Thin capitalisation revisions to make compliance more challenging: BDO
Practitioners will need to be proactive to keep up with thin capitalisation legislation changes, BDO has warned.
The Australian Taxation Office (ATO) has not yet provided guidance regarding arm’s length capital structures. In the meantime, taxpayers will have to second guess how they can demonstrate to the ATO that their capital structures are at arm’s length, BDO said.
“The recent revisions to the thin capitalisation legislation arguably made the compliance environment for Australian corporates – and for the ATO – more complex, subjective, and challenging,” BDO explained.
The arm’s length capital structure requirement is additional to three new tests outlined in the thin capitalisation legislation, including the third-party debt test, fixed ratio test and group ratio test.
Under the legislation, the net interest expense that a taxpayer can deduct is the lesser of the result of these three tests, and an arm’s length debt amount.
Arm’s length requirements mandate that financial transactions between multinational group entities should be conducted under terms and conditions that independent, unrelated parties will agree to in comparable circumstances.
As taxpayers await further guidance from the ATO regarding arm’s length capital structures, BDO advised that businesses should undertake analyses of their capital structures, including from the perspective of a lender and independent equity investor.
Furthermore, businesses should review how financial transactions are currently incorporated into existing transfer pricing documentation, and evaluate how the ATO may view existing and proposed financial transactions to anticipate sources of potential tax risk.
The arm’s length requirements are designed to prevent tax avoidance by ensuring that financial transactions between multinational subsidiaries are conducted at an arm’s length, curbing arrangements that can artificially shift profits to lower tax jurisdictions.
However, BDO warned that the ATO’s lack of guidance on how to identify “arm’s length” transactions could make it challenging for firms to adhere to the requirements.
“Recent Australian tax court decisions … may have the unintended effect of increasing the amount of debt that the taxpayer can otherwise in theory borrow, using the ATO’s own arguments and recent Australian court interpretations of the arm’s length principle,” BDO added.
BDO outlined the example of Mylan Australia, which won an anti-avoidance case against the ATO in 2024.
The ATO asserted that Mylan Australia should have financed its acquisition of a pharmaceutical business entirely with equity at the Australian level. However, the judge found that there could be a number of commercial reasons why a taxpayer might decide to finance itself with debt over equity.
In the ATO’s decision impact statement for this case, they reaffirmed that the ruling did not disturb their view that such arrangements could apply to debt pushdown schemes.
BDO said that this case highlighted the ATO’s sensitivity to highly leveraged taxpayers, including those with debt brought on from a corporate acquisition. However, there could be a variety of non-tax reasons why a taxpayer might prefer using debt over equity, which might allow taxpayers to argue that their debt amount was appropriate.
In other recent cases including Singtel Optus and the ATO, the tax office argued that the credit quality of a subsidiary should be the same as its parent company. This would allow the subsidiary to borrow more money at a lower rate.
According to BDO, this approach doesn’t align with OECD guidelines which treat subsidiaries as independent from their parent entities. The ATO’s stance on this issue may allow subsidiaries to take on more debt, than if they are to be treated separately.
This may lead to outcomes where a subsidiary can be nearly entirely debt funded under transfer pricing principles, BDO said.
Practical compliance guidelines (PCG) from the ATO, expected to come in early 2025, should clarify how a taxpayer may support its debt amount under transfer pricing principles, BDO said.
However, the ATO said the PCG will not provide specific advice on the technical interpretation or application of Australia’s transfer pricing rules, or other taxation provisions.
“As we await further guidance from the ATO on arm’s length capital structures, taxpayers should stay proactive and review their current debt arrangements, ensuring they align with the latest legislative changes and transfer pricing principles,” BDO advised.
