Intra-group finance guarantees and loans

Transcription

1 DISCUSSION PAPER EXTERNAL JUNE 2008 UNCLASSIFIED FORMAT AUDIENCE DATE CLASSIFICATION FILE REF: 08/7290 Intra-group finance guarantees and loans Application of Australia s transfer pricing and thin capitalisation rules UNCLASSIFIED For further information or questions, call Marc Simpson on

2 Preamble We issued draft Tax Determination TD 2007/D20 which dealt with the question: Income tax: where there is no excess debt under Division 820 of the Income Tax Assessment Act 1997 can the transfer pricing provisions apply to adjust the pricing of costs that may become debt deductions, for example, interest and guarantee fees? Our short answer was: Yes where these charges were not in themselves consistent with the arm s length principle. TD 2007/D20 clarifies the nature of Division 820 of the Income Tax Assessment Act 1997 ( Division 820 ) as a safe harbour so that the level of debt within the safe harbour rules is protected from the transfer pricing provisions of Division 13 of Part III of the Income Tax Assessment Act 1936 (ITAA 1936). This means that the level of debt is not subject to adjustment under the transfer pricing rules. Taxpayers and their advisers generally agree with this clarification. It is clear from the terms of Division 820 that the Parliament intended that a taxpayer could have a debt level higher than the arm s length amount of debt. It also seems reasonable to conclude that the Division envisaged that the additional debt would be interest bearing. However, this paper explores the scope of Division 13 where the rate of interest (or a guarantee fee) is above an arm s length amount. For example, you can have a 3 to 1 debt to equity ratio without regard to arm s length principles but you cannot incur grossly excessive interest charges. The critical question is whether in determining the arm s length interest rate or guarantee fee the analysis should be based on an arm s length amount of debt. This is a difficult question but its resolution we think rests with an understanding of the statutory purpose of both Division 820 and Division 13. We believe that it would be contrary to the scheme of the Act to allow a shifting of profits through nonarm s length interest rates or guarantee fees, even where the Act contemplates the possibility of nonarm s length debt levels. Such an approach would seem to give effect to both sets of provisions having regard to the statutory framework in which they appear and their policy intent. These difficulties arise particularly where the debt levels allowed by the thin capitalisation safe harbour are higher than would have been the case if the related parties had dealt with each other on an arm s length basis. If they are not, then the market can provide appropriate comparables for the interest rate or guarantee fee.where related party dealings have resulted in a non-arm s length gearing ratio, 1 it may not be possible or practical to ascertain from the market the arm s length consideration relevant to these circumstances because the circumstances themselves may be uncommercial or unrealistic when judged against normal and ordinary business practice. Hence subsection 136AD(4) may be applicable. The application of this provision is subject to the statutory purpose of Division 13 and the principles embodied in the Associated Enterprises Articles of Australia s double tax treaties. By necessity the application of the provision will require a reasonable postulation of what consideration independent parties would agree to in the business and economic circumstances under examination. This paper seeks to develop a rational framework that may assist taxpayers dealing with related parties to work out an appropriate interest or guarantee charge, informed by economic concepts, the nature of business and open market practices. The model envisages behaviours that are sufficiently independent to allow participants to optimise their separate economic interests. In short, the paper rests on the 1 Even if allowed for the purposes of Division 820. UNCLASSIFIED PAGE 2 OF 44

3 proposition that the statutory protection in relation to gearing ratios does not govern the Division 13 analysis of whether the interest charged on the debt or the guarantee fees paid to secure the debt are arm s length. To do so would subvert the statutory scheme and purpose of both the thin capitalisation provisions and Division13. Your feedback on the suggested methodology and framework would be appreciated, particularly if you have an alternative approach for working out an arm s length consideration in the circumstances outlined above. This paper touches on a range of other issues as well, including questions of deductibility, in respect of which your comments would also be appreciated. Introduction 1. The purpose of this paper is to facilitate consultation between the Australian Taxation Office (Tax Office) and business representatives as part of the process of developing a Tax Office view on the application of Australia s transfer pricing rules in Division 13 of the Income Tax Assessment Act 1936 ( Division13 ) and the Associated Enterprises Article of Australia s tax treaties ( treaty Article 9 ) to intra-group finance guarantees and loans. 2. This document is prepared solely for the purpose of obtaining comments from interested parties. This is not a publication that has been approved to allow you to rely on it and therefore does not provide you with protection from either penalty or interest. Nothing in this paper is intended to commit the Tax Office to taking a particular position in any ongoing audit or other matter involving any individual taxpayer. 3. This paper is a step in a process of consultation with tax professionals and industry bodies, with a view to providing taxpayers with a possible approach in circumstances where there are no arm s length comparables. It also addresses the pricing of loans and guarantees where comparables are available. This paper does not consider other transfer pricing issues currently being considered by the Tax Office in the course of developing separate public rulings on related topics. 4. The Tax Office invites comments on any aspect of the paper, and in particular on those issues that are highlighted for specific comment throughout the text. Comments are requested by 15 July We would be particularly interested in alternative methodologies or frameworks for application in circumstances where there are no arm s length comparables. 5. This paper also makes observations about the determination of the thin capitalisation safe harbour amount and your comments on this matter, and the legitimacy of deductions claimed, would also be appreciated. 6. The address for purposes of submitting comments is marc.simpson@ato.gov.au. 7. This paper is divided into four parts. Part A deals with the context of cross-border financing strategies and how corporate lending and guarantee arrangements operate in the UNCLASSIFIED PAGE 3 OF 44

