The ATO has now provide the following guidance on the application of the Arm’s Length Debt Test (ALDT) in the thin capitalisation rules:

  • Draft Tax Ruling TR 2019/D2 – issued on 5 April 2019
  • Draft Practical Compliance Guideline PCG 2019/D3 (the PCG)

The submission dates for these documents has now closed and it is unlikely that there will be material changes to either document.

Observations

  • The ATO makes it clear that it sees the ALDT as only applying to a narrow range of taxpayers.
  • The ATO has cast the low risk green zone narrowly and warned taxpayer’s outside the green zones that they can expect ATO scrutiny of any ALDT claims.
  • Tax Ruling TR 2019/D2 and PCG 2019/D3 provide detailed guidance on how the ATO expects the ALDT to be applied but represents a significant narrowing of its interpretation of the ALDT compared to now withdrawn Tax Ruling TR 2003/1.
  • In the context of this detailed guidance we have included below a high level summary of the guidance to assist in understanding the key elements in applying the ALDT.
  • The ATO guidance makes it clear that taxpayers wanting to apply the ALDT will need to invest in analysing and documented the application of the ALDT to their debt arrangements and in particular the commerciality of their capital structures.
  • Unlike the other PCG’s the ATO does not offer documentation concessions to those in the green zone.

Outline of PCG 2019/D3

PCG 2019/D3 includes two key sections:

  • Risk assessment framework for the ALDT
  • Guidance on applying the ALDT

Risk Assessment framework

The PCG outlines specific categories of taxpayers which qualify for the green low risk zone, with all other taxpayers allocated to the moderate to high risk zone.

These risk categories are illustrated in the table below. It is expected that relatively few taxpayers will qualify for the green zone and the broad message from the ATO is that they consider most taxpayers seeking to rely on the ALDT as being moderate to high risk.

It can be seen from the table above that the green zones are very narrow. This is illustrated in the following comments in the PCG[1]:

“The ATO has found that there are limited circumstances in which an entity would gear in excess of 60% of its net assets.”

Guidance on application of ALDT

Factual Assumptions

The PCG considers each of the factual assumptions under the ALDT and provides the following guidance:

Quantitative factors

The PCG also considers each of the relevant quantitative relevant factors required to be considered under the ALDT.

Each of the quantitative factor should be assessed from both the borrower and lenders perspective and a weight attached to each factor. This is summarised below:

Qualitative factors

The PCG also considers each of the qualitative relevant factors required to be considered under the ALDT. For each of the qualitative factors, each factor should be assessed from both the borrower and lenders perspective and assessed as adverse (to be avoided), neutral or supportive, as summarised below:

Requirement for annual testing

  • TR 2019/D2 reinforces the requirement for annual testing of the ALDT even where financing arrangements have not changed.
  • However PCG 2019/D3 provides that the ATO will accept a lower level of testing in later years where there has not been any material change to the notional Australian business or its financing