This article was first published by Bloomberg Tax, March 2024.

Analysing how Australian businesses should respond to ongoing transfer pricing litigation and anti-tax avoidance proposals, emphasising active documentation and robust processes.

Several regulatory actions underway in Australia likely will prompt businesses to reassess their internal funding strategies.

The landmark transfer pricing cases SingTel and Mylan are pending final judgments, the reformed thin capitalisation legislative framework is set to begin, and an expanded general anti-avoidance measure was announced in the May 2023-24 budget.

These developments intend to improve multinational tax integrity and protect Australia’s tax base, but they carry broader repercussions that could affect all businesses debt-funded by on-Australian parents.

Taxpayers can respond by maintaining proper transfer pricing documentation and safeguards to prevent audits or investigations by the Australian Taxation Office.

Transfer pricing involves ensuring an arm’s-length price of debt. In SingTel, the Federal Court disallowed the interest deduction claim on the basis that the intercompany interest rate wasn’t arm’s length.

The interest rate was amended to be contingent on the economic performance of the business, and then increased to 13.2575% - significantly higher than any rate offered by independent parties.

If the full Federal Court upholds the first instance judgment, it would be a landmark win for the commissioner of taxation, with net tax exposure for SingTel amounting to more than AU$300 million (about $193 million) including interests and penalties.

What constitutes an arm’s-length interest rate has become a battle of expert opinions, rather than what parties would consider to be commercially viable.

Hopefully, the full Federal Court provides guidance on how the arm’s-length interest rate may be affected by the commonly used parental guarantees and the associated guarantee fee. A strong creditworthiness of the parent generally lowers the interest rate for the borrower, while higher guarantee fees increase the effective interest rate.

While transfer pricing concerns the price of debt, thin capitalisation entails ensuring that the amount of debt is limited to an appropriate earnings before interest, taxes, depreciation, and amortization—or EBITDA—ratio. The proposed legislative amendment applies from July 1, 2023, with no grandfathering of any existing loan arrangements.

The many interactions among thin capitalisation, transfer pricing, and debt creation rules suggest there are no longer safe harbors for taxpayers. The legislative amendment provides that even if taxpayers satisfy the thin capitalisation tests to allow a certain safe harbor debt ratio, interest deductions may still be denied if the amount of debt isn’t itself an arm’s length amount.

Furthermore, the debt creation rule was introduced to deny interest deductions for artificially created debts from July 1, 2024, such as debt created to fund acquisition of an asset or obligation from an associate.

This measure applies in priority to the thin capitalisation tests and acts as a gatekeeper to interest deductions. Businesses need to be attuned to usage of debt, ensuring they can trace, apportion, and quarantine the debt as necessary.

In Mylan, the commissioner used anti-avoidance measures to deny interest deductions but didn’t pursue a potential transfer pricing argument even after the evidence was filed.

The taxpayer could have obtained no or lower amounts of tax benefits in the following scenarios: using 100% cash to purchase the target and eliminate any interest deductions, obtaining lower amounts of external debt, and obtaining related-party debt potentially at a lower interest rate.

The government, in its May 2023-24 budget, intends to expand the scope of the general anti-avoidance rule to include schemes that aim to reduce foreign income tax. Historically, the tax benefit has always been reducing Australian income tax.

This expansion could nullify any potential defense by Mylan that the arrangement was primarily for a US tax benefit, with the Australian interest deductions being an incidental benefit.

The potential legislation may require businesses to have greater oversight on the global tax benefits and greater engagement with cross-border tax advisers.

Given these measures, businesses should ensure they maintain documentation to substantiate an arm’s-length interest rate, an arm’s-length amount of debt, and a genuine commercial rationale for interest deduction claims. They should prepare a contemporaneous snapshot of their operations, including:

• Detailed board resolutions on the commercial rationale for the debt funding

• Assessment on the creditworthiness of the borrower and the group including credit rating agencies and financial institution evaluations

• Commercial rationale of amending the loan agreement

• Macroeconomic indicators such as the market, industry, economy, and regulatory environment and trends

• Comparative analysis of loan terms offered by external financiers, historical borrowing pattern of the borrower and the group, and any tax advice and transfer pricing analysis

Taxpayers also should mind ATO’s extensive discovery power to request information such as internal communication for anti-avoidance claims—and authority to bring proceedings many years after the debt funding transaction.

Businesses engaging in cross-border funding are grappling with increased uncertainty, complexity, and compliance on the amount of interest deductions. Taxpayers don’t appear to have any clear safe harbors as they await further guidance from the courts and ATO.

However, businesses can put in place sufficient documentation and robust processes to safeguard against potential ATO investigations, audits, or litigation. Those that lack an internal tax team or transfer pricing expertise should engage with tax lawyers and advisers at the outset of such funding structures.