4 open market. Part B discusses approaches to the setting of interest rates and guarantee fees in accordance with the arm s length principle. This part discusses the significance of creditworthiness in that context. Part C discusses methodologies that may assist in the calculations of an arm s length guarantee fee. Part D discusses the definition and role of creditworthiness in the context of arm s length pricing for both finance guarantees and intra-group loans. 8. The Tax Office view on the application of Division 13 to intra-group loans is stated in Taxation Ruling TR 92/11, Application of the Division 13 transfer pricing provisions to loan arrangements and credit balances. Nothing in this discussion paper is intended to be contrary to that public ruling or indicate that the Tax Office may be considering changing its views on determining an arm s length interest rate from those stated in TR 92/11. Paragraph 83 of that public ruling indicates that creditworthiness is a factor in determining an arm s length interest rate, but does not address how creditworthiness is determined for this purpose. Part D of this paper addresses this issue. 9. As with any transfer pricing issue, the extent of the analysis needed to address compliance with the arm s length principle for intra-group loans and guarantees should be judged by applying the standard of a prudent business person and having regard to the relative importance and complexity of the issue 2. TR 92/11 sets out a range of factors relevant to the characterisation of funding arrangements and facts and circumstances relevant to the determination of an arm s length consideration in relation to a loan. 10. In the context under consideration, the current gearing ratios of the related companies (where they are within the safe harbour thin capitalisation rules) are taken as a given for the purposes of the thin capitalisation provisions (see TD 2007/D27). In other words, there is no intent to adjust those gearing ratios using the transfer pricing provisions. Nevertheless, it would be a strange outcome if the thin capitalisation safe harbour could give rise to nonarm s length interest rates or non-arm s length guarantee fees which would have the outcome of shifting profits contrary to the purposes of the statutory scheme. It is submitted that the statutory protection in relation to gearing ratios should not govern the Division 13 analysis of whether the interest charged on the debt or the guarantee fees paid to secure the debt are arm s length. To do so would subvert the statutory scheme and purpose of both the thin capitalisation provisions and Division The views expressed in this paper on the application of the arm s length principle could apply equally to inbound and outbound transactions and the essential elements of the arm s length principle and the associated methodologies are relevant whether the taxpayer is a borrower, a lender, a guarantor or the beneficiary of a guarantee. 12. This paper deals with finance guarantees and loans between separate legal entities, not dealings between parts of a single entity. The principles and views in this paper cannot necessarily be applied by analogy in a permanent establishment context. There are special considerations in determining the creditworthiness of a permanent establishment 3. 2 TR 98/11 paragraphs OECD December 2006, Report on the Attribution of Profits to Permanent Establishments, OECD. UNCLASSIFIED PAGE 4 OF 44

5 13. This paper assumes that the related party transactions are confined to the provision of a guarantee or a loan by a parent company to a subsidiary and do not involve any wider range of transactions or relationships that give rise to additional transfer pricing issues. Part A: Background context for cross-border funding and guarantee arrangements 14. It is essential that a company be able to fund the assets on its balance sheet and its operations in order to remain viable. The only sources available to do this are equity, earnings (including profits from asset sales) and debt. The role of equity funding is to provide funding for the business and to assume the investment risk. Accordingly, where losses are incurred they are borne by the equity participants. The lenders still have to be repaid their principal with any interest that is owing. That is a lender s expectation when advancing funds. The nature of the lender s risk is different from that of an investor. The lender is not expected to fund losses and is not expected to participate in financial upside if the business is extremely successful. The lender is rewarded by a return based on the time value of money and the risk of non-payment through insolvency. A lender may refuse to lend when the risk of default is too high. 15. Where the debt funding required is not available on a stand-alone basis, equity and earnings may allow some (lower) level of borrowing, providing the overall risk profile of the business and other circumstances do not preclude the raising of debt funding. The significance of debt and equity funding in a business will vary depending on the extent to which the operations are balance sheet driven or fee based, the prospect of losses being incurred and the likely extent of such losses should they arise. In the open market it would be expected that the capital structure of a business would comprise the balance of debt and equity funding appropriate to the type of business being conducted, with sufficient equity to allow it to be competitive in terms of its cost of funds, and adequate for the market and economic outlook. 16. It is important to recognise that financial structures and operations within multinational enterprises can be organised in a number of ways. In some cases each entity, region or business division is given responsibility and authority to manage its own cashflow and funding requirements. This would generally entail the establishment of capital structures with sufficient equity to allow independent access to the debt markets to raise the amount of debt needed by the region or division at a price that would allow them to remain competitive. 17. In other cases the financial model adopted by the multinational group involves centralised management of balance sheet funding and working capital, with minimal equity being used by subsidiary companies. The group then supports those subsidiaries with debt funding from the parent or group treasury company, or provides guarantees, collateral, or other comfort that allows the subsidiaries to access debt funding from the market. Multinationals adopting such centralised approaches typically point to the potential to reduce their cost of funds (through, for example, borrowing on the consolidated balance sheet and managing net overdraft positions), the possible improvement in their overall access to debt funding or particular capital markets or financial products, the ability to take advantage of natural UNCLASSIFIED PAGE 5 OF 44

