The ATO has published much-awaited guidance in relation to outbound interest-free loans - which it has released for comment in Draft Taxation Ruling TR 2017/4 DC2. This adds a proposed Schedule 3 to the existing ATO risk-rating tool for cross-border loans, Practical Compliance Guideline PCG 2017/4.
This sets out the most guidance that the ATO has provided as to its perception of risk regarding interest-free loans for purposes of Subdivision 815-B ITAA 1997 (Subdivision 815-B), and goes beyond the interpretative guidance provided in Tax Determination TD 2019/10 in relation to the interaction between Subdivision 815-B and the debt-equity rules in Division 974 ITAA 1997.
In summary, the guidance starts with the general proposition that outbound interest-free loans are “high risk” until proven otherwise. This is predicated on the assessment that parties acting at arm’s length do not typically advance loans on a non-interest bearing basis.
At the very least, groups with outbound interest-free loans (other than those of an immaterial or very short-term nature) should review the draft guidance, and consider whether the potential risk profile of such arrangements is commensurate with their general risk appetite. This may include varying the terms of the loans to provide for interest if there is insufficient justification to support an interest-free position, or it may involve performing some further work to substantiate the reasons why interest-free loans may be appropriate.
Starting Point: High Risk
The Draft Schedule 3 contains a familiar colour-coded risk rating table, and awards points based on the “Pricing Risk” of the interest-free loan only (ie the “Motivational Risk” scoring table is not considered relevant in relation to outbound interest-free loans).
The starting point is that an interest-free loan is classed as “High Risk” (amber zone). This can be further increased – potentially into a “Very High Risk” (red zone) category, if the currency of the loan is not consistent with the operating currency, and/or to the extent the borrower has a high credit rating.
However, it is possible for an interest-free loan to be classified as “Low-to-Moderate Risk” or even “Low Risk” if evidence can be provided to demonstrate that:
- the arm’s length conditions include a zero interest rate; or
- the loan is in substance a capital contribution or
- independent entities would not have entered a loan and would have issued/subscribed for equity; though there are specific requirements addressing these options (discussed below).
Reduction of Risk Rating to “Low-to-Moderate Risk”
It is possible to reduce the risk-rating awarded to an interest-free loan to “Low-to-Moderate” risk if each of the two separate limbs below can be satisfied through providing evidence:
- the Australian lender effectively has the same rights and obligations of a shareholder, or alternatively, the parties had no intention of creating a debt which would be repaid; and
- the parties intended the funds would only be repaid or interest paid when the borrower could repay, or alternatively, the borrower has questionable prospects of repaying and is unable to borrow externally.
Regarding the second limb, relevant factors in considering whether or not the borrower could have borrowed the funds from an independent lender include:
- common funding practices in the industry (including typical debt/equity ratios);
- the nature of the business at the time (e.g. a miner in the prospecting or exploration stage where there are no assets or revenues); and
- the financial position of the borrower (including the capacity to pay interest and to repay principal).
Relevant evidence in this regard could include group treasury policies and independent research on relevant industry practices.
Reduction of Risk Rating to “Low Risk”
It may be possible to further reduce the risk-rating for an interest-free loan to “Low Risk”, where all of the following factors are present:
- the purpose of the loan was to acquire capital assets to expand the core business;
- it is customary in the relevant industry to enter into longer-term investments;
- there is evidence that the borrower is not in a position to repay the loan until the project turns cash flow positive;
- it is unlikely the borrower would be able to secure funds externally; and
- the purpose was aligned with the group's policies and practices in respect of funding needs.
Given the starting point of an interest-free loan being “high risk”, taxpayers will need to collect evidence and to conduct analyses consistent with the guidance in Draft Schedule 3 in order to demonstrate a “low-to-moderate risk” or “low risk” rating for their interest-free loan arrangements.
Applying this risk-rating tool will be particularly important for those groups that are required to disclose their risk-ratings to the ATO (eg in the Reportable Tax Position Schedule), but other taxpayers may well wish to understand their risk profile and take steps to remediate any “high risk” positions.
Draft Schedule 3 conspicuously avoids using the term “quasi-equity” being the term used in TR 92/11 in relation to interest-free loans to support the non-application of Division 13 ITAA 1936 (Division 13). There are important legislative differences between the transfer pricing rules in Division 13 and Subdivision 815-B. As such, taxpayers with outbound interest-free loans that have relied upon a TR 92/11 “quasi-equity” analysis should review such analyses in light of the guidance in Draft Schedule 3.
Finally, the ATO’s risk assessment framework in relation to inbound interest-free loans has not been released. It, therefore, remains to be seen whether the ATO will apply similar considerations to inbound interest-free loans consistently with the guidance provided in the Draft Schedule 3.
Nevertheless, taxpayers with inbound interest-free loans, particularly those that have relied upon a TR 92/11 “quasi-equity” analysis, should review such analyses in light of the guidance in Draft Schedule 3.
HOW CAN RSM HELP?
If you have any requestion regarding interest-free loans, contact your local RSM office.