Australia's new arm's-length capital structure requirements: Navigating the dual compliance landscape

The new reality of debt funding in Australia

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Australia's approach to regulating cross-border financing has undergone a fundamental transformation. The 2023 reforms have created a dual-compliance framework that requires multinational enterprises to satisfy both earnings-based thin capitalisation limits and arm's-length transfer pricing requirements for their debt arrangements.

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This shift represents one of the most significant changes to Australia's international tax landscape in recent years - and creates new challenges and considerations for businesses operating across borders.

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The transformed legislative framework

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From assets to earnings: A paradigm shift

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The Treasury Laws Amendment (Making Multinationals Pay Their Fair Share—Integrity and Transparency) Act 2023 has completely reshaped Australia's thin capitalisation regime. The traditional asset-based tests have been replaced with earnings-based limitations that align with OECD recommendations.

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Under the new framework, taxpayers must calculate their maximum allowable debt deductions as the lesser of:

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1. Fixed ratio test (FRT): Debt deductions capped at 30% of tax EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation)
2. Group ratio test (GRT): Proportional debt-to-EBITDA ratio relative to the global group
3. Third-party debt test (TPDT): Debt attributable to external creditors

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While these tests provide clear mathematical thresholds, they represent only the first layer of compliance requirements. The second layer - and perhaps the more challenging one - comes from the transfer pricing rules.

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The transfer pricing overlay: A critical new dimension

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The 2023 reforms made a subtle but profound change to the interaction between thin capitalisation and transfer pricing rules. Previously, Section 815-140 of the Income Tax Assessment Act 1997 (ITAA 1997) effectively "switched off" transfer pricing provisions for debt quantum if thin capitalisation requirements were met.

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This protection has been removed. Now, Subdivision 815-B requires taxpayers to ensure their debt quantum aligns with arm's-length principles, regardless of compliance with the FRT, GRT, or TPDT. This means that even if your debt levels are well within the earnings-based thresholds, you may still face challenges if the ATO determines that independent parties would not have agreed to similar arrangements.

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The legacy of the arm's-length debt test

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While the formal Arm's-Length Debt Test (ALDT) under Division 820 has been repealed, its analytical framework lives on through transfer pricing requirements. Understanding this legacy framework provides valuable guidance for navigating the new compliance landscape.

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The six-step methodology

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Historically, the ATO's approach to arm's-length debt involved six key steps:

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1. Define the Australian business's functional and financial profile
2. Adjust existing debt terms to arm's-length conditions (excluding parental guarantees)
3. Calculate borrowing capacity from the borrower's perspective (based on profitability and cash flow)
4. Calculate lending capacity from the lender's perspective (based on credit metrics)
5. Apply the lesser of the two amounts
6. Document the analysis comprehensively

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This methodology, outlined in Taxation Ruling TR 2003/1 and refined in TR 2020/4, emphasised rigorous documentation and alignment with OECD transfer pricing guidelines. While the formal ALDT is gone, the analytical burden has simply transferred to Subdivision 815-B.

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Judicial precedents shaping compliance expectations

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Recent court decisions provide valuable insights into how the ATO and courts approach cross-border financing arrangements.

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The credit support conundrum: Lessons from Chevron and SingTel

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In Chevron Australia Holdings Pty Ltd v Commissioner of Taxation (2017) and Singapore Telecom Australia Investments Pty Ltd v Commissioner of Taxation (2021), Australian courts imputed parental credit support into the arm's-length analysis. This "passive association" doctrine effectively equalised subsidiary and parent credit ratings, resulting in lower allowable interest rates.

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The key takeaway: When analysing debt capacity and pricing, courts have consistently recognised that third-party lenders would factor in implicit parental backing, even without formal guarantees.

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Commercial rationale: The Mylan decision

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More recently, in Mylan Australia Holding Pty Ltd v Commissioner of Taxation (2024), the Federal Court rejected the ATO's application of Part IVA (anti-avoidance provisions) to a debt push-down structure. The court emphasised that tax benefits alone do not establish a dominant tax purpose if substantial commercial rationale exists.

