A changing tax landscape for cross border investment in agriculture
Recent trends show a significant up-tick of interest in agriculture by foreign investors. This article focuses on two important tax aspects of a foreign transaction which commonly involve a cross-border debt funding arrangement – transfer pricing and the thin capitalisation regime.
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A changing landscape for cross-border investment in agriculture
According to the Foreign Investment Review Board, the value of approved foreign investment in agriculture was $3.6 billion in 2011/12 and totalled $12.5 billion for the five years ending 2011/12. Recent trends show a significant up-tick in interest by foreign investors. In FIRB’s latest annual report, the volume of applications (by number and total value) increased significantly. In 2014/15 – there were 77 proposals for a total of $5.3 billion, an “average” transaction of more than $68 million. (FIRB attributes at least part of this increase in application volume to the lowering of the screening threshold from 1 March 2015; 17 applications were reviewed in the period that would not have met the previous, lower value screening thresholds).
Whilst there has been much public discussion on the level, source and merits of foreign interest in Australian agriculture, in this edition of the Agribusiness Bulletin we focus on two important tax aspects of a foreign transaction which commonly involve a cross-border debt funding arrangement – transfer pricing and the thin capitalisation regime.
Whether you are a foreign entity looking to maximise your investment within the regulations, or an Australian entity seeking foreign interest, a better understanding of these concepts could help you get a deal done.
The Australian taxation system has a number of anti-avoidance measures that apply to cross-border arrangements, however it also recognises by way of exemptions and carve outs that there are situations where taxpayers are acting on a commercial basis.
Cross-border financing arrangements have seen increased scrutiny from the Australian Taxation Office to ensure that that the Australian tax base is not eroded by excessive debt deductions. The media and politicians have also amplified this pressure, questioning whether companies that access foreign capital through debt are paying their ‘fair share of tax.’
In relation to debt funding, the Australian taxation system has strong transfer pricing legislation to prevent Australian taxpayers being charged interest from overseas related parties (and take a subsequent tax deduction) in excess of that seen in arm’s length situations; and there are also thin capitalisation provisions to prevent an excessive allocation of debt to Australian subsidiaries of multinational companies.
Whilst transfer pricing has received significant media coverage during the past couple of years in Australia given recent court cases, Senate Committee hearings and changes to the Australian tax legislation and global guidance resulting from the OECD’s Base Erosion and Profit Shifting initiative, the thin capitalisation rules have attracted less public attention notwithstanding a number of reviews and proposed changes by different stakeholders within Australia since it was first considered in the Ralph Report in 1999. Further, in certain situations the thin capitalisation rules can also apply to limit the potential interest deductions for domestic debt transactions.
Thin capitalisation, deductible interest and ‘arm’s length debt’
Under the thin capitalisation rules, which were introduced in 2001, a taxpayer is generally prevented from taking interest deductions on an amount of debt which is above the safe harbour amount - broadly 60% of assets (this was reduced from 75% in 2014, and also applied prospectively to existing arrangements). For those taxpayers which are above this threshold, they have the option to consider the world wide gearing test or the arm’s length debt test (ALDT) to support their level of debt, and subsequent interest deduction; otherwise there will a portion of interest deduction disallowed for tax purposes.
Whereas the safe harbour is a threshold test, the ALDT requires a much more involved process to analyse a taxpayer’s capacity to borrow for the purposes of establishing an ‘arm’s length’ amount of debt. This analysis involves a series of steps including considering what an independent borrower and lender would consider a commercial amount of debt, having regard to the Australian business.
In the December 2014 report to the Assistant Treasurer by The Board of Taxation (Review of the Thin Capitalisation Arm’s Length Debt Test) it was noted that of the 2,757 taxpayers subject to the thin capitalisation rules in 2013, the vast majority (2,670) relied on the safe harbour. However since the reduction in the safe harbour in 2014, the ALDT is becoming increasingly important for a number of taxpayers, including in the primary producer and natural resource industries which face thin capitalisation issues and denial of interest deductions. Perhaps acknowledging this expected increasing reliance on the ALDT, the Report highlighted the importance of the ALDT to avoid tax-driven disincentives for investment into Australia, given this test can reflect the economic circumstances of certain industries.
Broadly, in any deal some of the key tax questions that should be considered include:
- What is the existing or proposed capital structure?
- Will funding include third party or related party debt?
- If there is related party debt, what is the arm’s length interest rate and terms which should be applied?
- Is the amount of debt considered commercial for thin capitalisation purposes (i.e. can the safe harbour be relied on or will the world wide gearing test or arm’s length debt test be required)?
- What supporting documentation is required to comply with Australian transfer pricing and thin capitalisation requirements?
As this is general advice only, you should consult a specialist advisor who understands your specific situation and needs for further information.
Given the growing focus on the commerciality of debt funding from a tax perspective, and increased ATO scrutiny, there is a need for taxpayers to consider any transfer pricing and thin capitalisation implications as early as the feasibility stages of a project or property acquisition. Failure to do so may result in denied or reduced interest deductions creating additional Australian tax being payable and potential double taxation implications, along with potential penalties and interest being applicable. Application of the ALDT may provide taxpayers with a higher level of interest deductions than would otherwise be the case under the thin capitalisation ‘safe harbour’, but it’s critical that thorough analysis be performed and documented accordingly.