2019 and will apply where the ALDT has been used to establish an entity's maximum allowable debt.

All legislative references in this article are to the Income Tax Assessment Act 1997 unless otherwise specified.

Observations on TR 2020/4 and PCG 2020/7

• The revised ATO guidance in TR 2020/4 and PCG 2020/7 does little to bolster the practical understanding of taxpayers in applying the ALDT when compared to the guidance previously provided in TR 2003/1. To put it bluntly, it appears that the ATO is adopting a position which makes the ALDT very difficult to satisfy. This prospect is particularly galling for business given it could lead to significant debt deduction denials in the coming years due to asset write downs as a result of the COVID-19 pandemic.
• In order to assist taxpayer compliance the ATO should provide a practical explanation of how taxpayers should arrive at an appropriate weighting of the relevant factors. Further examples that cater for a range of facts and circumstances and a range of risk ratings should also be provided to assist taxpayer compliance. The lack of guidance on the basis that it is not possible for the ATO to provide a method statement that caters for every scenario does not do much to assist taxpayers at a practical level.

Thin capitalisation rules

The thin capitalisation rules can apply to inward and outward investing entities to limit the amount of interest and other debt deductions that might otherwise be available.

The ALDT applies to non-ADI inward investing entities (section 820-215) and non-ADI outward investing entities (section 820-105) and applies similarly for both types of entities.

The ALDT considers how much debt an Australian business would reasonably be expected to have, applying certain factual assumptions and relevant factors. Considering the entity's isolated commercial activities in connection with Australia, the ALDT will be satisfied if:

• The entity's adjusted average debt is not greater than the amount of debt the Australian business would reasonably be expected to have; and
• Debt capital has been provided to the Australian business by commercial institutions independent from the entity on arm's length terms and conditions. 

Summary of the updated guidance in TR 2020/4 and PCG 2020/7

TR 2020/4 provides guidance on key technical issues that may arise in determining an arm's length debt amount, and to provide interpretive guidance relating to the record keeping requirements in section 820-980. PCG 2020/7 provides administrative guidance in the application of the arm's length debt test and provides an outline of the ATO's intended compliance approach. TR 2020/4 and PCG 2020/7 should be considered together.

The following is a summary of the key aspects of the revised guidance together with our observations.

TR 2020/4

• The phrase 'would reasonably be expected' is critical to the application of the ALDT. The test 'requires an objective assessment of what a reasonable hypothetical borrower and commercial lending institution (which is broad enough to encompass banks, ADIs, and the provision of debt capital on any market on arm's length terms and conditions) would be expected to borrow and lend in the facts and circumstances of the entity'. The concept of 'reasonable expectation' has been extensively considered, and the required standard under the ALDT is 'higher than a prediction of a possible level of debt and must be a prediction based on evidence' such that it is 'reasonable likely, expected, or probable.'

• The amount that the borrower would borrow in the circumstances (objectively construed) is distinguished from what the borrower could borrow (i.e. capacity to take on additional debt). The borrowing decision of an entity is influenced by the overall cost of funding and the need to ensure an appropriate return for equity investors.
• The ALDT is to be retested in each relevant income year as an entity that satisfies the ALDT in an income year may fail the ALDT in subsequent income years due to a change in facts and circumstances (such as a reduction in asset values or a change in lending patterns).

