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13.2.8. Interaction with Transfer Pricing Provisions

In a ruling issued specifically to address this question (i.e. TR 2010/7), the ATO has stated that because the focus of the thin-capitalization provisions is on limiting the costs an entity incurs on a debt interest it has issued that is deductible from its assessable income, it follows then that all provisions in the tax law governing deductibility, including the transfer pricing provisions, must be applied before the thin-capitalization provisions become applicable. Thus, the transfer pricing provisions will be applied first to determine the fundamental issue of whether the financing costs incurred by the entity are consistent with the arm’s length standard. The thin-capitalization provisions will then be applied to determine the amount of deduction to be allowed in accordance with the prescribed limits depending on the type of entity involved.

Importantly, because the focus of the thin-capitalization provisions is on the amount of debt held by an entity while the transfer pricing provisions address the issue of how the consideration given for such debt is to be priced, it is possible that even if an entity is considered not to have excess debt by virtue of the thin-capitalization provisions, the transfer pricing provisions may still apply to permit the adjustment of the pricing of the consideration provided to obtain and maintain the debt funding.

The ATO has issued a final taxation determination (TD 2019/10) clarifying that the application of debt-equity rules cannot limit the operation of the arm's length principle under the transfer pricing rules. However, same can be applied for classification of interest into equity interest or debt interest in the financing arrangement for applying the arm’s length conditions. The transfer pricing rules apply in respect of conditions that operate between the related entities in a financing arrangement and the arm's length conditions are considered for working out the entity's taxable income, taxable loss, tax offsets and withholding tax payable. The application of the transfer pricing rules negates the benefit that the entity gets in the actual financing arrangement, that is entered into without following the arm’s length conditions and, in such instances, the debt equity rules apply for correct classification of the interest under the financing arrangement.

The TD applies to income years commencing on or after 29 June 2013.