Overview of recent developments
Comprehensive new transfer pricing laws were introduced during the course of 2012 and 2013.These laws were passed in two instalments— first, Subdiv 815 A of the Income Tax Assessment Act 1997 (Cth) (ITAA97) dealing with assessing powers under the equivalent of our double tax agreements (DTAs) and retrospective to 1 July 2004, and second, Subdivs 815-B to 815- D ITAA97 which were broader (applying to both DTA and non-DTA circumstances) and of prospective effect from 1 July 2013. In addition, Subdiv 284-E of Schedule 1 to the Taxation Administration Act 1953 (Cth) contains specific transfer pricing documentation requirements.
The new laws significantly update Australia’s domestic transfer pricing laws, prospectively replace Div 13 of the Income Tax Assessment Act 1936 (Cth) (ITAA36) and are intended to better align those new laws with internationally consistent transfer pricing approaches outlined by the OECD.
Each of Subdiv 815-A, 815-B and 815-C deals with the interaction of the thin capitalization and transfer pricing laws as they apply to debt deductions. Subdivision 815-B, which applies the arm’s length principle to cross border conditions between entities, contains a special rule in s 815- 140 ITAA97 that, in simplest terms, compels taxpayers to consider/determine a rate for debt interest as if arm’s length conditions had operated.
Despite the specific wording in s 815-140 and assurances in the accompanying explanatory memorandum (EM), it would appear that a basis has been left open for the argument that in determining the arm’s length rate of interest, regard should be given to the amount of debt that might reasonably be expected to be made available between independent parties dealing wholly independently with one another, that is, particularly when related parties are involved in the loan (controlled transaction).
Although arguably supported by the OECD Transfer Pricing Guidelines, the EM suggests that this approach would only be adopted in some exceptional cases. However, this approach could be adopted irrespective of otherwise complying with other limits and restrictions.
While any practical application of this approach would be controversial, it is questionable whether this approach would be supported by the plain words of s 815-140, and given the primacy of the language of the statute, raises significant statutory interpretation (as well as tax law design) issues.
Taxpayers are well advised to give due consideration to the expanded economic analysis, additional documentation requirements and related penalties exposures of the new transfer pricings laws.
Current environment and related issues
On 6 November 2013, the new Coalition Government announced that it was endorsing and proceeding with the implementation of the thin capitalization reforms announced in the May 2013 Australian Budget. Among other measures to be effective from 1 July 2014, the acceptable debt amount in the thin capitalization rules will be reduced for general entities from 75 per cent to 60 per cent on a debt to Australian assets basis (effective debt to equity ratio of 1.5:1). Similar tightening of acceptable ratios will apply to non bank financial entities and Authorized Deposit-Taking Institutions (ADIs). Further, the new worldwide gearing limit of 100 per cent will be extended to inbound investors and the threshold below which debt deductions will not be contested will be increased from AU$250,000 to AU$2 million.
These reforms to the thin capitalization rules when enacted and effective from 1 July 2014 may result in a greater reliance on the alternative arm’s length debt amount test in the thin capitalization rules, which is distinct and separate to the arm’s length amount of debt referred to in the transfer pricing laws above. Particularly for major infrastructure projects, property investments/developments and certain resources and services projects, a greater reliance on the arm’s length debt amount method is anticipated, especially in this lower interest rate environment in Australia.
According to Australian Taxation Office (ATO) figures for the 2011 income tax year, the arm’s length debt amount method was used by 55 non ADI general investing entities (mainly inward investing entities) resulting in interest deductions of approximately AU$1.860 billion. ATO audit activity on loans, guarantees, letters of comfort, insurance arrangements and related financial issues as well as recent cases/disputes, continues to escalate.
Given the recent history of ATO approaches to related matters such as securitized lease vehicles and the discussion paper (and draft tax determinations) on intra group finance guarantees and loans, reliance on ATO administrative practice and rulings that could be amended or withdrawn should be approached cautiously in the current environment.
What lies ahead
While the ATO’s (and other revenue authorities) principal focus will be on multinational groups shifting or pushing down interest expenses across the group, these expanded and additional powers to focus on the arm’s length amount of debt are expected to be at the forefront of international tax compliance activities in the coming years.
It is understood the ATO is currently working on several rulings and practice statements dealing with transfer pricing reconstruction powers, documentation and penalties with a view to these being publicly released during the course of 2014.
The Board of Taxation is also currently reviewing the thin capitalization arm’s length debt test and is due to report and make recommendations to the Government by December 2014.