The overlap of Australia's new transfer pricing laws with the thin capitalization rules is causing challenges and likely duplication of analysis for taxpayers - particularly for the arm's length amount-of-debt test.
Australia legislated comprehensive new transfer pricing laws in 2012[i] and 2013.[ii] These laws were passed in two installments: Subdivision 815-A, dealing with assessing powers under the equivalent of our Double Tax Agreements (DTAs) and retrospective to July 1, 2004, and Subdivisions 815-B to D, which were broader (applying to both DTA and non–DTA circumstances) and of prospective effect from July 1, 2013. In addition, Subdivision 284–E of Schedule 1 of the Taxation Administration Act 1953 contains specific transfer pricing documentation requirements.
The new transfer pricing laws were largely introduced as a response to the Commissioner of Taxation's loss in the full Federal Court decision in Commissioner of Taxation v SNF (Australia) Pty Limited (2011)[iii] (SNF decision). In that decision, the Court rejected several of the Commissioner’s fundamental technical arguments – not least, it rejected the legitimacy of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations as approved by the Council of the OECD (OECD Transfer Pricing Guidelines[iv]) as an aid to the interpretation of Australia's DTAs and existing domestic transfer pricing laws.
The new laws significantly modernize Australia's domestic transfer pricing laws, prospectively replace Division 13[v] and aim to better align those new laws with internationally consistent transfer pricing approaches outlined by the Organisation for Economic Cooperation and Development (OECD).
The new transfer pricing laws now provide direct access to the OECD guidance materials and purportedly clarify how these laws should interact with the thin cap provisions contained in Division 820.
Each of Subdivision 815-A, B and C deals with the interaction of the thin cap and transfer pricing laws as they apply to debt deductions. For convenience and major relevance, in this article we principally deal with the interaction of Subdivision 815-B and Division 820, although we make some references to the other subdivisions. Subdivision 815-B applies the arm's length principle to cross-border conditions between entities.
Subdivision 815-B contains a special rule, in section 815-140, which modifies the way an entity works out its taxable income or loss and how the thin cap rules apply, affecting debt deductions for the entity for a particular income tax year. Essentially, taxpayers are directed to apply Subdivision 815-B prior to applying Division 820 in determining such factors as the appropriate debt deductions available to the taxpayer.
Despite the specific wording in section 815-140 and assurances in the accompanying Explanatory Memorandum (EM) at paragraphs 3.8, 3.144, 3.145 and 3.146, 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 – for example, 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 even when there is otherwise compliance with the safe harbor or other thin cap limits.
While any practical application of this approach would be controversial, it is questionable whether this particular approach would be supported by the plain words of section 815-140: the primacy of the statute’s language raises significant statutory interpretation (as well as tax law design) issues. Further, there are important administrative law issues associated with the extent to which taxpayers can rely on an administrative approach outlined in Taxation Ruling TR2010/7[vi] which precedes the new transfer pricing laws passed in 2012 and 2013 and the SNF decision.
Taxpayers are well advised to contemporaneously address the expanded economic analysis, additional documentation requirements and related penalties exposures of the new transfer pricings laws.
CURRENT ENVIRONMENT AND RELATED ISSUES
In November 2013, the new Australian government announced[vii] that it was endorsing and proceeding with the implementation of the thin cap reforms announced in the May 2013 Australian budget. Among other measures to be effective from July 1, 2014, the safe harbor debt amount in the thin cap rules will be reduced for general entities from 75 percent to 60 percent on a debt to Australian assets basis (effective debt to equity ratio of 1.5:1). Similar tightening of safe harbor ratios will apply to non-bank financial entities and ADIs.[viii] Further, the new worldwide gearing limit of 100 percent will be extended to inbound investors and the de minimis threshold will be increased from AU$250,000 to AU$2 million of debt deductions.
These reforms to the thin cap rules, when enacted and effective from July 1, 2014, may result in a greater reliance on the alternative arm's length debt amount test in the thin cap rules, which is distinct and separate from the arm's length amount of debt referenced 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.
The Board of Taxation is currently reviewing the thin cap arm's length debt test and released a Discussion Paper in December 2013. The focus of the review and Discussion Paper is twofold: to reduce compliance costs for business and to ease the administration for the ATO, as well as considering who should be eligible to access the test. The Board of Taxation is due to report and make recommendations to the government by December 2014.
ATO audit activity on loans, guarantees, letters of comfort, insurance arrangements and related financial issues as well as recent cases/disputes, continues to escalate.
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.
Last but not least is the current G20/OECD BEPS Project,[ix] which will develop proposals and recommendations to tackle the 15 issues identified in the BEPS Action Plan, including Action 4, which deals with interest deductions and other financial payments, as well Action 2, dealing with hybrid arrangements/instruments. The BEPS initiative could result in a combination of multilateral, bilateral or unilateral initiatives to deal with limiting excessive debt deductions and including approaches to the arm's length amount of debt.
While the initiative focused on developments in e-commerce and the digital economy, there are certain perceptions that interest expenses are at the core of aggressive international tax planning. This year, Australia has assumed the presidency of the G20 in 2014; with this role, there are likely to be additional expectations in the international community for Australia to make progress on the BEPS Action Plan. Mark Konza, in his expanded role as ATO Deputy Commission, Corporation Tax Erosion, recently provided a useful overview of the ATO initiatives around BEPS, including the focus on excessive interest arrangements and related party leveraging.[x]