6 hedges and better manage interest rate and currency risks, and improved recognition in the capital markets as reasons for such approaches. Group treasuries can operate as a cost centre or a profit centre 18. In some cases the group operates the centralised treasury as a cost centre which charges the various parts of the group for its funding costs and overheads. In other cases the treasury is expected to operate as a profit centre and is allowed to trade in certain instruments and within certain limits as well as, or sometimes as an adjunct to, managing group funding and liquidity and the attendant cost of funds, interest rate and currency risks. 19. Different group strategies regarding the operation of the treasury may give rise to internally generated profits or losses which in turn can affect the profitability of the operating divisions. 20. The business outcomes being sought by the multinational group in respect of its treasury and its operating entities will vary from case to case and taxation (both in the home jurisdiction and in the countries in which the group conducts operations) will usually be a relevant factor in the group s consideration of its funding strategies and cross-border financing arrangements. The reasons for this are that taxation has a direct and significant bearing on the cost of debt and equity funding and because after tax rates of return are a key indicator of investment success. 21. As explained in the 1995 OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations ( the OECD Guidelines ) 4, on occasions multinational enterprises may put arrangements in place to share the costs of obtaining services where there is a mutual benefit. These arrangements involve the pooling of resources and skills by the participants where the compensation intended is the expected benefits that flow from the pooling arrangement to each of those parties without separate compensation. Independent parties do enter into arrangements to share costs and risks where there is a common need from which the enterprises can mutually benefit. The OECD Guidelines explain that such arrangements are found when a group of companies with a common need for particular activities decides to centralise or undertake jointly the activities in a way that minimises costs and risks to the benefit of each participant. This analysis is relevant to cases where shared services models are implemented by a multinational group for the provision of financial services. Whether it is appropriate to regard the arrangements between the parties as constituting a cost contribution arrangement will depend on the facts and circumstances of the case. It will be particularly relevant to consider this issue in cases where the previously separate treasury functions of several subsidiaries were centralised in one entity. Availability of debt funding depends on creditworthiness, the likelihood of parent support and market and country factors 22. Sometimes the balance sheet and earnings of subsidiaries, regional groups or business divisions are strong enough to support the raising of debt funding in the capital markets. In 4 OECD Guidelines, paragraphs 8.3 and , OECD. UNCLASSIFIED PAGE 6 OF 44

