Australia: Australian Tax Update: Interaction of Australia's transfer pricing, thin capitalisation rules and double tax treaties

Last Updated: 5 January 2010
Article by Jock McCormack

The June 2008 ATO Discussion Paper had proposed that in certain circumstances taxpayers whose amount of debt was within the safe harbour debt limit of the thin capitalisation rules, could have part of their debt funding treated as performing the role of equity and therefore part of the interest expense treated as of a capital nature and thus non-deductible for taxation purposes.

The ATO at paragraph 46 of TR 2009/D6, states that the transfer pricing provisions in Division 13 cannot apply to defeat the operation of the thin capitalisation rules (Division 820) in determining whether an entity's debt levels are excessive for the purpose of disallowing deductions on purportedly excess debt. The ATO however in paragraph 49 does remind taxpayers of the threat of the potential application of the general anti-avoidance provision (Part IVA) where it would be concluded that the dominant purpose of a participant in the loan or scheme arrangement was to enable the taxpayer to obtain the related deductions on the debt.

The preliminary view expressed by the ATO in the June 2008 Discussion Paper on the interaction of Australia's transfer pricing rules (Division 13 and the Business Profits and Associated Enterprises Articles contained in Australia's Double Tax Treaties) relied on OECD and Tax Treaty approaches that may not be properly supported under Australian tax law.

The ATO has publicly acknowledged that TD 2007/D20 and the June 2008 Discussion Paper raised two very controversial issues upon which it has been seeking external Legal Counsel's advice.

These two issues are as follows:

  • Whether the Associated Enterprises Articles (Article 9) contained in Double Tax Treaties or our domestic transfer pricing provision (Division 13) confer a 'reconstruction' power. There is important recent judicial commentary that our treaties, including Article 9, only allocate taxing rights between countries rather than provide a separate taxing power; and
  • Whether Article 9 similarly provides the ATO with authority to make transfer pricing adjustments separate from Division 13; most particularly in the context of debt/equity ratios, that is thin capitalisation limits regarding acceptable levels of debt. Division 13 is generally specific that the ATO can only determine arm's length pricing (that is, interest rates), as distinct from restructuring transactions and thereby imposing an acceptable level of debt to equity ratio in addition to that provided by the thin capitalisation rules.

Most importantly in Undershaft (No 1) Limited v Commissioner of Taxation [2009] FCA 41 (Undershaft (No. 1) Case), Justice Lindgren in several directly targeted comments stated that the principal purpose of Double Tax Treaties was to avoid double tax on the same income and to essentially allocate taxing rights, thereby restricting one State's taxing powers. Justice Lindgren further stated that a Double Tax Treaty does not provide a State with a power to tax or oblige a State to tax an amount over which it is allocated a right to tax. Accordingly, the preferred view based on Justice Lindgren's learned comments in the Undershaft (No. 1) Case would appear to be that the Associated Enterprises Article – or any other article – do not allow, provide or confer upon the ATO a reconstruction power to effectively determine an arm's length amount of debt outside our thin capitalisation rules. Not surprisingly, the ATO in its Decision Impact Statement on the Undershaft (No. 1) Case issued on 29 July 2009, argued that Double Tax Treaties do in certain circumstances give a power to tax.

Support for the views expressed by Justice Lindgren in the Undershaft (No. 1) Case exists in an earlier 2008 decision, Roche Products Pty Ltd v Federal Commissioner of Taxation (2008) ATC 10-036. In that decision, Justice Downes similarly stated at paragraph 191 that treaties allocate taxing power between the treaty parties rather than confer any power to assess on the relevant revenue authority.

Rather threateningly in paragraph 27 of TR 2009/D6, the ATO has responded that the issue of whether there is a power to assess to give effect to the Treaty provisions is likely to be of practical significance only if the Commissioner's view that Division 13 is as extensive as the Treaty provisions in this respect, is found to be wrong by the Courts.

One should not underestimate the ATO and in this context, it has made it clear that it is reviewing and seeking to come to a final resolution of its view on this and related issues in the coming months, and that the current draft Ruling and draft Practice Statement will alleviate any uncertainty pending finalisation of the ATO view.

These two ATO public releases provide further guidance to taxpayers and the ATO's staff more particularly on determining the arm's length pricing – particularly interest rates - associated with taxpayer loans.

TR 2009/D6 seeks to clarify the ATO's view on the interaction of these provisions. Where an entity does not have debt in excess of the maximum allowable level, and the thin capitalisation rules do not result in a disallowance of any portion of the entities debt deductions, the transfer pricing provisions may still apply to other terms of the loan agreement to adjust the pricing of associated costs to an arm's length level (for example, interest). In this case, although the amount of debt would be below the maximum allowable amount determined by the thin capitalisation provisions, the transfer pricing provisions may still apply to deem the interest payable as the arms length amount (and therefore reduce the deduction allowable in respect of interest) for Australian taxation purposes.

