Currently, if the debt/equity ratio exceeds 75 percent then a portion of interest expense will be non-deductible, unless the arm’s length debt test can be satisfied. Unlike the safe harbour test, the arm’s length test is a qualitative test, placing the onus on the taxpayer to prove their debt levels funding its Australian business are at ‘arm’s length’ to justify the full interest deduction, often requiring them to seek a private ruling from the Australian Taxation Office (ATO).
With the government proposing to reduce the safe harbour gearing limits down from 75 percent to 60 percent, greater reliance on the arm’s length debt test is expected for those borderline cases that may breach safe harbour test under the changed law. As a result of the heightened focus and expected reliance on the arm’s length test, the Board of Taxation is currently considering alternative ways to simplify the current arm’s length test and to make it easier for the ATO to administer.
The 7 reform proposals the Board of Taxation is considering:
- Remove the annual testing requirement.
- Review the factual assumptions in determining the arm’s length debt test (so that its prospective looking only).
- Additional safe harbour tests based on earnings.
- Simplify the arm’s length debt test where there is no related party debt.
- Allowing credit support from related parties.
- Facilitate advanced thin capitalisation agreements.
- Further guidance on current technical issues e.g. clarifying the type of special purposes entities that should obtain the exemption from the thin capitalisation rules (allowing interest expense to be 100 percent tax deductible).
All options proposed have merit. Low asset service companies or companies with valuable intangibles may benefit, from a compliance perspective, from a safe harbour test based on earnings or interest cover ratio (like New Zealand) as an alternative to the arm’s length and safe harbour tests. These companies may currently be disadvantaged as these valuable assets are not recognised under the current safe harbour test (as they are not assets recognised for accounting purposes), thereby distorting their true debt/equity ratio.