7 other cases some form of support will be required from the parent to enable the subsidiaries, regional groups or business divisions to obtain debt funding. The nature of the support could range from situations where the parent borrows on the strength of its balance sheet and earnings and on-lends to the subsidiary needing the funding, to security or guarantee arrangements, negative pledges, banking covenants and letters of comfort (which may be provided to the third party lender or the subsidiary company seeking to raise the funding). 23. The relative financial strength of the subsidiary, regional group or business division compared to the multinational group as a whole will vary. In some cases the operations of a regional group are extensive, highly profitable and the cashflows are strong and the multinational group has other businesses that are struggling and limiting group profitability. Judged on a stand-alone basis the regional group may be stronger financially than the multinational group as a whole. However to take another example, if the multinational group is able to achieve its internal rate of return target with all of its businesses, and the outlook is positive for all of its operations, the group as a whole is likely to be stronger financially than any subsidiary because of the size of the group balance sheet. 24. The financial strength of a multinational group has a major impact on its credit rating (along with other economic and market factors) and bears directly on the amount of debt it can raise and the interest rate the group is able to obtain on its debt funding. 25. The ability of a subsidiary to borrow and the interest rate that it has to pay on its borrowings will depend on its financial strength and whether the capital markets and specific lenders see the financial fortunes of the subsidiary as being linked to those of the parent and the group as a whole. In any event major lenders and the capital markets more generally will have regard to group relationships in evaluating the credit risk they are prepared to assume in respect of any one group or industry. 26. For example, lenders may not be prepared to advance debt funding to particular industries or businesses, or the market as a whole may consider that a particular industry has no further tolerance to debt funding. Accordingly the willingness of lenders to actually provide debt funding for the activities conducted by a subsidiary is a factor that needs to be considered in determining the ability of the subsidiary to borrow and the cost of those borrowings. It may not be sufficient that a borrower is in theory creditworthy, especially where a borrower has been refused debt funding by the market. Alternatively, a lender may be prepared to lend to a subsidiary of a major multinational, which may not be creditworthy on a strict stand-alone assessment, where the lender judges that the subsidiary is conducting activities that are core to the group s activities and that accordingly the parent is likely to stand behind the subsidiary in the event of difficulty lest its own credit rating be adversely affected. Such lending decisions may also be affected by the relationship that the lender may have with the parent company or by the desire to create a lending relationship with the group for strategic reasons. 27. The higher the level of debt funding the more risky the borrower entity is and capital markets will tend not to lend to an enterprise that is inadequately capitalised having regard to the risks of its business and industry. Where the enterprise has strong cashflows it may UNCLASSIFIED PAGE 7 OF 44

8 be able to borrow but if its credit rating is below investment grade 5 the interest rate it pays will be significantly higher. Ratings below investment grade are generally referred to as sub-prime or junk bond status. The further below investment grade the exponentially higher the interest rate, assuming that lenders are still prepared to lend, which may not be the case. 28. Where the parent company is prepared to guarantee the borrowings of a subsidiary the subsidiary will be judged to have a creditworthiness the same as or similar to that of the parent company since the borrowings are being supported by the group s consolidated balance sheet and operations. 29. The direct provision of funding by a parent company or the giving of a guarantee allow the group as a whole to optimise its profitability by keeping the overall cost of external debt funding to a minimum. Transfer pricing issues that arise in respect of parent company loans and guarantees 30. The application of the arm s length principle requires the consideration of what independent enterprises dealing wholly independently with each other would have done in the circumstances to further their own individual economic interests. In this regard independent enterprises will consider the options available to them having regard to their respective costs and benefits. Moreover, it has been recognised that transfer pricing distortions may be caused by the cashflow requirements of enterprises within a multinational group 6. Accordingly, tax managers within multinational enterprises, their tax advisers and tax administrations need to have regard to jurisdictional and entity level issues to ensure that they are not overlooked when multinational groups implement highly integrated or centralised strategies that are driven by considerations of what is best for the group as a whole Secondly, in applying the arm s length principle in the context of transfer pricing provisions in the tax law, the fact that the market may analyse the financial arrangements on a group basis may not be determinative since such an approach may defeat the purpose of the statutory rules. However, incidental benefits from association with a larger group where the market accords those benefits without an associated company actually providing an economic service that confers a benefit on the recipient would not usually be a basis for imposing a charge. 5 Investment grade is BBB- or above according to the Standard and Poors ratings system and Baa3 or above according to the Moodys rating system. 6 OECD Guidelines, paragraph 1.4, OECD. 7 Care needs to be taken in examining the transfer pricing implications of interest and guarantee charges, especially where the relevant company s gearing ratio is within the thin capitalisation rules. Where the gearing ratios do not make commercial sense, it may be inappropriate to look for comparables without first putting the balance sheet on an arm s length basis for this (Division 13) purpose. For Division 820 purposes there is no change to the actual debt levels. UNCLASSIFIED PAGE 8 OF 44