Draft Law Administration Practice Statement (PS LA 3187) provides a rule of thumb approach to determining the transfer pricing arms length amount of interest payable by a taxpayer on a cross-border related party loan. That is, the arm's length amount of interest payable should be the weighted average cost of debt of the ultimate parent company as applied to the taxpayers existing debt amount.

Draft Determinations impacting Private Equity and related Transactions – Texas Pacific Gro up (TPG) and Myer transactions

Draft Taxation Determinations 2009/D17 and 2009/D18, described in more detail below, have been released by the ATO following TPG Capital's sell out of its interest in Myer. We understand that TPG structured the initial investment in Myer as follows:

  • TPG was an entity resident in the Cayman Islands, a tax haven. Various United States resident investors and a private equity group controlled TPG.
  • TPG owned a Luxembourg entity which owned an entity in the Netherlands.
  • The Netherlands entity was the holding company of an Australian company that acquired all of the shares in Myer.
  • It has been represented that the primary purpose of TPG acquiring Myer was to improve Myer's profitability in the short term and to sell Myer via a public offering at a profit.
  • The interposition of the Netherlands entity triggered the Australian-Netherlands tax treaty in relation to business profits sourced in Australia. Therefore, the profits from the public sale of Myer should not be taxed in Australia.
  • The interposition of the Luxemburg entity purportedly triggered tax advantages as between other European/ International companies. Therefore, the Australian profit gave rise to not only a non-taxable gain in the Netherlands, but also a tax free dividend in Luxembourg. Subsequently, a tax free dividend could potentially also be paid to the owners of the Cayman Islands entity.

This structure raises several interesting issues as to the Australian taxation treatment of profits derived from the sale of the assets in Australia by a foreign private equity investor. The preliminary view of the ATO in respect of such issues has been clarified in two draft determinations, discussed below.

Draft Taxation Determination 2009/D17 – Anti-Avoidance provisions and Treaty Shopping

The ATO has expressed a view that the anti-tax avoidance provisions in Part IVA of the Australian Income Tax Assessment Act 1936 (ITAA 1936) may apply to private equity acquisitions where foreign entities invest in Australian companies and the requirements of Part IVA are satisfied (that is, where a tax benefit has been obtained in connection with the scheme and the scheme was entered into for the purpose of obtaining a tax benefit).

For example, where an entity proposes to purchase Australian assets through the equity investment of a company resident in a tax haven, which then makes an equity investment into a company resident in a country where Australia has a tax treaty, which subsequently purchases the Australian assets and subsequently sells those assets for profit, the profit on sale may be subject to relief, amongst other reasons, under the relevant tax treaty. In such circumstances, each of the interposed entities may be mere holding companies, their primary purpose being to hold shares in the next company in the chain.

In the ATO's view, Part IVA may apply to such measures where, amongst other factors, the arrangements:

  • go beyond what might be thought necessary to achieve the commercial goal of bringing various buyers together to make the purchase;
  • are put into place merely to attract the operation of a particular tax treaty and obtain a tax benefit; and
  • where the manner of acquisition involves an unnecessary hierarchy of holding companies.

Draft Taxation Determination 2009/D18 – Capital v Revenue distinction on disposal of target assets by private equity entity

The ATO has expressed the view that a private equity entity may make an income gain (that is, on revenue account rather than on capital account) from the disposal of the target assets it has acquired. The profit on such disposal may potentially be included in the assessable income of the entity under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) where the transaction is in the course of the entities business, even if the profit arises from the sale of a CGT asset that is not taxable Australian property.

For example, where a private equity entity resident in a country in which Australia does not have a tax treaty acquires Australian target assets and disposes of these at a profit, that profit would be subject to tax in Australia, subject to the potential application of section 855-10 of the ITAA 1997 if the profit or gain should be treated as on capital account, giving rise to a capital gain. However, in circumstances where the acquisition and subsequent disposal of target assets is made by a non-resident private equity entity that is a resident of a country with whom Australia has a tax treaty, potential treaty relief from Australian taxation might also be available.

The revenue vs capital treatment of gains on disposal of Australian assets has been a controversial issue for many years, and should only be evaluated on a case by case basis. Further, other issues including the source of any gain or income, permanent establishment status and potential treaty relief require proper analysis in the context of the particular facts to determine the ultimate Australian tax position.

Opportunity for submissions on ATO Public Releases

The ATO is accepting submissions from the public on all of the above ATO releases, primarily by 29 January 2010, after which we expect the ATO to promptly articulate its position on all issues in more detail and more conclusively.

© DLA Phillips Fox

DLA Phillips Fox is one of the largest legal firms in Australasia and a member of DLA Piper Group, an alliance of independent legal practices. It is a separate and distinct legal entity. For more information visit

This publication is intended as a first point of reference and should not be relied on as a substitute for professional advice. Specialist legal advice should always be sought in relation to any particular circumstances.

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