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ATO Publishes Guidance on COVID-19 and Thin Capitalisation — Orbitax Tax News & Alerts

The Australian Taxation Office (ATO) has updated its guidance on thin capitalization to include guidance in relation to COVID-19, including a simplified approach to the arm’s length debt test (ALDT).

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COVID-19 and thin capitalization

The recent disruption brought about by COVID-19 may affect not only taxpayers' compliance with their reporting obligations, but also the underlying economic fundamentals that inform the choice of method for calculating maximum allowable debt for thin capitalisation purposes.

In line with our recent announcements about support for businesses affected by COVID-19, we understand this is a time of significant uncertainty and we will need to be flexible in how we administer our approach to compliance.

Simplified approach to the arm’s length debt test (ALDT)

For the tax years encompassing the February and March 2020 period (the relevant year), if you are a non-ADI taxpayer you may no longer be able to rely on the safe harbour or worldwide gearing tests to determine your maximum allowable debt as a result of balance sheet effects brought by COVID-19. These balance sheet effects may be as a result of impairment of asset values or short-term draw downs on debt facilities as a direct result of COVID-19. If so, you may wish to consider the following for the affected income year.

For the purpose of calculating average values for thin capitalisation amounts, the selection of alternative valuation measurement periods may allow a degree of smoothing of values in situations where wide variations have occurred throughout the income year.

Other options available

While the facts and circumstances will vary for each taxpayer, we encourage you to explore the use of all the alternative measurement periods in testing the suitability of the safe harbour or worldwide gearing tests.

If you will otherwise need to rely on the arm’s length debt test (ALDT) for the relevant year, as a direct consequence of COVID-19, you can expect we will not dedicate compliance resources to reviewing the application of ALDT if the requirements listed below are met, other than to verify that the use of the test was directly related to a COVID-19 reflex.

The requirements for the simplified ALDT approach include:

  • You would have satisfied the safe-harbour test but for the COVID-19 related balance sheet effects.
  • It is still expected that you will use best endeavours to apply all criteria of the ALDT.
  • For entities that are classified as inward investing entities (and not also outward investing entities) our compliance approach (as outlined above) applies only to the extent that no additional related party funding is received, other than short-term (less than 12 months) debt facilities. In these instances, we would expect any new capital to be equity.
  • We would not expect inward investing entities to require the use of ALDT because dividends were paid, thereby weakening the Australian balance sheet.

If your economic circumstances are expected to persist over the longer term and, as a result, you are likely to rely on the ALDT beyond the immediate income tax year, take the opportunity to discuss your circumstances with us.

You can also expect that we will take a balanced approach to matters such as record keeping and timing of the creation of records for the purposes of the test. You should attempt to prepare documents supporting the application of the ALDT, but we will not apply compliance resources to determine if the documents satisfy the standards set out in Draft Practical Compliance Guideline PCG 2019/D3 ATO compliance approach to the arm's length debt test.

We are committed to working with you and your advisors to provide certainty in these challenging times. We have a dedicated team responsible for the oversight and management of thin capitalisation risks. If you wish to discuss your application of the ALDT with us, you may contact Shahzeb Panhwar, Assistant Commissioner, International Tax Structuring at International@ato.gov.au. Alternatively, if you have a dedicated relationship manager you may approach them directly for assistance with your case.