9 32. A parent company has the option of funding its offshore investment directly with a mix of debt and equity. In this case the funding is supported by the balance sheet and operations of the parent and the group as a whole, enabling it to raise the debt funding its subsidiary needs. The debt cost in those circumstances would be aligned with the weighted average cost of debt and creditworthiness of the parent or the group as a whole. Such an approach raises transfer pricing issues regarding the price at which the funds are on-lent to the subsidiary. An alternative strategy would be to allow the offshore subsidiary to borrow from the banks and the capital markets. This can have the advantage of producing a natural hedge where the subsidiary borrows in the same currency as it derives its revenues. However, where the subsidiary is not financially strong enough to raise the debt funding it needs (for example, where it is highly leveraged) or would pay a higher rate of interest than the parent, it makes commercial sense to provide a guarantee to limit the external cost of funds to the best interest rate the multinational group can obtain. Where such a guarantee or other financial support is provided the transfer pricing issues include a consideration of the relationship between the members of the group involved in the guarantee arrangement and the costs and benefits accruing to each, the circumstances in which the need for the guarantee or other support arises, whether it is appropriate to charge a fee for the guarantee or other support and, if so, the pricing of the guarantee or other accommodation. 33. Multinational enterprises may have an incentive from a managerial point of view to use arm s length prices to be able to judge the real performance of operating divisions. Accordingly special attention is needed where arrangements produce internally generated profits in one centre that seem to distort the operating performance of other centres when the economic substance of the arrangements is considered. It also needs to be acknowledged in the context of treasury operations that transfer pricing distortions may be caused by the cashflow requirements of enterprises within the multinational group or by highly centralised approaches to cashflow management that are designed to optimise the overall financial position of the group but may disregard jurisdictional issues. Interaction of Australia s transfer pricing rules and thin capitalisation provisions 34. The thin capitalisation provisions in Division 820 apply to limit debt deductions (eg. loan interest and guarantee fee expenses) by reference to the quantum of debt and equity of an entity. As explained in TD 2007/D20, the transfer pricing rules should not be applied to defeat the operation of Division 820 in determining what debt levels are excessive for the purpose of disallowing debt deductions on that excess debt. However, as also explained in TD 2007/D20, Division 820 does not prevent the application of the transfer pricing rules where the pricing of an intra-group loan, such as the interest rate or an amount directly incurred by the Australian borrower for the provision of a guarantee to obtain or maintain the loan, is not arm s length 8. 8 TR 2003/1, paragraphs and TR 2005/11 (which deals with bank branches), paragraphs UNCLASSIFIED PAGE 9 OF 44

10 Taking account of credit support from associates - distinction between the arm s length debt test in the thin capitalisation provisions and the arm s length principle under the transfer pricing rules 35. The arm's length debt test is one of the tests available to a taxpayer for determining its maximum allowable debt for the purposes of Division 820. In order to apply this test, it is necessary to identify and isolate an entity's commercial activities in connection with Australia (the Australian business). The test will be satisfied where, considering the borrower's financial and economic circumstances: (i) (ii) the entity's adjusted debt is no greater than the amount of debt that the Australian business would reasonably be expected to have; and the funds would have been provided to the Australian business as a loan (or a series of loans) by independent commercial lending institutions on arm's length terms. 36. The objective of the analysis is to establish an arm's length notional amount of debt that the entity's Australian business would reasonably be expected to be able to borrow and be lent. In conducting this analysis, for entities that are not approved deposit-taking institutions (non ADIs), the arm's length debt test requires the assumption that the taxpayer is taken to be an independent entity that finances its Australian operations without financial or credit support services being provided by its associates. 37. On the other hand, when determining the pricing of the interest rate or a guarantee the existence of credit support will be relevant if, for example, it would be relevant to arm's length parties entering into comparable dealings. This is acknowledged in the Explanatory Memorandum to the New Business Tax System (Thin Capitalisation) Bill 2001 where at paragraph 10.25, it states "prudent commercial lenders usually look at the consolidated financial position of the group to which the borrower belongs and the resources on which it could draw within that group to fund interest charges and capital repayments." 38. Paragraph of the Explanatory Memorandum then refers to the necessary factual assumption by stating that when applying the arm's length debt test for the purposes of Division 820: it is necessary to limit the extent to which the wider group is taken into account by specifying that relationships with associates that are not part of the Australian operations are to be disregarded. Any credit support from the non-australian business operations of the entity is to be disregarded. 39. This factual assumption and the others stipulated for the purposes of determining the arm s length debt amount for the various parts of Division 820 exist to ensure the test focuses only on the actual funding of the business or businesses conducted in Australia. 40. In contrast, when considering how the arm's length principle applies to the price for the supply of debt or a guarantee from the perspective of transfer pricing rules more generally, the respective parties and tax administrators need to consider the full extent of each entity s separate economic interests and the commercial and financial relationships that actually UNCLASSIFIED PAGE 10 OF 44

