More Draft ATO Guidance on Inbound Related Party Financing

The ATO has just released a third document outlining their views on aspects of the administration of the new thin capitalisation rules. This document deals with how the transfer pricing rules will apply to limit the amount of inbound related party debt which an Australian entity can bear. Some of the views expressed are surprising.

The document is open for submissions until 30 June.

Background

The thin capitalisation regime was fundamentally changed for commercial businesses (though not for ADIs nor for some financial entities) from 1 July 2023 by amendments made in the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share – Integrity and Transparency) Act 2024. The main change was to shift the thin capitalisation test from an assets-to-debt ratio to an interest-to-earnings ratio, but other changes were also made including adding the debt deduction creation regime, and for general class investors to expose the quantum of debt to scrutiny under Australia’s transfer pricing regime. 

The Explanatory Memorandum which accompanied the Bill promised, ‘the ATO intends to issue guidance material to assist taxpayers, after legislation has passed the Parliament’ and so far, the ATO has issued two documents, both on the debt deduction creation rules:

• PCG 2024/D3: Restructures and the new thin capitalisation and debt deduction creation rules - ATO compliance approach; and
• TR 2024/D3: Aspects of the third party debt test in Subdivision 820-EAB of the Income Tax Assessment Act 1997

The recent document, PCG 2025/D2 – Factors to consider when determining the amount of your inbound, cross-border related party financing arrangement – ATO compliance approach (Draft PCG) is a first attempt at explaining how the ATO will evaluate whether the requirements of Australia’s transfer pricing regime have been properly considered and applied in deciding the quantum of inbound related party debt owed by an Australian entity. 

Until the 2023 change, thin capitalisation and transfer pricing were largely functionally separate regimes – Div 820 determined the quantum of permissible debt, and Div 815 determined the permissible price of debt – although there was a complex interaction to be managed if there was both too much debt, and it was too expensive!  But the amendments removed that separation so that the amount of cross-border related party debt would no longer be immune from scrutiny under Div 815. This Draft PCG ‘outlines [the ATO’s] compliance approach to assessing the tax risk associated with the amount of your inbound, cross-border related party financing arrangement under Subdivision 815-B of the ITAA 1997.’

Draft PCG

Status and reliability

The Draft PCG contains the usual statements that about where and how the ATO will ‘apply compliance resources …’  It also contains the usual warning for Compliance Guidelines: ‘this Guideline is general in nature, does not constitute a 'safe harbour' and does not replace, alter, or affect our interpretation of the law in any way. It does not relieve you of your legal obligation to self-assess your compliance with all relevant taxation laws.’  In other words, the ATO does not consider itself legally bound by anything in the document. The Draft PCG then says, ‘if we conduct a review of your inbound, cross-border related party financing arrangement, we may take account of other indicators and factors beyond those contained in this Guideline’ which makes this document even less reliable.

Zones – meaning and effect

The Draft PCG sets out four ‘zones’ reflecting different levels of compliance effort by the ATO.  The four zones are:

White       The financing arrangement has already been reviewed and any dispute has been concluded either by a settlement or judgment, by an APA, or the ATO has assessed the structure after 1 January 2025, and there has been no material change to the arrangement. Taxpayers in the White Zone can expect the ATO will ‘not have cause to apply [any] compliance resources in relation to the amount of your inbound, cross-border related party financing arrangement …’

Green      An arrangement will be in the low risk Green Zone if it is described in one of the two low risk examples in the PCG (outlined below) or already reviewed by the ATO and there has been no material change.  Taxpayers in the Green Zone can expect the ATO will only apply compliance resources to confirm that the taxpayer meets the Green Zone criteria.

Blue        The Blue Zone is the residual category, and will probably apply to most taxpayers. It describes taxpayers whose situation is not described in any of the examples in the PCG and has not been reviewed by the ATO.  Taxpayers in the Blue Zone can expect ‘[the ATO] will actively monitor your arrangements using available data and may review your arrangement to understand any compliance risks.’

