ATO issues draft practical compliance guidelines on outbound interest-free loans

20 August 2020

The Australian Taxation Office (ATO) has recently issued a draft practical compliance guideline on interest-free loans given by Australian entities to their related party. The guideline has been issued in draft for comments as Schedule 3 to PCG 2017/4 which relates to cross-border financing arrangements[1] and includes examples on how to undertake the risk assessment under this schedule. Based on the comments, the ATO will finalise the guideline and notify the date of applicability of the guidelines.

Financing arrangements

PCG 2017/4 is a risk assessment tool to determine the risk rating of financing arrangements with overseas related parties. The risk associated with each financing arrangement is assessed based on a combination of various qualitative and quantitative indicators. The risk framework includes six risk zones ranging from red (very high risk) and amber (high risk) to green (low risk) and white (reviewed arrangements). The higher the risk rating, the more likely it is for the ATO to review the arrangement.

Schedules 1 and 2 of PCG 2017/4 relate to interest bearing loans and derivatives respectively. Schedule 3 released on 12 August 2020, relates to interest-free loans.

Risk rating of outbound interest-free loans

The draft Schedule 3 includes a pricing risk scoring table, with scores attached to various indicators. This table is similar to the pricing risk scoring table in Schedule 1 which relates to interest-bearing loans. The risk zone is based on the total pricing score.

Given that independent entities would not typically enter into such arrangements, the ATO considers outbound interest-free loans between related parties to be high-risk arrangements with an automatic score of 10 or a risk rating of red or amber.

Certain factors can be satisfied that may lower the rating and if the minimum required factors are satisfied, then the rating could be blue (i.e. low to moderate risk) or even lower if further additional conditions are satisfied. Broadly, the risk rating is lowered if it can be evidenced that:

  • The zero-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.

Step 1: Minimum required factors

The initial risk score could be reduced to three to fall in the low to moderate risk zone if the responses to one of the alternatives under each of the following questions is “yes”.

Question (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?

Question (b)

Can it be evidenced that:

i. the intentions of the parties are 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?

In determining whether an entity could borrow externally, the guideline allows consideration of:

1. Commercial practice in the industry

This includes consideration of common funding practices of the industry in which the borrowing entity’s business operates for entities in comparable circumstances, such as:

  • Commercial practices in the industry in which the borrower operates, including the time at which the debt funding is sought and purpose of borrowing.
  • Debt to equity ratio of the borrowing entity in relation to comparable entities in the particular industry or in the country in which the investment is made.
  • Whether the business of the borrowing entity could sustain a high level of debt.

2. Business activity of borrowing entity

The nature of the activity of the borrowing entity could be at a stage where no independent lender would lend to it in their ordinary course of business. For example, a mining business could be in the prospecting or exploration stage where there are no assets to provide as security, or current revenue stream to meet repayment obligations or the business activity is still at the pre-final investment decision stage.

3. Financial position of borrowing entity

An independent lender would typically assess the potential default risk and the creditworthiness of the borrowing entity. This factor includes consideration of:

  • Repayment capacity of the borrowing entity. A lack of such capacity may be indicative that an advance is in substance equity.
  • Factors such as poor operating cash flow, high gearing levels and poor economic outlook are indicative of an entity that would be unlikely to be able to borrow at commercial rates and would seek equity funding, where possible.

Step 2: Additional factors

The risk score could be further reduced to zero bringing the risk rating to green (i.e. low risk) if the following additional conditions are satisfied:

1. Non-charging of interest is identified as arm’s length conditions. For example, an off-take arrangement where the commercial benefit of interest has been substituted for consideration in another form (that is, delivery of a commodity/resource being extracted).

2. Absence of fixed maturity date indicating the borrower is not legally obliged to repay the debt, and hence the loan could be considered as equity.

3. Deeply subordinated debt which could be considered as an equity arrangement.

4. Presence of regulatory barriers in holding additional equity in an investment in a foreign country.

5. Interest-free loans documented to demonstrate:

  • Purpose of the loan was to acquire capital asset for the expansion of the core business.
  • Longer-term investments are customary in the relevant industry.
  • Repayment of the loan is not possible until the project turns cash flow positive over the long term.
  • It is unlikely the borrowing entity would be able to secure funds externally.
  • The purpose of the loan was aligned with the group’s policies and practices in respect of funding needs.

The ATO has noted the characterisation of the debt arrangement is based on the relevant commercial and financial relations and it is not expected to change during the course of the arrangement. The ATO also recommends consistent treatment of the debt arrangement for transfer pricing, tax and withholding purposes. Any inconsistency may result in treating the arrangement as a high-risk arrangement.

Documentary evidence

The guideline requires documentary evidence to support a lower-rating for the debt arrangement under Steps 1 and 2. A list of documents that could be relied upon by taxpayers is included in the draft guidelines.

Disclosure of rating

While Schedule 3 of the guideline is in draft, it is unclear if the ATO will apply it in its ongoing review engagements. Once finalised the risk rating will also be required to be disclosed in the Reportable Tax Position Schedule, that forms part of the income tax return.

Date of effect

The ATO has not issued any specific date for the application of Schedule 3 of PCG 2017/4. The date of applicability will be communicated in the final version of the guideline.

Although in draft, it is much welcomed that the ATO has formally issued some guidance on risk assessing interest-free outbound loans. While the draft schedule does not provide guidance on when a transfer pricing analysis is required for an interest-free loan, it provides guidance on particular conditions that may require consideration of an interest-free outbound loan as a low-risk equity arrangement.

If you need any advice relating to transfer pricing, please get in touch directly with these members of our Tax Advisory team:

Keerthiga Sharma, Manager, Tax Advisory (Sydney)

Anthony Patrk, Partner, Tax Advisory (Sydney)

John Baillie, Senior Partner, Tax Advisory (Melbourne)

Trevor Pascall, Senior Partner, Tax Advisory (Brisbane)

[1] Practical Compliance Guideline PCG 2017/4 ATO compliance approach to taxation issues associated with cross-border related party financing arrangements and related transactions