11 operate between the entities, including the existence of any guarantee, security or other form of credit support. 41. In relation to guarantee fees, it is noted that the definition of debt deduction in section includes, in addition to interest and amounts in the nature of interest, any expenses directly incurred in obtaining or maintaining the debt funding. Where a guarantee fee is otherwise deductible 9 and meets this nexus test it falls within the class of debt deductions that are subject to the overall limits contained in the thin capitalisation provisions and its deductibility may thereby be affected. Comments are invited on any further issues raised by this paper relating to the interaction of the transfer pricing rules and thin capitalisation provisions over and above any issues raised in relation to TD 2007/D20. Interaction of Australia s transfer pricing rules with deduction and general anti-avoidance provisions 42. Before considering the application of the thin capitalisation or transfer pricing rules, regard has to be had to the general deduction provisions. Where interest on a loan or the cost of a guarantee is properly a loss or outgoing of a capital nature it is not deductible under section 8-1 of the Income Tax Assessment Act Where a loan is provided to a company that is unable to borrow on a stand-alone basis, having regard to the fullest assessment of its profit potential on the basis of all the information available, even on deferred interest terms, a question may arise as to the purpose(s) of the loan and the economic substance of the arrangement between the parties. This needs to be determined objectively having regard to the facts and circumstances of the particular case. The question of whether interest deductions are or are not allowable under section 8-1 requires an examination of what the debt funding was intended to achieve from the perspectives of the profit earning structure of the borrower s business, including shareholder interests, and the operations by which it makes its profits. (Compare Sun Newspapers 10.) 44. In a case where a subsidiary could not borrow on a stand-alone basis, depending on the facts and circumstances, it may be open to argument on the basis of the reasoning of Allsop J in the St George Bank Case 11 that, at least to some extent, the debt funding is performing the role of equity. This inability to borrow may in turn have implications for the application of Accounting Concepts and Standards which require recording in financial statements to have regard to economic substance. Accordingly, to the extent that the debt is fulfilling the role of equity it might be open to argue that the interest expense attaching to the loan should be treated as being of a capital nature, at least for the period that the thinly 9 Paragraph (1)(b) requires that a cost be deductible apart from Division 820 in order for it to be a debt deduction. 10 Sun Newspapers Ltd and Associated Newspapers Ltd v. FC of T (1938) 61 CLR St George Bank Limited v Commissioner of Taxation [2008] FCA 453 UNCLASSIFIED PAGE 11 OF 44

12 capitalised structure remains in place. (From a practical perspective, while the equity level continues to be thin relative to the asset base the debt funding cannot be withdrawn without causing an insolvency and in the absence of sufficient equity losses would be likely to be borne by the related-party lenders.) 45. These matters are untested in the courts. While the focus of the discussion paper is on the interrelationship of the transfer pricing and thin capitalisation provisions, the analysis involved may in some cases prompt a question as to whether a particular interest expense is not deductible in whole or in part because it is of a capital nature. 46. A further issue arises in relation to the operation of the debt/equity provisions contained in Division 974 of the Income Tax Assessment Act If an advance that is made in the legal form of a loan is classified as equity under Division 974 then the interest payable on that loan is not deductible 12 (but the distribution may be able to be franked). 47. Where the need for a parent guarantee arises because a highly leveraged capital structure has been imposed by a parent company in relation to the investment it has made in an offshore subsidiary, such that without the guarantee the subsidiary effectively could not borrow, or could not do so on financially competitive terms and conditions, the guarantee is an essential component supporting the capital structure of the subsidiary and is incidental to the parent s participation as a shareholder in the Australian subsidiary. In these circumstances serious questions arise as to the deductibility under section 8-1 of any fee charged for the guarantee on the basis that the outgoing is wholly or in part capital in nature. 48. Notwithstanding the capital exclusion a deduction for a guarantee fee may be available under section of the Income Tax Assessment Act 1997 (although the cost may need to be spread over the period of the loan or 5 years, whichever is the shorter), provided no adjustment is warranted under Australia s transfer pricing provisions. 49. While the Tax Office does not expect the general anti-avoidance provisions to be relevant in the majority of cases, where a financing arrangement involving the bearing of interest expenses and/or costs in respect of a guarantee can objectively be determined to be an arrangement to create deductions that would not otherwise be available, and to have the sole or dominant purpose of avoiding income tax otherwise payable in Australia, such deductions may also be open to challenge under Part IVA of the Income Tax Assessment Act In the normal case, unless the outcome was a gross distortion, the safe harbour rules would preclude a determination that Part IVA applied. However further consideration should be given to arrangements which involve non-arm s length fees or charges. Comments are invited on any issues raised by this paper relating to the interaction of the transfer pricing and thin capitalisation rules and deduction and anti-avoidance provisions. 12 See section of the Income Tax Assessment Act UNCLASSIFIED PAGE 12 OF 44