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This decision provides some comfort to businesses, affirming that intra-group debt financing for acquisitions (even at 75% leverage) is permissible if supported by non-tax commercial drivers such as currency risk management or overseas foreign loss considerations.

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Notably, the ATO did not challenge Mylan's 10.15% interest rate, which aligned with its parent's cost of funds—suggesting that robust transfer pricing documentation can mitigate audit risk even in highly-leveraged structures.

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Anticipating the ATO's compliance approach

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While the ATO's formal guidance on the new regime is still developing, historical practices and existing Practical Compliance Guidelines (PCGs) provide valuable insights into their likely approach.

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Risk factors and red flags

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Based on previous ATO guidance and compliance activities, several factors may trigger closer scrutiny:

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• Debt-to-EBITDA ratios: Exceeding industry benchmarks (e.g., 3:1 for manufacturing)
• Subordination and currency mismatches: Loans subordinate to external debt or denominated in non-functional currencies
• Interest margins: Inbound loans priced more than 0.50% above the parent's cost of funds
• Thinly capitalised structures: Debt greater than 40% of assets minus non-debt liabilities

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Documentation expectations

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The ATO's approach to transfer pricing documentation is well-established through Subdivision 284-E and TR 2014/8. Under the new regime, we anticipate documentation requirements will expand to include:

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1. Comprehensive borrowing capacity analysis: Credit ratings, leverage ratios, and profitability metrics relative to industry peers
2. Parental support adjustments: Quantifying the impact of implicit guarantees on debt capacity
3. Economic theories: Application of capital structure theories (Modigliani-Miller irrelevance theorem, trade-off theory, or pecking order theory) to justify chosen debt levels

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Strategic approaches for multinational enterprises

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The dual-compliance framework creates significant challenges, but also opportunities for proactive management of cross-border financing arrangements.

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Holistic capital structure review

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Now is the time to conduct a comprehensive review of your Australian operations' capital structure:

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• Perform a dual-perspective analysis (borrower capacity + lender risk tolerance) using frameworks similar to TR 2020/4
• Benchmark against ASX-listed peers' debt-to-EBITDA ratios specific to your industry (e.g., mining: 2.5–3.5x; retail: 1.5–2x)
• Model tax EBITDA under varying leverage scenarios to identify potential risk thresholds

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Enhanced transfer pricing documentation

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Documentation has never been more critical for defending cross-border financing arrangements:

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• Integrate debt quantum analyses into your Master File/Local File documentation
• Address passive association explicitly, using credit rating methodologies to model stand-alone versus group-supported ratings
• Document the commercial rationale for your capital structure beyond tax considerations

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Consider advance pricing agreements

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For significant or complex financing arrangements, Advance Pricing Agreements (APAs) offer valuable certainty:

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• Proactively engage with the ATO on contentious structures (e.g., hybrid instruments, cross-border guarantees)
• Use the APA process to establish agreed parameters for both debt quantum and pricing
• Create documentation that can serve as a defence in future periods

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Finding balance in the dual-compliance world

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The 2023 reforms have created a more complex compliance landscape for cross-border financing, but well-prepared businesses can navigate these challenges successfully. The key lies in balancing formal thin capitalisation requirements with arm's-length transfer pricing principles.

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While the mathematical thresholds of the FRT, GRT, and TPDT provide clear outer boundaries, the more nuanced arm's-length analysis requires careful consideration of industry norms, commercial rationale, and functional analysis. Businesses that integrate both perspectives into their financing decisions will be best positioned to defend their structures against ATO scrutiny.

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By combining technical rigour with commercial pragmatism, multinational enterprises can develop financing arrangements that support their business objectives while meeting Australia's evolving compliance requirements.

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TPEQ helps multinational enterprises navigate Australia's complex thin capitalisation and transfer pricing regimes, developing compliant yet commercially pragmatic approaches to cross-border financing. Contact our team to discuss your specific challenges.