Red         The Red Zone is the high risk category and applies to a taxpayer covered by any of the three high risk examples in the PCG, or which has been reviewed by the ATO and assessed as high risk.  Taxpayers in the Red Zone can expect ‘[the ATO] will prioritise our resources to review your arrangement [which] may involve commencing a review or audit.’

The two common themes to defining the zones are, being described in one of the Examples (or not), and the ATO’s assessment after conducting a review.  This makes the Examples crucial.

The five Examples

Given how significant they are to classifying the Zones, the five examples in the Draft PCG are not especially wide-ranging.

The two Low Risk examples are:

• the borrower elects to apply the third party debt test (TPDT) – in other words, the taxpayer has decided to abandon any deduction for interest on its related party debt. Unless the related party debt deductions are trivial this seems unlikely; but if the related party debt is trivial, then it would likely pass the arm’s length test. The Example is therefore of little practical utility;
• the borrower’s leverage and interest coverage ratios are better than both those of the global group and of ‘a set of comparable entities.’  In other words, the taxpayer has done a full transfer pricing review and concluded that the quantum of related party debt meets the arm’s length standard. Again, the Example is not helpful. If the related party debt demonstrably meets the arm’s length standard, on what basis could the ATO conclude anything but, this situation is low risk?

The three High Risk examples are just as curious:

• the borrower already holds cash reserves equal to 30% of the borrowed funds but is earning on those cash reserves less than 90% of the cost it bears for the borrowed funds;
• the borrower has the benefit of guarantee ‘[which] has … enabled Aus Co to borrow a greater amount of debt than it could have otherwise obtained without the guarantee …’
• the borrower has capacity below the fixed ratio; it borrows further funds and on-lends at least ‘part’ of the borrowed funds earning less than the cost of the borrowed funds.

The Examples revolve around four facts: the borrower has significant cash reserves, the borrower’s debt is guaranteed, or the borrower is increasing its existing level of debt (but still satisfies the fixed ratio test).  The fourth factor is, what does the borrower do with the borrowed funds?  It is not clear from the Examples whether that is a problematic on its own or whether it must occur in the presence of some other factor.

The treatment of guarantees is troubling. In PCG 2017/4 (issued after the decision in Chevron) the ATO treats the existence of ‘appropriate collateral’ (defined to include a guarantee) as lowering the risk profile when pricing inbound financing; the Draft PCG treats this as raising the risk profile when assessing the level of debt.

Finally, it is worth noting, there is nothing in the Draft PCG which limits these Examples just to the circumstances which existed when the debt was put in place. So, assessing a taxpayer’s transfer pricing risk against these Examples will apparently involve ongoing vigilance; it is not ‘set-and-forget.’

Documentation and deliberations

The rest of the Draft PCG deals with documentation and deliberations – how the taxpayer will record its deliberations and conclusion on the level of debt, and what factors the ATO expects those deliberations will have considered.

The Draft PCG says taxpayers are expected to generate, retain and provide to the ATO (once requested) an extensive array of ‘calculations, ‘workings,’ ‘correspondence’ and other documents, ‘to support your transfer pricing position, for each income year that financing arrangement remains on issue.’

These documents are meant to display consideration of, ‘factors to consider when determining the amount of your inbound, cross border related party financing arrangement’ – that is, matters the ATO believes external lenders would consider in deciding how much to lend.  The factors include:

• the need for the borrowed funds: ‘it would be anticipated that any financing raised will be for a defined, pre-agreed purpose …’,
• conformity with group financing policies and practices,
• impact on the return to shareholders,
• an assessment of the cost of funds and its impact on the borrower’s credit metrics
• consistency with covenants in existing loans,
• whether the borrowing comes an explicit guarantee,
• the security offered to the lender,
• evidence of the borrower’s ability to service the interest and principal repayments due under the debt, and
• the extent to which the borrower is already leveraged.

Submissions

The ATO is accepting submissions on the Draft PCG until 30 June 2025.