13 Part B: Setting interest rates and guarantee fees in accordance with the arm s length principle 50. An essential aspect of a transfer pricing analysis required in the context of cross-border financing arrangements is the need to properly establish the nature and extent of the arrangements and to consider whether the character of the transaction derives from the relationship between the parties rather than being determined by normal commercial conditions operating between two parties dealing at arm s length with each other. 13 This requires a careful analysis of the relevant facts and circumstances and an understanding of the functions performed, the assets used and the risks assumed by each of the parties to the arrangement and a comparison with what comparable independent parties in comparable circumstances would do to further their individual economic interests. 51. The focus is on determining the true nature and effect of each element of the arrangement and the arrangement as a whole, allowing due weight to the legal form of each element, the business context in which they occur and any relationship between different elements of the arrangement. For example, an investment in an associated enterprise may be structured in the form of interest-bearing debt when, at arm s length, having regard to the economic circumstances of the borrowing company, the investment would not be expected to be structured in this way. Depending on the facts and circumstances of the particular case, it may be appropriate for tax administrations in applying the relevant transfer pricing provisions to regard the purpose and object of providing the funding in the form of debt, when properly viewed in the overall commercial context, as serving, from a practical and business point of view, the ends of establishing or extending a business organisation. In such circumstances it is open to argue that no interest cost would be charged between independent parties dealing at arm s length with each other in relation to the supply and acquisition of that funding The following are scenarios: (i) A parent provides debt funding to a wholly owned group company that is unable on a stand-alone basis to borrow the debt funding it needs; (ii) A parent or offshore associate provides debt funding to a group company that has the financial strength to be able to borrow the debt funding it needs without support from its parent company; 13 This requirement derives from the need to establish for the purposes of the Associated Enterprises Articles of Australia s double taxation agreements that conditions operate between the two enterprises in their commercial or financial relations, which differ from those which might reasonably be expected to operate between independent enterprises dealing wholly independently with each other ; and the requirement in subsections 136AD(1) to (3) of ITAA1936 that having regard to the connection between the parties or other relevant circumstances it can be concluded that the parties were not dealing at arm s length with each other in relation to the supply or acquisition (in the present context) of funding. 14 See the definitions of arm s length consideration in subparagraphs 136AA(3)(c) and (d) of the Income Tax Assessment Act Compare OECD Guidelines, paragraphs 1.37 and 1.38, OECD, noting that the provisions of Division 13 as affected by any relevant parts of the International Tax Agreements Act 1953 need to be applied according to their terms. UNCLASSIFIED PAGE 13 OF 44

14 (iii) (iv) A parent company provides a guarantee to a subsidiary that is unable to borrow the funds it needs on a stand-alone basis; and A parent company provides a guarantee to a subsidiary that is able to borrow the funds it needs on a stand-alone basis, to allow the subsidiary to access funding at the lower cost available to the parent. The relevant general principles are as stated in guidance issued by the Tax Office and the OECD on transfer pricing, particularly those guidelines dealing with the transfer pricing aspects of intra-group services, ie. Taxation Ruling TR 1999/1 and Chapters VII and VIII of the OECD Guidelines. 53. In discussing the four scenarios two categories of credit support could be distinguished: (a) (b) explicit credit support, which is a formal legal agreement, whether a guarantee, letter of comfort or other assurance, by which an enterprise (the guarantor ) agrees in respect of a loan to an associated enterprise to pay to the lender any amount payable on that loan in respect of which the borrower defaults; and implicit credit support, which includes: (i) (ii) a letter of comfort or similar statement of intent which does not constitute a contractually binding commitment of the type referred to at (a); and credit support obtained as an incidental benefit from the taxpayer s passive affiliation with the multinational group, its parent or another group member. It may be that other credit support arrangements exist. In such cases the principles outlined in this paper would need to be applied as appropriate on the basis of the facts and circumstances of the particular case. 54. It is important to note that Scenarios (i) and (iii) are likely to include situations where independent parties dealing at arm s length with the subsidiary company would not provide a loan or a guarantee. In such situations it is likely that it will not be possible or practicable to ascertain the arm s length consideration for the loan or guarantee. Where this is the case regard will have to be had to subsection 136AD(4) which allows the Commissioner to determine the arm s length consideration. The application of this provision has to have regard to the statutory purpose of Division 13 and the principles embodied in the Associated Enterprises Articles of Australia s double tax treaties. By necessity the application of the provision will require a reasonable postulation of what consideration independent parties would agree to in the business and economic circumstances under examination if the elements dictated by the non-arm s length relationship were modified to allow a comparison with what independent parties would do. Such a postulation in the context of subsection 136AD(4) entails an estimate or an approximation process, informed by economic concepts, the nature of business and open market practices, and envisaging UNCLASSIFIED PAGE 14 OF 44

