Australia: Interest-free loans between related parties; thin capitalisation arm’s length debt test
Australia: Interest-free loans between related parties
The Australian Taxation Office (ATO) released draft risk-guidance relating to outbound interest-free loans made between an Australian taxpayer and its international related parties.
The ATO’s draft Schedule 3 contained in PCG 2017/4DC2 – interest-free loans between related parties, provides updated guidance regarding key factors to consider when determining the transfer pricing risk of outbound interest-free debt lent by Australian taxpayers to international related parties.
Consistent with current guidance contained in Schedule 1 of PCG 2017/4, the ATO considered there is a high risk connected with outbound interest-free loans. The draft Schedule 3 does not set out relevant parameters and transfer pricing analysis to support that an outbound loan may be more akin to quasi-equity, but rather outlines circumstances that may lower the risk profile of the arrangement on the basis that the arrangement is to be more closely compared to an equity contribution. The draft schedule builds on previous guidance provided by the ATO in paragraph 60 of TR 92/11, with relevant factors to consider and evidence to collate appearing to be broadly aligned.
The ATO recommended conducting a preliminary analysis, focusing on key features that it considers may be relevant for concluding that an interest-free loan is more akin to an equity contribution. These include:
- The relevant rights of the lender (such as voting rights, contingent returns or other typical equity rights)
- No set repayment date (or repayment contingent on future positive cash flows)
- The degree of subordination to existing debt
- Evidence regarding the borrower’s inability to borrow the interest-free debt from a third-party lender on commercial terms
Once these aspects are understood, the ATO then indicated that the pricing risk scoring table of Schedule 1 of PCG 2017/4 is to be applied (which would result in the interest-free loan receiving a score of 10 points for the first pricing sub-factor). To reduce this score of 10 points to three (3) points and as a result, to move the interest-free loan to the lower risk zone of blue / low to moderate risk (assuming no other points are scored for the other pricing sub-factors), the taxpayer needs to answer “yes” to one of the alternatives in each of the following questions:
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?
- (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?
b. Can it be evidenced that:
- (i) The intentions of the parties are that the funds would only be repaid or interest imputed at such time that the borrower is in a position to repay?
- (ii) The borrower is in a position where it has questionable prospects for repayment and is unable to borrow externally (see paragraphs 215 of this Schedule)?
With respect to evidence to substantiate question (b) (ii) above, the ATO noted that this will include indicia such as the business activity connected to the interest-free debt, common funding practices in the industry, and the financial position of the recipient entity.
The ATO then noted that the pricing sub-factor score may be further reduced to zero (0) when evidence can be provided that demonstrates additional factors, which are considered more likely to apply to infrastructure-related industries, as follows:
- That the purpose of the loan was to acquire capital assets for the expansion of the core business
- When it is customary in the applicable 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 over the long term
- It is unlikely that it would be able to secure funds externally
- The purpose was aligned with the group’s policies and practices in respect of funding needs
Relative to other schedules in PCG 2017/4 (that generally involve closed questions and the calculation of “bright line” financial metrics), the questions that require addressing in this draft Schedule 3 are relatively broader and similar to TR 92/11, will require a degree of judgement and experience. So that taxpayers are well placed to address the draft Schedule 3, evaluate if any interest-free outbound debt arrangements are revisited, and collect relevant evidence that the draft Schedule 3 suggests be collated (such as relevant legal agreements, group treasury policies, credit rating data, and market data including practices in the industry or pre-approved/formal bank quotes).
Thin capitalisation arm’s length debt test
The ATO also finalized its interpretative and practical guidance—Taxation Ruling (TR) 2020/4—on key technical aspects of the arm’s length debt test for thin capitalisation purposes.
- The arm’s length debt test is one of the tests available to establish an entity’s maximum allowable debt amount for thin capitalisation purposes.
- The debt test focuses on identifying a notional amount of debt an Australian business would reasonably be expected to have, and what independent commercial lenders would reasonably be expected to lend (at arm’s length).
The Practical Compliance Guideline (PCG) 2020/7 provides the ATO’s compliance approach to the arm’s length debt test and addressing what the ATO considers to be a reasonable approach to undertaking a comprehensive and robust arm’s length debt test, including a risk-assessment framework for a taxpayer to self-assess its level of risk.
For more information, contact a tax professional with KPMG’s Global Transfer Pricing Services in Australia:
Tim Keeling | +61 2 9455 9853| email@example.com
Frank Putrino | +61 3 9838 4269 | firstname.lastname@example.org
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