• TR 2020/4 confirms the Commissioner's view that the Australian business should be considered independently and in isolation from its foreign operations, and that in order to do so:
  • The Australian business should be considered separately from the subjective leverage preferences of shareholders; and
  • The entity's membership of a global group should be disregarded for the purposes of the ALDT. Any form of credit support, security, or guarantee provided to the entity in relation to the Australian business by its associates, or by the use of the assets attributable to the entity's overseas permanent establishments should be disregarded.
• The Commissioner considers that the requirement in section 820-680 to comply with the accounting standards for the purposes of determining an entity's assets and liabilities does not apply for the purposes of the ALDT on the basis that the 'statutory context of the ALDT does not lend itself to being constrained to assets determined and calculated under the accounting standards.' With respect, this is exactly what section 820-680 seeks to do, and the note to section 820-680 of the ITAA 1997 does not refer to any modifications for the ALDT as it does for other sections in Division 820. Indeed, section 820-215(2)(c) provides that the relevant factual assumptions include that the nature of the entity's assets and liabilities had been as they were during the year – to which section 820-680 would apply. The additional and broader considerations that the Commissioner seeks to include have not been adequately explained.
• The ALDT is determined based on legislated assumptions and factors, each of which must be taken into account. Statements in TR 2020/4 to the effect that 'the weight given to a particular factor will depend on the precise facts and circumstances of the entity in the tested year' and 'not every single factor will have a material impact on the quantum of the ALDT' are unhelpful from a practical perspective and provides little actual guidance. Compounding this lack of guidance is the requirement for the taxpayer to maintain adequate records that specify the weighting given to each factor together with a rationale as to why that conclusion has been reached.
• The ruling states that there is no specified time or frequency throughout the income year that the ALDT should be tested. Instead, the approach adopted should result in an amount that would reasonably be expected to exist throughout the year in all instances. If business conditions change throughout the income year (as is certainly the case throughout the COVID-19 pandemic) the ALDT may need to be determined for different periods and then averaged for the income year. This indicates that the ATO has adopted a concessional (and realistic) approach to the requirements in section 820-215(1)(a)(i). In contrast, a strict reading of what is meant by 'throughout the income year' could result in the lowest level of debt capital being applied.
• If the self-assessed ALDT amount fails to adequately consider the assumptions and factors then the Commissioner may substitute a more appropriate amount that does so.

Interaction with the transfer pricing rules

In certain circumstances an entity relying on the ALDT may also need to consider the cross border transfer pricing rules under Subdivision 815-B. Both regimes consider arm's length principles but there are differences that can arise regarding the identification of the notional Australian business. For example, there are differences in the facts and circumstances that should be considered, and Subdivision 815-B does not contain an explicit ability to disregard the support provided to an entity by its associates (excluding the reconstruction powers in section 815-130). It is therefore not reasonable to assume that the application of the arm's length principle will give the same result under Subdivision 815-B and the ALDT.

PCG 2020/7

ATO compliance approach

• The ATO has adopted several positions in PCG 2020/7 which are difficult to agree with. The position that it is not common for independent Australian business to gear in excess of 60% of their net assets does not appear to have regard for the differing circumstances or the challenges faced by business at different parts of the economic cycle (as is the case during the COVID-19 pandemic).
• Similarly, the ATO position that the ALDT will generally not enable an entity to achieve a maximum allowable debt in excess of the safe harbour debt amount and would only do so where it is common practice for an industry to operate with higher debt to equity ratios is, in our view, a misapplication of the 'reasonableness' requirement. To the extent that 'commercial practices' (referred to in section 820-105(3)(h)) are impacted by the decision of many taxpayers to rely on the safe harbour test, that should not impact on the ability of other taxpayers to rely on the ALDT.

Applying the risk assessment framework

The ATO compliance approach will vary depending on where the entity falls in the ATO risk zone. The lowest risk zone includes circumstances where arrangements have already been reviewed and concluded, and will result in no review by the ATO other than to confirm consistency with the agreed approach. In contrast, the highest risk zone includes circumstances where cross border related party debt comprises more than 50% of the notional Australian debt capital. For high risk cases the ATO will commence reviews as a matter of priority, may proceed to audit, and may apply formal information gathering powers, and the entity will not be able to access the APA program. Even if the entity is in a low risk category the ATO may still conduct compliance activity to test the application of the ALDT and may consider other factors beyond those specified in the PCG.

