Australia: TR 2010-7 - interaction between thin cap and transfer pricing

Last Updated: 27 October 2010
Article by Daren Yeoh

New ATO Taxation Ruling impacting on the pricing of offshore related party loans

On 27 October 2010, the Commissioner of Taxation (the "Commissioner") finalised its draft ruling on the interaction between the transfer pricing provisions and the thin capitalisation provisions. Draft ruling TR 2009/D6 (the "Draft Ruling") was finalised as Taxation Ruling TR 2010/7 (the "Ruling").

When does the Ruling apply?

The Ruling applies retrospectively. This means that taxpayers may have to revisit the approach used to price intercompany loans in the past. In this regard, it is noted that the Commissioner generally has no time limit to make a transfer pricing adjustment.

What is the mischief being targeted by the Ruling?

In paragraph 78 of the Ruling, the Commissioner states:

"We had become concerned that some foreign parent companies had funded their Australian subsidiary with a relatively low amount of equity and high amount of debt, and therefore had assumed a higher level of credit risk in respect of that debt than an independent lender might be expected to assume. The parent then demanded a high interest rate, guarantee fee or other credit support charges because the debt was unsecured and the subsidiary had a weak debt: equity ratio and a consequent low standalone credit rating. This was a new development in the tax system that, it would appear, evolved after the commencement of Division 820."

At paragraph 53 of the Ruling, the Commissioner signals that it may be appropriate for him to consider the debt and capital structure of a taxpayer where it has a low net profit position and that profit position is attributable to high levels of debt carried by the taxpayer. Similarly, the Commissioner will also be asking whether the taxpayer's financing arrangements reflect commercial realities i.e. would arm's length lenders lend based on the debt and equity structure of the taxpayer.

What is the technical issue being addressed by the Ruling?

The thin capitalisation provisions generally allow a safe harbour gearing (debt to equity) ratio of 3 to 1. Interest deductions on the portion of the debt in excess of the safe harbour level (the "excess debt") may be denied under the thin capitalisation provisions. However, a salient point to note is that the thin capitalisation rules apply to interest amounts which are otherwise allowable and not denied under other provisions in the Income Tax Acts including the transfer pricing rules. The debate is whether the transfer pricing provisions can be used to deny interest deductions on the portion of the debt which is in excess of what the taxpayer could borrow in an arm's length dealing (even when the taxpayer does not have any excess debt).

The Good News: Consistent with the Draft Ruling, the Commissioner opined that the transfer pricing provisions cannot apply to defeat the operation of the thin capitalisation provisions in determining whether an entity's debt levels are excessive for the purpose of disallowing deductions on that 'excess debt'. We note that this view is more favourable to taxpayers compared to the legal advice that the Commissioner received from the former Federal Court Judge, Ron Merkel QC.

The Not So Good News: However, the Commissioner warns that the transfer pricing provisions can be used to reprice the loan based on arm's length principles. This could involve, inter-alia, repricing the loan based on an alternative debt and capital structure that makes commercial sense. This will potentially have the effect of improving the assessment of the borrower's creditworthiness, which in turn may result in a lower acceptable interest rate on the loan.

Is there a "rule of thumb: approach that can be used by taxpayers?

The Commissioner has previously released a Draft Practice Statement PS LA 3187 which provides a practical "rule of thumb" approach to price the interest on related party loans. This Draft Practice Statement was never finalised and appears to have been discontinued.

However, paragraph 57 of the Ruling suggests that taxpayers may consider pricing the loan using the parent's credit rating, which is broadly the approach put forward in the Draft Practice Statement. Paragraph 49 states that this may be appropriate where"... the operations of the borrower are core to the group in the sense that its functions were a vital part of an integrated business, it would generally be expected that the borrower company would have the same credit standing as its parent". It appears that the threshold may not be very high in determining whether the operations of the borrower are core to the group. Ultimately the assessment will depend on the surrounding facts and circumstances.

Approaches suggested in the Ruling to price loans

One approach is using the parent's credit rating as discussed above. In using this approach, one should also consider the practices of the other relevant jurisdiction in relation to the pricing of loans.

Paragraph 55 suggest that an alternative approach might be to price an amount of debt by having regard to the amount of debt that the taxpayer would reasonably be expected to have if it was dealing at arm's length with an arm's length lender. For example, assume that a taxpayer has equity of $100m and debt of $300m.The interest rate on the debt is 15%. Assume that the level of debt that might reasonably be expected to exist in an arm's length scenario is $200m at an interest rate of 10%. In this case, a possible approach would be to claim an annual interest deduction of $30m being 10% on the actual debt amount of $300m.

Practically, finding a comparable financing arrangement that that is "commercially realistic" will be difficult and subjective. In this regard, paragraph 57 suggests looking at comparable companies which operate in the particular market, which under their capital structures were able to borrow from third parties the amounts in questions. In other words, the taxpayer may determine its credit worthiness on the assumption that it has a gearing level that is same as the average of that achieved by comparable companies. It is also arguable that comparable companies could include those with the same functional, asset and risk profile as that of the taxpayer. However, it is noted this quantitative analysis only provides half the picture. Qualitative factors (such as growth plans, market competition etc) should also be taken into account as well.

If you have any questions in relation to this publication or would like to discuss the pricing of your offshore related party loans or any other international or transfer pricing issues, please contact Daren Yeoh on

This publication is issued by Moore Stephens Australia Pty Limited ACN 062 181 846 (Moore Stephens Australia) exclusively for the general information of clients and staff of Moore Stephens Australia and the clients and staff of all affiliated independent accounting firms (and their related service entities) licensed to operate under the name Moore Stephens within Australia (Australian Member). The material contained in this publication is in the nature of general comment and information only and is not advice. The material should not be relied upon. Moore Stephens Australia, any Australian Member, any related entity of those persons, or any of their officers employees or representatives, will not be liable for any loss or damage arising out of or in connection with the material contained in this publication. Copyright © 2009 Moore Stephens Australia Pty Limited. All rights reserved.

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