ATO finalises its risk assessment framework for cross-border financing arrangements
23 January 2018
Building on the Australian Taxation Office’s (ATO) success in the Chevron Australia decision, the ATO continues its scrutiny and focus on cross-border financing arrangements. The release of the final version of Practical Compliance Guideline 2017/4 (PCG) provides an insight into the ATO’s approach in risk assessing the cross-border financing arrangements of taxpayers that are part of a multinational group (MNE).
The ATO has not only taken inspiration from the Chevron case, but its principles have been expanded through this updated PCG to the extent of going beyond the original rulings of the courts. This is especially the case in relation to the increased scrutiny that has been placed on the parent entity’s cost of debt, guarantee fees and currency mismatches – all points of contention within the Chevron case.
Whilst any self-assessment or transfer pricing analysis regarding financing must begin with the terms and conditions, the ATO has made numerous amendments in order to produce a framework which has ultimately placed a higher focus on commerciality aspects. This signals somewhat greater acceptance by the ATO that MNE’s related party cross border financing arrangements are not exclusively motivated by tax considerations but also impacted by commercial considerations.
Finally, it should also be noted that the OCED has not issued guidance on financing arrangements to date, which are expected to be released mid-year. Depending on the content of OECD guidance, the PCG may create a deviation in the way debt instruments are priced in the counterparty country. There is therefore, a possibility of increased risk due to the unilateral nature of the PCG and potential for double taxation.
- Effective date of the PCG - The PCG will have effect from 1 July 2017 and apply to existing and newly created financing arrangements. The ATO will allow taxpayers 18 months (from 18 December 2017), to transition historic and future arrangements into the low risk ‘green zone’ without attracting interest and penalties, thus giving taxpayers some time to respond to the risk assessment framework.
- Two dimensional structure that incorporates commerciality – The PCG has continued with the ‘traffic light risk rating approach’ however it has incorporated a two dimensional framework (i.e. pricing and motivational factors). Under the new framework, the highest risk rating is reserved for arrangements that are priced aggressively and (in the ATO view) motivated to derive a tax advantage.
- Advantages of being in the ‘Green Zone’ – The green risk zone has become more attractive as it not only conveys low review risk but also (assuming its determination to be correct and true) conveys compliance benefits (refer to Annexure A at the end of this Transfer Pricing Alert for detail on the ATO’s expected treatment in relation to the specific risk zones).
- Insight into the ATO’s risk assessment – Assessment under the PCG is not compulsory however it is a useful exercise to gain an insight into how the ATO will assess and respond to a taxpayer’s cross border financing arrangements. The risk assessment framework does not replace the application of the Australian transfer pricing rules and does not provide a safe harbour.
- Guidance on self-assessment and evidence - The PCG provides improved guidance on undertaking a self-assessment and evidencing / documenting the assessment. The PCG also incentivises preparation of documentation in order for taxpayers to reduce their potential compliance burden.
- Importance of legal agreements - The PCG highlights the importance of legal agreements and commerciality of the terms contained in the legal agreements. Taxpayers need to be aware that the ATO will be reviewing the intercompany loan agreement to ensure it does not contain ‘artificial’ or ‘contrived’ terms.
- Risk rating is based on highest rating – Taxpayers who have multiple debt instruments need to be aware that the overall risk assessment cannot be better than the riskiest arrangement, and as such, a taxpayer with three arrangements falling into different categories, will need to assess their ‘worst’ position and prepare to act accordingly.
- Review existing intra-group financing arrangements - All MNEs with cross border related party debt in existence as at July 2017 should review their arrangements as a matter of priority.
- Assess under the risk assessment framework – MNEs should self-assess all of their relevant related party financing arrangements against the PCG and document their analysis in line with the PCG. This will provide an understanding of how the ATO will react and will allow MNEs to prepare accordingly.
- Consider viability of restructuring arrangements to reduce the risk rating or zone - Those taxpayers facing a high risk of ATO review, should consider their appetite for the ATO’s attention and may consider restructuring arrangements to lower the risk rating and prepare robust transfer pricing analysis that evidences the arm’s length nature of the arrangement to support the conclusion that a transfer pricing benefit has not been derived. If the analysis doesn’t support the position, alternatives will need to be explored.
- Contemplate whether to enter into a Private Ruling or APA with the ATO - For material arrangements, given that the PCG provides no safe harbours and the ATO displays a positive attitude toward taxpayers with arrangements in the low risk ‘Green Zone’, taxpayers may consider obtaining a Private Ruling or APA with the ATO to increase certainty.
If the PCG is relevant to your company, please reach out to your BDO transfer pricing or tax adviser if you would like to discuss your arrangements, including the impact of the risk assessment tool and potential risk mitigation strategies that might be suitable for you.