On 16 May 2017, the Australian Taxation Office (ATO) issued in draft form a Practical Compliance Guideline (PCG 2017/D4) outlining its proposed compliance approach to the transfer pricing implications arising from cross border ‘related party financing arrangements’ (RPFAs).
The timing of the PCG release is interesting – there are only a few days remaining for Chevron to lodge a special leave application with the High Court, against the drubbing it received in the Federal Court on the interest payable on its US$2.5 bn RPFA. Is this purely coincidental? Or is the ATO being prescient, or perhaps making a point?
The PCG outlines an assessment framework allowing taxpayers to self-assess the level of tax risk associated with any RPFAs.
The PCG will come into effect from 1 July 2017, and apply to all new and existing RPFAs.
It does not provide guidance on technical tax matters; it is not legally binding on the ATO; nor does it provide ‘safe harbour’ protection for taxpayers.
However, if the taxpayer self-assesses itself within the green ‘low risk’ zone, the ATO “…. will generally not allocate compliance resources to test the relevant tax outcomes of the RPFAs.”
The ATO will test to confirm an accurate application of the guidance, and that the taxpayer can support it’s positioning within the selected risk zone.
Application of the PCG
Australia’s tax law generally requires taxpayers to self-assess tax liabilities, including in the case of transfer pricing rules, whether or not the terms and conditions of international related party transactions satisfy the arm’s length standard, or alternatively, whether they give rise to a ‘transfer pricing benefit’.
The PCG applies to ‘financing arrangements’, but looks only to the transfer pricing aspects of those arrangements, not the other tax issues which apply to the securities, such as the Division 974 (debt/equity classification rules). However, to make sense of the PCG, the ‘financing arrangement’ must be a ‘debt interest’ under Division 974, as that is a prerequisite to claiming tax deductions for the related borrowing costs.
The PCG currently contains only one schedule, which risk assesses standard loan arrangements. The current schedule does not address financial guarantees, interest-free loans, or related party derivative arrangements, but guidance on these matters and others, may be added to the PCG in the future.
The PCG applies to both inbound and outbound loan arrangements.
The PCG does not apply to cases where:
- there is a financial institution within the group
- there is an Australian resident securitisation vehicle within the group
- the RPFA is a form of Islamic finance, or
- there is an Australian resident taxpayer within the group which is eligible to utilise the simplified transfer pricing recordkeeping options.
This last exclusion is interesting - smaller taxpayers will now need to determine whether they qualify for the simplified transfer pricing recordkeeping regime, or not, before applying the PCG risk assessment framework. In our experience, many taxpayers have made that assessment, but there remain a number who have not. It is now a practical pre-requisite before applying the PCG.
How the framework works
The ATO has developed the risk matrix, which allows taxpayers to compare features of their own RPFAs against the features of ‘referable debt arrangements’.
Depending upon the difference between the actual and the ‘referable debt’ features, a score is attributed to the various tested factors. The scores are summed, and the total will determine the risk category into which the tested taxpayer will fall. The spread is as follows:
White zone - arrangement already reviewed and concluded by the ATO
Green zone – low risk Score: 0 to 4
Blue zone – low to moderate risk Score: 5 to 10
Yellow zone – moderate risk Score: 11 to 18
Amber zone – high risk Score: 19 to 24
Red zone – very high risk Score: 25 or more.
The risk matrix – and how to calculate your rating
The various indicators are listed down the left side of the matrix.
Moving to the right, the matrix is split between outbound loans, and across to the far right, inbound loans - with the ‘Goldilocks’ features in the middle, in green, covering both outbound and inbound RPFAs.
Some of the tested indicators require reference to traditional transfer pricing comparable analyses, for instance, the first factor – price (interest rate) which can be tested against a number of alternative benchmarks: the global group cost of debt; traceable third-party debt; or relevant third-party debt of the borrowing entity.
As an example, for an outbound loan, where no interest is charged, the score for that factor would be 10. Alternatively, where the interest rate is equal to or higher than the referable debt, then the score would be 0 (see the ‘Goldilocks’ column).
Other tested indicators draw from the financial records of the taxpayer, or group, e.g. the leverage of the borrower, and the interest coverage ratio. The score attributable will depend upon the positioning of the taxpayer within a range. For instance, where the leverage exceeds 60%, then for an inbound loan, the score will be 10.
Other tested indicators require a simple yes or no response – appropriate collateral; subordinated or mezzanine debt; alignment of (or difference between) the loan currency with the taxpayer’s operating currency; an arrangement highlighted by a taxpayer alert; involvement of a hybrid entity or arrangement; and/or the presence of exotic loan features. Depending upon the response to these different factors, different scores can be identified in the matrix.
Finally, an adjustment is permitted to take account of the potential sovereign risk associated with making loans from relatively stronger economies to relatively weaker economies (sovereign risk factor).
