On 5 April 2019, the Australian Taxation Office (ATO) released a draft ruling TR 2019/D2 with respect to the requirements for the application of the arm’s-length debt test (ALDT) in the thin capitalization rules.
The draft ruling proposes that the guidance is to apply both before and after its date of issue, despite there being no change to the law concerning the ALDT. The eventual final ruling, along with a planned draft Practical Compliance Guideline (PCG), will replace an existing taxation ruling. Comments on the draft ruling (and practical compliance guideline) are due by 31 May 2019.
What this draft Ruling is about
This draft Ruling deals with the application of the arm’s length debt test contained in the thin capitalization rules in Division 820 of the Income Tax Assessment Act 1997 (ITAA 1997).
The thin capitalization rules set a limit on the amount of debt that can be used to finance an entity’s Australian operations. For entities that are not authorized deposit taking institutions (non-ADIs), the arm’s length debt amount for the year is one amount that can be used to determine an entity’s maximum allowable debt. For tax purposes, an entity’s debt deductions are reduced to the extent that its adjusted average debt exceeds its maximum allowable debt.
This Ruling applies to an entity who seeks to apply the arm’s length debt test contained in section 820-105 (for outward investing entities (non-ADI)) and section 820-215 (for inward investing entities (non-ADI)). The purpose of this Ruling is to provide interpretative guidance on key technical issues that may arise in determining an entity’s arm’s length debt amount. This Ruling also provides interpretative guidance relating to the record-keeping requirements in section 820-980.
Background
The thin capitalization regime affects Australian entities which are foreign controlled and foreign entities with Australian permanent establishments or Australian investments (inward investing entities). Australian entities that are not foreign controlled can be affected where they have international operations or are associate entities of such entities (outward investing entities).
Under the thin capitalization regime, interest and other debt deductions will be reduced to the extent that an entity’s adjusted average debt exceeds the entity’s maximum allowable debt. The maximum allowable debt is the greatest of:
- the safe harbor debt amount
- the worldwide gearing debt amount
- the arm’s length debt amount.
The explanatory memorandum to the New Business Tax System (Thin Capitalisation) Bill 2001 (EM) notes that an entity is not required to calculate its maximum allowable debt under each test. It has the option of choosing one of the available tests. Thus, if an entity is able to establish under one of the methods that its maximum allowable debt is greater than its adjusted average debt, it will not have to apply another test. The arm’s length debt test in sections 820-105 or 820-215 applies to outward investing (non-ADI) entities and inward investing (non-ADI) entities respectively. The tests are substantially similar in content and structure. In order to apply the arm’s length debt test it is necessary to identify and isolate the entity’s commercial activities in connection with Australia (Australian business).