Low risk zone

The following guidance is provided regarding what will be accepted as an ALDT falling within the low risk zone:

• Inward investing entities that receive debt funding solely from commercial lending institutions that are not an associate of the entity and on arm's length terms, or have no foreign operations or form of security provided by an associate.
• Outward investing entities that are widely held publicly listed entities on the Australian Stock Exchange, and where the notional Australian business would have the same issuer credit rating as the actual entity had from an internationally recognised credit rating agency. The ATO confirms that it will only accept the quantifiable elements of the credit rating assessment in order to reduce the impact of any subjective elements.
• A regulated utilities business (which has at least 70% of its total assets comprising regulated assets) will fall within the ALDT low risk zone if its regulated asset base leverage is less than 70% and it has cash flow from operations of greater than or equal to 2.7 times for the income year.

Low to moderate risk zone

An ALDT amount will fall within the low to moderate risk zone if the global group is publicly rated on third party debt that is on arm's length terms and conditions and the notional Australian business would achieve the same credit rating on its ALDT amount. The ATO does not accept that the use of credit ratings agencies in isolation is sufficiently reliable for a low risk designation.

Application of the arm's length debt test

• The PCG confirms that the ALDT is highly dependent on the facts and circumstances specific to the entity and that it is not possible to prescribe a methodology to cater for all facts and circumstances.
• The PCG provides the ATO view on what is an appropriate approach to applying the ALDT, having regard to the factual assumptions and relevant factors, and is briefly summarised below:
  • Consideration of all factual assumptions in order to construct the notional Australian business as a stand-alone entity with commercial activities in Australia, no foreign interests, no associate entity debt or credit support;
  • Consideration of the arm's length terms and conditions reflective of arm's length dealings of the notional Australian business. This must be based on independent parties in the same industry and in similar circumstances, and should draw on transfer pricing guidance for the purpose of comparable selection (disregarding the notional Australian business's membership of a global group).
  • Conduct an analysis to corroborate the borrower's amount from a commercial perspective. The object of this analysis is to ensure that the debt amount is reasonable and should consider the returns to the hypothetical owners of the Australian business. This appears to be at odds with the position in TR 2020/4 that shareholders do not form part of the relevant facts and circumstances.

Factual assumptions and relevant factors

The PCG considers each of the factual assumptions and relevant factors in detail. Some of the key aspects of the factual assumptions and relevant factors are considered below:

• Accounting information relied on in the preparation of the entities tax return will be usually be the starting point for the collation of the financial data for the notional Australian business.
• Emphasis should be given to the business actually carried on when evaluating the functions performed, assets used, and risks assumed.
• The value of the notional entity's assets and liabilities are not necessarily constrained to book values and may be taken from other reference points. It is not clear what the other permitted reference points are outside of regulated utilities.
• The existence of a commercial arrangement on arm's length terms with an associate of the entity is not always sufficient to indicate the existence of credit support.
• The analysis must give effect to the arm's length terms and conditions on which the stand alone notional Australian business would have borrowed. Modelling must be based on sound commercial principles (which includes an appropriate credit rating), supportable by appropriate evidence, and on equivalent terms and conditions to independent parties in similar circumstances. Evidence from third party databases (which presumably includes databases such as Bloomberg) may be used in the absence of publicly available agreements of independent parties.
• Where a credit rating assessment has been used to support an ALDT analysis the ATO will consider the reasonableness of that approach and whether it correlates with the credit rating of independent comparables.
• The analysis of ALDT terms and conditions will have regard to financial covenants including negative pledges. It appears that covenants that would not typically be included in the debt interest arrangements between independent parties should be disregarded.
• There is no prescribed order in which the factors should be applied, and somewhat confusingly, PCG 2020/7 then acknowledges that some factors should be considered prior to or in conjunction with other factors but does not provide a further explanation of how this should occur. Disappointingly, this makes things more uncertain for taxpayers. An analysis of each of the factors should include a table with suggested quantitative factors and the weight the taxpayer ascribes to each of those factors, and a further table with a list of qualitative factors and whether each of those factors is either adverse, neutral, or supportive of the notional amount.