Example drawn from the PCG
ForCo Inc is the US parent company of a global oil and gas group. Its profile includes the following:
- 31 December accounting year end
- interest coverage ratio of 16
- average cost of debt of 2.54%
- the average of 33%.
ForCo Inc’s Australian subsidiary (AusCo) has received a related party loan with the following features:
- interest rate of 3.16%
- USD currency
- no subordination
- no security
- it is not a hybrid instrument and does not involve hybrid entities
- the lender is resident in Hong Kong with a headline tax rate of 16.5%
- there are no exotic features or derivatives in the loan.
The following points are relevant for AusCo’s profile:
- engaged in the oil and gas exploration and extraction business
- 31 December tax and accounting year end
- interest coverage ratio of 13
- leverage of 35%.
|Indicator||AusCo Pty Ltd's circumstances||Score|
|Priced consistently with global group cost of debt||3.16% is 62 basis points higher than the group average cost of 2.54%||1|
|Leverage||Consistent with parent||0|
|Interest coverage ratio||13||1|
|Headline tax rate of lender entity jurisdiction||16.5%||3|
|Currency of debt is different to operating currency||No||0|
|Involves an arrangement covered by a taxpayer alert||No||0|
AusCo scores 8, which puts it into the Blue zone – low to moderate risk. The company could remain in this zone, which would likely attract a slightly higher level of ATO interest, or it could seek to change some of the conditions around the RPFA, reduce the score to 4 or below, and move back into the Green zone – low risk. The result of changing any of the features would likely have the effect of reducing the tax deductible interest expense paid by AusCo to the related Hong Kong lender.
The commercial trade-off becomes apparent: less deductible interest expense 'buys' protection (?) against detailed ATO scrutiny of the RPFA.
Likely level of ATO response to the different zones
The following summarises the differentiated ATO compliance responses based on the escalating risk ratings.
White zone: the arrangements have already been reviewed and concluded by either the ATO or a Court, and provided there have been no changes in the interim, no further review would be conducted.
Green zone: no compliance resources would be directed in this case, although the ATO would review to confirm the taxpayer has performed the calculations in accordance with the PCG guidance, and verify the accuracy of the calculations.
Blue zone: the ATO will actively monitor the arrangement using available data, and will review arrangements by exception.
Yellow zone: ATO engagement with the taxpayer to understand and resolve areas of difference; informal approach and possible Alternative Dispute Resolution (ADR) processes.
Amber zone: review is likely to be commenced as a matter of priority, with the ATO engagement to understand and resolve areas of difference; ADR processes applied.
Red zone: reviews likely to commence as a matter of priority, perhaps starting as an audit. Formal engagement; ADR unlikely to be relevant; increased risk of fast-tracked litigation.
The ATO’s initiative in issuing Practical Compliance Guidelines has generated strong views at each end of the spectrum. Those who are critical focus on the lack of formal protection for the taxpayer – the PCG is not binding on the ATO, nor is it a safe harbour – all that is promised is the uncertain prospect of ‘not deploying any compliance resources against the particular taxpayer’.
Other criticisms have focused on the generic approach of the PCG – a ‘one size fits all’ approach which is commercially unrealistic, and does not provide the necessary flexibility to reflect real-world arrangements.
At the other end, the PCG initiative is welcomed as providing greater insight to the thinking and reasoning of the ATO, and greater certainty about what is acceptable and what is not. It is accepted that the ATO will take a conservative and pro-revenue view in the settings adopted within the PCG, but that is to be expected in the circumstances. It remains open to a taxpayer to operate in a higher risk zone, if it feels confident in supporting that position.
Irrespective of the view taken, PCG’s are a reality, and exhibit the manner in which the ATO is going to proactively ‘manage’ tax risk and best target its limited resources to the higher risk related party financing arrangements.
PCG 2017/D4 is a draft, and there is now an open consultation period within which comments can be lodged with the ATO. There may be some greater flexibility built into the PCG through this process, but the basics are unlikely to change.
Taxpayers now have a tax risk assessment framework which can be applied to their own circumstances, in order to self-assess a risk rating on their existing and future related party financing arrangements.
From the perspective of good corporate governance, prudent tax governance, and external audit consideration, taxpayers can be expected to apply this framework in order to support the level of tax risk surrounding any related party financing arrangements in place.
For smaller taxpayers, a determination as to whether they qualify for the simplified transfer pricing recordkeeping regime would be a preliminary step which may exempt them from requiring to perform the PCG self-assessment.
Following the handing down of the Federal Court decisions in the Chevron litigation, Australia leads the world in dealing with the transfer pricing implications of financing arrangements. The release of PCG 2017/D4 builds upon that lead. Should the High Court decide to grant special leave to hear Chevron’s appeal, there may be a pause in finalising this PCG; but we will know that in the next couple of days.
In the meantime, affected taxpayers should become familiar with the framework set out in the PCG
If you have any questions regarding its application to your circumstances, please contact your regular RSM transfer pricing or tax representative.