Thin capitalisation reforms: transfer pricing prevails in determining company debt amount

The Australian Taxation Office (ATO) has previously been struggling to apply the transfer pricing rules to adjust the quantum of debt in intercompany financing arrangements.  

Under the previous legislation, the thin capitalisation regime was instead designed to address any issues regarding the quantum of the debt. Conversely, transfer pricing should be applied to govern the arm’s length conditions associated with the intercompany financing arrangements. 

However, under the new thin capitalisation amendments which received Royal Assent on 8 April 2024, the battle as to which rules should apply to the quantum of the debt has been resolved. A legislative amendment in section 815-140 of the ITAA 1997 places transfer pricing in the driving seat going forward.  

The removal of the thin capitalisation safe harbour provisions

Following the introduction of the new thin capitalisation regime, taxpayers will no longer have the existing 60% safe harbour available to rely on to support the quantum of their debt. Instead, transfer pricing will need to be properly considered. Transfer pricing applies under a self-assessment regime with no de-minimis thresholds, so the onus of proof is on taxpayers to support the quantum of their debt as arm's length. The arm’s length debt amount is a complex area, which is expected to place an additional compliance burden on taxpayers.

What should the quantum of debt be from a transfer pricing perspective?

This is not an easy question to answer as so much depends on the specific facts and circumstances of each taxpayer. The ATO has not previously issued any guidance to address this question from a transfer pricing perspective. It has only provided guidance on the application of the arm’s length debt test from a thin capitalisation perspective, which requires certain factual assumptions to be taken i.e., no parental support or guarantee. We expect this will lead to some forthcoming ATO guidance over the coming years, though given these rules are backdated to 1 July 2023 taxpayers will be navigating these rules with less certainty in the meantime.

Australia often turns to guidance from the Organisation for Economic Co-operation and Development (OECD) to align its approach with international consensus. Some insight into this topic has been provided in Chapter X of the OECD Transfer Pricing Guidelines 2022, though the 2017 version of the OECD Guidelines is the last version that was formally acknowledged as relevant guidance material under Australia’s transfer pricing legislation. This leaves taxpayers with even more questions about managing risks and understanding the practical implications of the thin capitalisation amendment.

How does the transfer pricing legislation practically impact my financing arrangements?

• Financing only needs to consider thin capitalisation if the $2 million de-minimis of debt deductions has been breached.
• However, the transfer pricing rules do not have any de-minimis and apply to all international related party financing arrangements. As such, additional consideration should now be given to supporting the quantum of the debt under transfer pricing principles, as well as the interest rate and other terms and conditions of the financing.
• This is expected to be a key focus of the ATO, given intercompany financing has been at the forefront of ATO disputes and review activity, so ensure your transfer pricing documentation is adequate.
• Given the new thin capitalisation provisions are now based on a profits-based approach (i.e. debt deductions are capped at 30% of EBITDA), it is best practice to consider the interplay between the thin capitalisation and transfer pricing provisions to maximise any debt deductions, while appropriately managing any tax risks. 

Key takeaways and action points:

• You should review your current financing arrangements to ensure you properly understand the impact of the new thin capitalisation and transfer pricing rules and whether this is likely to result in a denial of deductions.
• This may lead to refinancing options being considered. 
• Transfer pricing support regarding the quantum of the debt being arm’s length, should be included in any future transfer pricing documentation. 
   

FOR MORE INFORMATION

If you require any further information on these draft thin capitalisation amendments, please speak with Danielle Sherwin.