Example

•  PCG 2020/7 provides a single example regarding a regulated utility company in a fairly vanilla ALDT arrangement. The example merely states whether or not a relevant factor falls within the ALDT range established by the comparables and does not assist in taxpayer understanding of why a particular weight was ascribed to each relevant factor. The length of the example underlines the extensive analysis required and associated compliance cost for taxpayers to substantiate an ALDT position.
• The ATO is encouraged to provide further examples that consider a variety of facts and circumstances in order best to assist taxpayer compliance.

What are the key differences of the updated guidance when compared to TR 2003/1?

TR 2003/1 included a suggested six step methodology (i.e. it was not mandatory) to arrive at an ALDT amount in practice. The six steps were not replicated in PCG 2020/7 but each of those steps form part of the revised approach. In our view the updated guidance appears to give the ATO more flexibility in its application of the ALDT when compared to the more specific and practical approach adopted in TR 2003/1.

Summary of PCG 2017/4 and draft Schedule 3

PCG 2017/4 provides guidance on interest-bearing loans between related parties. The guidance imposes a self-assessment obligation on taxpayers to assess the risk of their cross border financing arrangements. PCG 2017/4 risk assessments have become highly prevalent in ATO risk reviews and Foreign Investment Review Board (FIRB) approval processes.

The ATO has recently released a draft Schedule 3 to PCG 2017/4, which sets out specific risk indicators for interest-free loans between related parties.

Schedule 3 outlines the factors under which the risk score assigned to inbound and outbound interest-free loans made between related parties may be modified for the purposes of Schedule 1 of PCG 2017/4. Draft Schedule 3 includes a specific pricing risk scoring table which includes 6 'yes or no' questions to consider, with weighting for each answer differing depending on the inbound or outbound nature of the interest-free loan.

The draft Schedule includes framing considerations for identifying the arm's length conditions, that should be applied to the relevant facts and circumstances of each case in respect of outbound interest-free related party financing arrangements. The guidance provides examples of scenarios where it may be more appropriate to identify the arm's length conditions on the basis that the commercial or financial relations comprise an equity contribution, rather than a loan. 

If a related party financing arrangement is rated as low risk, taxpayers can expect the ATO will generally not apply compliance resources to review the taxation outcomes other than to validate the taxpayer's self-assessment of its financing arrangements. The guidance provides factors that will contribute to a lower score allocation (and therefore a lower likelihood of ATO compliance activity), including:

• The rights and obligations of the provider of funds are effectively the same as the rights and obligations of a shareholder
• The parties had no intention of creating a debt with a reasonable expectation of repayment and, therefore, did not have the intent of creating a debtor-creditor relationship
• The intentions of the parties are that the funds would only be repaid or interest imputed at such time that the borrower is in a position to repay
• The borrower is in a position where it has questionable prospects for repayment and is unable to borrow externally.

The guidance outlines other relevant factors in considering whether the recipient of the funds could have borrowed the amount advanced from an independent lender, including:

• Common funding practices of the industry in which the recipient's business operates for entities in comparable circumstances
• The business activity of the recipient entity
• The financial position of the recipient entity.

Draft Schedule 3 specifically cites the 'reconstruction provisions' as outlined in section 815-130 which provide for circumstances in which the arm's length conditions would be identified based on a different characterisation or construction of the commercial or financial relations actually entered into. This may suggest that the ATO intends to review self-assessment under PCG 2017/4 of interest-free loans, that could lead to a determination as to the application of section 815-130.

Draft Schedule 3 emphasises that while economic arguments presented may be useful in certain circumstances, the factors outlined in Schedule 3 will primarily have regard to available evidence.

In lieu of this updated guidance and in particular the released draft of Schedule 3, it is important that taxpayers now assess the risk associated with interest-free intra-group cross border loans with reference to the ATO guidance and ensure adequate evidence required to defend this position.

The ATO has invited comments in response to the draft Schedule 3, with closing date for comments 14 October 2020.

Please contact a member of our Tax team if you would like further information.