15 behaviours that are sufficiently independent to allow participants to optimise their separate economic interests. Scenario (i): offshore parent providing debt funding to a wholly owned group company that is unable to borrow on a stand-alone basis 55. As discussed above, the provision of debt funding by a parent to a wholly owned subsidiary that is not creditworthy, that is, it is unable because of its economic circumstances to borrow the funding it needs from independent parties, brings into question the real purpose and effect of the arrangements between the parties. The arrangement cannot be explained by reference to ordinary commercial dealing between independent parties that are dealing wholly independently with each other as lender and borrower. Accordingly it is unlikely that direct reference could be made to a transaction that would be a reliable benchmark for the appropriate interest charge. Hence we may be in a situation where subsection 136AD(4) applies. 56. Judged by reference to independent dealings in comparable circumstances between independent parties, the required debt funding would not be provided and the borrower would have to raise more equity and borrow a lesser amount. Alternatively the lender may be prepared to assume a higher level of risk in respect of part of the funding in return for a commensurate equity interest, assuming the investment is otherwise attractive. 57. Based on arm s length principles it would be reasonable to postulate in the context of subsection 136AD(4) that the level of equity required will depend on the nature of the activities being conducted and the amount needed to ensure that the subsidiary is competitive on a stand-alone basis. At a conceptual level the amount of equity needed for a going concern would need to be sufficient to cover the risk of losses in a particular industry and to provide the amount of additional funding that, added to the debt funding that could be raised, would fully fund the assets on the balance sheet. The total funding would have to be sufficient to obtain ownership of (or create) the necessary assets and conduct the business operations. The income would need to be able to service the working capital needs and provide appropriate rewards for the owners, subject to economic and market cycles and the funding costs would need to be such as to allow the business to achieve these objectives. Implicit in this is that each entity s business decision making needs to be undertaken with a view to remaining competitive and viable within its industry (whether or not that transpires to be the case). The capital structures of independent enterprises carrying on business in the particular industry would seem to be a reasonable guide to the level of equity needed for viability. Regulatory requirements in the banking and insurance sectors would also be relevant. 58. To the extent that the debt funding performs the role of an equity contribution it would seem appropriate, based on the reasoning in TR 92/11 and paragraph 1.37 of the OECD Guidelines, that for the purposes of applying subsection 136AD(4) that portion of the debt funding be regarded as quasi equity and that it be costed on an interest-free basis, consistent with its purpose and effect. This is in line with the OECD view that the cost of funding a company s participation is a shareholder activity' and that it would not justify a charge to the borrowing company. It is clear in such a case that the parent is assuming a higher level UNCLASSIFIED PAGE 15 OF 44

16 of risk than an independent lender would be prepared to take and would need as a practical matter to subordinate its position as lender to the claims of third party creditors. However, since it is entitled to the full equity return, it is arguable that risk is being appropriately rewarded, even where the quasi equity funding carries no interest charge, because any increased profitability from the use of the additional funding accrues to it as owner and, depending on the funding needs of the subsidiary, can be paid out as dividends at the parent company s direction. Any interest paid on debt funding performing the role of quasi equity could arguably be taken into account as part of the reward for the assumption of the higher level of risk than the risk a lender would assume. As such, in the context of applying subsection 136AD(4), it would not be classified as part of an independent lender s reward were that lender acting on an arm s length basis in its dealings with the borrower. 59. The analysis can be explored through an example where an Australian subsidiary that is an industrial company has a balance sheet of $400 million in assets that is funded by its foreign parent with $300 million of debt and $100 million of equity. The debt funding is provided unsecured at an interest rate of 15% compared with 10% being paid by the parent on the $400 million it borrowed to make the $100 million investment in the subsidiary and also provide the $300 million loan. The 15% rate is based on the junk bond or sub-prime status of the subsidiary that is caused by its weak debt:equity ratio. The interest expense each year is accordingly $45 million for the Australian subsidiary. The capital structure of the Australian subsidiary is within the 3:1 safe harbour debt:equity test in Division 820 but the capital structure leaves the subsidiary in a position where it is not creditworthy on a stand-alone basis. 60. So, the question then arises that if the subsidiary could not borrow $300 million from independent lenders, what is its tolerance to debt funding having regard to its assets of $400 million, its equity of $100 million and its current profitability and cashflow? Market and wider economic and country factors will also be relevant. If we assume that having regard to all the relevant criteria the subsidiary could borrow $100 million from independent lenders at 12%, that would still leave $200 million needed to fund the balance sheet of $400 million, assuming the cashflow from the subsidiary s business operations was sufficient to meet its working capital requirements and service the debt obligations on the $100 million loan. 61. As an independent entity dealing with other independent parties in the capital markets the subsidiary is not able to raise the full amount of the additional $200 million as debt funding. However it is able to raise $90 million from independent parties at 12% interest on the basis that $110 million of equity is raised. The market does not rate the subsidiary as creditworthy for any higher amount given the total borrowings of $100 million plus the additional $90 million needs to be serviced from the same underlying cashflow. 62. It follows in this example that $110 million of the debt funding that the parent has provided could not have been raised as debt in the open market in dealings between independent parties dealing wholly independently with each other having regard to the economic circumstances of the subsidiary (including its assets, shareholders funds, earnings and cashflow, and the other risk, market and economic factors taken into account by independent lenders). While the $110 million is in form part of a loan from the parent it is UNCLASSIFIED PAGE 16 OF 44