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On 29 May 2025, the Australian Taxation Office (ATO) issued Draft Practical Compliance Guideline PCG 2025/D2 Factors to consider when determining the amount of your inbound, cross-border related party financing arrangement – ATO compliance approach (the Draft Guideline). True to its title, the Draft Guideline details the ATO’s proposed compliance approach in relation to assessing the tax risk associated with the quantum of debt associated with inbound, cross-border related party financing arrangements.
Background
Prior to the enactment of the new thin capitalisation rules last April[1], the transfer pricing provisions were effectively ‘switched off’ for the purposes of determining the arm’s length amount of debt for an entity, rendering the former asset-based thin capitalisation rules the sole determinant of such matters.
With the shift to the new earnings-based thin capitalisation regime and debt deductions no longer being disallowed on a quantum of debt basis, accompanying amendments were made to section 815-140 of the ITAA 1997 to ‘switch on’ the transfer pricing provisions for the purposes of determining the arm’s length amount of debt for an entity (it is recognised that certain financial entities may be exempt).
The Draft Guideline, which represents the ATO’s third ‘high priority’ release in response to the advent of the earnings-based thin capitalisation regime, provides welcome guidance, albeit limited, on the ATO’s intended approach to applying the transfer pricing provisions in this context.
Draft Guideline
The Draft Guideline applies to income years commencing on or after 1 July 2023, to both existing and newly-created inbound, cross-border related party financing arrangements.
Positively, the Draft Guideline recognises that there are a diverse range of capital structures that independent parties may adopt depending on their respective commercial circumstances, albeit with a less than subtle preference for anything that is not cross-border related party debt.
As taxpayers will have come to expect, the Draft Guideline establishes the ATO’s proposed compliance approach by reference to four ‘risk zones’, which are summarised in the following table.
Risk Zones
Arrangements will fall into the ‘white’ risk zone where any the following apply and there has been no material change to relevant conditions since the applicable event:
- There is an applicable court decision in relation to the Australian tax outcomes of the arrangement, to which the taxpayer was a party;
- The taxpayer has an advance pricing agreement with the ATO, which specifically addresses the permissible amount of debt; or
- The ATO has reviewed the taxpayer’s arrangement in relation to its amount on or after 1 January 2025 and provided a ‘low risk’ rating therefore.
Arrangements will fall into the ‘green’ risk zone where they:
- Are covered by one of the low-risk examples set out in the Draft Guideline, which broadly involve either: (i) an application of the third party debt where the taxpayer’s related party debt deductions are not included in its third party earnings limit, or (ii) where the taxpayer’s leverage and interest coverage ratios are equal to or better than its global group and comparable entities, and they are not covered by a high-risk example (see below); or
- Have been reviewed by the ATO (in respect of amount) and a ‘low risk’ rating (or ‘high assurance’ under a justified trust review’ was provided, and there has not since been a material change in the arrangement.
Arrangements will fall into the ‘blue’ risk zone where they are not covered by a low-risk or high-risk example in this Draft Guideline or the white ‘risk zone’ criteria.
Finally, arrangements will fall into the ‘red’ risk zone where they:
- Are covered by one of the high-risk examples set out in the Draft Guideline, which broadly involve: (i) use of cross-border related party finance while holding significant cash reserves, (ii) related party explicit guarantee in place to support the amount of an inbound, cross-border related party financing arrangement, or (iii) using cross-border related party finance to utilise excess capacity under the fixed ratio test; or
- Have been reviewed by the ATO (in respect of amount) and a ‘high risk’ rating (or ‘low assurance’ under a justified trust review) was provided.
Relevant considerations
Additionally, the Draft Guideline non-exhaustively details the following considerations, factors and documents to which it will have regard in assessing the level risk associated with an inbound, cross-border related party financing arrangement:
Options realistically available (where use of internal generated funds, alternate debt capital or equity capital would be preferred)
- Funding requirements;
- Group policies and practices;
- Returns to shareholders;
- Cost of funds;
- Covenants;
- Explicit guarantees;
- Security;
- Serviceability; and
- Leverage.
The detailed guidance provided by the ATO provides taxpayers with invaluable insight into the practicalities of its proposed compliance approach and evidentiary points the ATO will consider.
Take-Aways
The Draft Guideline puts taxpayers on notice regarding its proposed compliance approach in relation to the quantum of inbound, cross-border related party financing arrangements. It emphasizes the primacy that the transfer pricing rules now have on any thin capitalisation analysis and makes it clear that taxpayers not falling into the white or green ‘risk zones’ will need to be able to demonstrate that the quantum of their cross-border related party borrowings are arm’s length and commercially justified. To demonstrate this, taxpayers will likely need to bolster the level of quantitative analyses (if any) that may have been historically performed.
The ATO has invited comments on the Draft Guideline by no later than 30 June 2025.
FOR MORE INFORMATION
Please contact your local RSM Advisor if you would like to discuss the potential implications of the Draft Guideline for your organisation
[1]Treasury Laws Amendment (Making Multinationals Pay Their Fair Share – Integrity and Transparency) Act 2024.
