The draft Guideline provides guidance to entities in applying the arm’s length debt test in Division 820 of the Income Tax Assessment Act 19972 and should be read in conjunction with draft Taxation Ruling TR 2019/D2 Income tax: thin capitalisation – the arm’s length debt test. This Guideline also provides a risk assessment framework that outlines our compliance approach to an application of the arm’s length debt test in certain circumstances that are identified as low risk. The arm’s length debt test is one of the tests available to establish an entity’s maximum allowable debt for thin capitalisation purposes. The test focuses on identifying an amount of debt a notional stand-alone Australian business would reasonably be expected to borrow, and what independent commercial lenders would reasonably be expected to lend on arm’s length terms and conditions. An entity’s debt deductions are reduced to the extent that its adjusted average debt exceeds its maximum allowable debt. The arm’s length debt test may be used to support debt deductions for commercially justifiable levels of debt. In practice, the test is typically only used when an entity is unable to satisfy the safe harbour and worldwide gearing tests (as the compliance burden of applying these tests is generally lower). It is not common for Australian businesses to gear in excess of 60% of their net assets and historically relatively few entities have applied the arm’s length debt test. We consider the choice to apply the arm’s length debt test carries with it the necessity to undertake more rigorous analysis than the safe harbour and worldwide gearing tests. While the arm’s length debt test in some respects draws upon arm’s length concepts that are broadly common to transfer pricing, the test itself is not a transfer pricing analysis, nor does it necessarily proxy an outcome consistent with the arm’s length conditions under Subdivision 815-B. Rather it requires an overlay of factual assumptions that produce a hypothetical entity against which specific factors are to be assessed. This Guideline is limited to providing guidance and a risk assessment framework relating to the application of the arm’s length debt test contained in sections 820-105 and 820-215. It does not set out our approach to reviewing other taxation issues that might arise in relation to debt deductions ...

The Practical Compliance Guideline (Guideline) from the ATO outlines the compliance approach to the taxation outcomes associated with a ‘financing arrangement’, as defined in section 995-1 of the Income Tax Assessment Act 1997 (ITAA 1997), or a related transaction or contract, entered into with a cross border related party. Such an arrangement, transaction or contract is referred to in this Guideline as a ‘related party financing arrangement’. This Guideline does not cover financing arrangements characterised as equity in accordance with Division 974 of the ITAA 1997. The framework in these Guideline and the accompanying schedules are used to assess risk and tailor engagement according to the features of the related party financing arrangement, the profile of the parties to the related party financing arrangement and the choices and behaviours of the group. The tax risk associated with the related party financing arrangement is assessed having regard to a combination of quantitative and qualitative indicators. If the related party financing arrangement is rated as low risk, then the Commissioner will generally not apply compliance resources to review the taxation outcomes other than to fact check the appropriate risk rating. If the related party financing arrangement falls outside the low risk category, the Commissioner will monitor, test and/or verify the taxation outcomes. The higher the risk rating, the more likely the arrangements will be reviewed as a matter of priority. The framework set out in this Guideline can be applied to: (a) assess the tax risk of your related party financing arrangement (b) understand the compliance approach we are likely to adopt given the risk profile of your related party financing arrangement (c) work with us to mitigate the transfer pricing risk in relation to your related party financing arrangement and be confident you have reduced your risk exposure, and (d) understand the type of analysis and evidence we would require when assessing the risk outcomes of your related party financing arrangements ...

The 2013 Draft Handbook on Transfer Pricing Risk Assessment is a detailed, practical resource that countries can follow in developing their own risk assessment approaches. The handbook supplements useful materials already available with respect to transfer pricing risk assessment. The OECD Forum on Tax Administration published a report entitled “Dealing Effectively with the Challenges of Transfer Pricing” in January 2012. One chapter of that report also addresses transfer pricing risk assessment ...

A holding company of an international Group was established in Spain and in it and in the Group’s operating entity, which was made dependent on it and with which it was fiscally consolidated, intra group loans were requested, for the acquisition of shares in other Group companies, which were mere asset relocations without any economic or business substance, with the sole objective of reducing taxation in Spain: Both in the Spanish holding company and in the operating entity, financial expenses were deducted as a result of that indebtedness, which lead to a drastic reduction in profits in the operating company and losses in the holding company, with the final result that this income remains untaxed. On this background an assessment was issued by the tax authorities where the financial expenses were disallowed under Spanish “fraud by law” provisions. As stated in Article 6.4 of the Civil Code: “Acts carried out under the protection of the text of a rule which pursue a result prohibited by the legal system, or contrary to it, shall be considered to have been carried out in fraud of law and shall not prevent the due application of the rule which it was sought to circumvent“. This, transferred to the tax sphere, is equivalent to the text of Article 24 of the LGT, in the wording given by Law 25/1995, of 20 July 1995 (applicable to the case in question), which states: “In order to avoid tax evasion, it shall be understood that there is no extension of the taxable event when tax is levied on events, acts or legal transactions carried out for the purpose of avoiding payment of the tax, under the cover of the text of rules issued for a different purpose, provided that they produce a result equivalent to that derived from the taxable event. Fraud of tax law must be declared in special proceedings in which the interested party is heard. 2. Events, acts or legal transactions carried out in fraudulent evasion of tax law shall not prevent the application of the evaded tax rule nor shall they give rise to the tax advantages that were intended to be obtained through them. 3. In the settlements made as a result of the tax evasion case, the tax rule that has been evaded shall be applied and the corresponding late payment interest shall be paid, without the imposition of penalties for these purposes alone“. Decision of the TEAC The TEAC confirmed the existence of fraud by law and upheld the assessment. All the actions are legal and real; there is no simulation, but from the set of all the circumstances, without proof that there is a substance and economic business reality, it is concluded that it is a simple exchange of shares within the Group, with the sole purpose of generating the financial expenses in the Spanish entities of the Group, all of which is declared in fraud of law, and the situation is regularised by not admitting the financial expenses involved. There are no international tax reasons for the alleged fraud of law (application of DTAs, infringement of Community Law, etc.) as the application of the concept of fraud of law should have been applied in the same way in the case of a Group with a national parent company and article 24 of the LGT, the provision from which the application of fraud of law derives, does not contain any distinction or restriction depending on whether residents or non-residents are involved. The rules on related-party transactions or transfer pricing do not apply, as it is not disputed that the transactions were carried out at market value; indeed, it is acknowledged that this was the case. It is from the set of circumstances analysed that the existence of fraud by law can be concluded. If it were possible to correct it through the mere application of a specific rule (either related-party transactions or thin capitalisation, etc.) we would no longer be dealing with a case of fraud by law. Click here for English translation Click here for other translation ...