On 12 August 2020, the ATO released an updated draft practical compliance guideline with updated guidance regarding key factors to consider when determining the transfer pricing risk of outbound interest-free debt lent by Australian taxpayers to international related parties.
On 12 August 2020, the ATO released an updated draft version of Practical Compliance Guideline PCG 2017/4 that describes its compliance approach to cross-border related party financing arrangements and related transactions.
PCG 2017/4DC2 includes a new third draft schedule, which outlines the factors under which the risk score assigned to outbound interest-free loans between related parties may be modified. This provides an ability for taxpayers to move away from the high-risk zones and lower the risk rating of their outbound interest-free loan arrangements, provided certain conditions are satisfied.
Reduced pricing score
The ATO confirms that an interest free outbound loan will be considered ‘high risk’ from a transfer pricing perspective. The ATO’s starting point for outbound interest-free debt remains a pricing risk score factor of 10 points, consistent with schedule 1 of PCG 2017/4, however the taxpayers have an opportunity to self-assess a lower score, based on relevant factors outlined in the draft schedule 3.
Taxpayers now can lower this score however, by analysing and documenting the arm’s length conditions to determine if an outbound interest-free loan is more akin to an issue of equity or the interest-free nature of the loan is arm’s length. This effectively reverses the ATO’s view on outbound interest-free loan arrangements, as compared to schedule 1 of PCG 2017/4.
There are three exceptions to the ‘high risk’ starting position, which are outlined in paragraph 206 and require evidence that:
- A zero percent interest rate is an ‘arm’s length’ condition of the loan; or
- The loan is ‘in substance’ an equity contribution; or
- Independent entities would not have entered into the actual loan and would have entered into an equity funding arrangement.
PCG 2017/4DC2 does not set out the parameters for when a transfer pricing analysis of an interest-free loan ought to be conducted by regarding the transaction as a contribution of equity. However, it does acknowledge that there are particular circumstances where an outbound interest-free loan is not as high risk for transfer pricing purposes because it might be established that it is appropriate to compare to an equity contribution. Paragraph 213 highlights the factors relevant to considering whether an underlying transaction should be evaluated as an equity contribution. These generally align with previous ATO guidance contained in TR 92/11. These include where lenders have rights similar to those of a shareholder e.g. voting rights, there is no set repayment date and the rights to repayment are deeply subordinated below that of other lenders.
Self-assessing a reduced pricing score
The ATO has also amended how the pricing risk-scoring table within schedule 1 of the PCG should be applied. Where a taxpayer answers 'yes' to one of the alternatives for each of the following questions (outlined in paragraph 214 and reproduced below), they should only add three points (blue zone - low to moderate risk) rather than 10 points (amber zone - high risk) on account of having a zero interest rate on a loan.
(a) Can it be evidenced that:
(i) the rights and obligations of the provider of funds are effectively the same as the rights and obligations of a shareholder? or
(ii) the parties had no intention of creating a debt with a reasonable expectation of repayment and, therefore, did not have the intent of creating a debtor-creditor relationship
(b) Can it be evidenced that:
(i) the intentions of the parties are that the funds would only be repaid or interest imputed at such time that the borrower is in a position to repay? or
(ii) the borrower is in a position where it has questionable prospects for repayment and is unable to borrow externally (see paragraphs 215 of this schedule)?
This two-step approach involve a multitude of layers of factors and circumstances and the draft schedule evinces strong expectations from the ATO that taxpayers gather appropriate evidence to
substantiate conclusions in relation to the interest rate pricing risk.
This guidance from the ATO has been long awaited and many taxpayers have been relying on old guidance to establish the level of transfer pricing risk in respect of outbound interest free loans. Now that the draft guidance has been issued, taxpayers can reassess their outbound interest free loans and collate relevant evidence e.g. legal agreements, group treasury policies, etc., to establish their risk rating under the PCG.
Furthermore, now that the ATO’s updated views in respect of interest free loans have become clear, any existing interest free loan arrangements that do not fall within the lower risk zone per the analysis and examples listed in the schedule should be revisited as a matter of urgency as they present a high risk from a tax and transfer pricing perspective.
PCG 2017/4DC2 is proposed to apply from 1 July 2017 and comments on draft schedule 3 are due by 14 October 2020.