Currently, if the debt-equity ratio exceeds 75%, 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 taxpayers to prove their debt levels funding its Australian business are at “arm’s length” to justify the full interest deduction, often requiring taxpayers 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% to 60%, 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.
Seven alternatives being considered
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 seven reform proposals the Board is considering include:
- Remove the annual testing requirement
- Review the factual assumptions in determining the arm’s length debt test (so that it looks prospectively only)
- Additional safe harbour tests based on earnings
- Simplify the arm’s length debt test when there is no related-party debt
- Allow 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 to obtain the exemption from the thin capitalisation rules (allowing interest expense to be 100% tax deductible)
All of the proposed options 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 because these valuable assets are not recognised under the current safe harbour test (in that they are not assets recognised for accounting purposes), thereby distorting their true debt-equity ratio.
Read a March 2014 report prepared by the KPMG member firm in Australia: Seven ways to reform Thin Capitalisation Arm's Length Debt Test
Contact a tax professional with KPMG's Global Transfer Pricing Services.