The tax treatment of cross-border related party debt is one of the hottest issues around. Close on the heels of the Full Federal Court’s recent landmark decision in Chevron, the Australian Taxation Office (ATO) has today released a draft Practical Compliance Guideline (PCG) on the topic: PCG 2017/D4 ATO compliance approach to taxation issues associated with cross-border related party financing arrangements and related transactions.
The ATO makes it clear that the PCG is neither a public ruling, nor a “safe harbour”. It also does not provide guidance on the technical interpretation of the transfer pricing laws. There is no mention of the Chevron case or any other Court decisions.
Rather, the objective of the PCG is to provide a basis for self-assessment of a taxpayer’s tax risk arising from cross-border interest payments on related party debt transactions. The PCG applies to both inbound and outbound transactions, subject to a number of exceptions including: arrangements undertaken by banks, other ADIs and Australian securitisation vehicles; entities subject to the ATO’s existing simplified transfer pricing guidelines, and Islamic finance.
Going forward, the Reportable Tax Position (RTP) schedule will have a question asking if a taxpayer has applied the PCG to its related party debt. If so, the taxpayer will be asked to disclose the self-assessed risk zone. Although taxpayers will not be required to self-assess their risk ratings, if they don’t, this will also need to be disclosed on the RTP.
The PCG is reflective of the current trend of the ATO issuing “compliance guidelines” and not actual tax rulings. Tax rulings are binding on the ATO and are actual interpretations of the law. “Compliance guidelines” such as this PCG, are not binding on the ATO, merely said to be indicative of what the ATO will “allocate compliance resources” to testing, and not an interpretation or application of the law. But they are clearly intended to change taxpayer behaviour. Even though an arrangement that is classified as “high risk” under these guidelines may in fact accord with the transfer pricing laws, some taxpayers may still be inclined to modify their arrangements to fit within a low risk category to avoid the compliance burden associated with increased ATO scrutiny.
The heart of the PCG is a table with 11 quantitative and qualitative “risk indicators” which are given scores, on a loan by loan, year by year basis. The taxpayer’s overall risk level, from “white” (arrangements already reviewed by the ATO) to “red” (very high risk), is based on the arrangement with the highest risk rating. Where a taxpayer is in the “green zone – low risk” the PCG says that the ATO will “generally not apply compliance resources” to the arrangements, other than to confirm facts and check eligibility. At the other end of the spectrum, where a taxpayer is in the “red zone”, reviews are likely to be commenced as a matter of priority and cases might proceed directly to audit. Somewhat ominously, the PCG notes that the ATO will monitor outcomes for related party debt to ensure that there is no “drift” within the allowable range for any particular indicator.
The PCG includes provisions to encourage taxpayers to “transition” existing arrangements to the “green zone”. For a limited period, the ATO will remit penalties and interest as regards prior years, where certain conditions are met. Of course, as noted above, a “high risk” rating under the PCG does not necessarily mean that something is not in accordance with the transfer pricing rules.
A key risk indicator assesses the interest rate on the related party debt in comparison to any “referable debt”, being the global cost of group debt, traceable third party debt, and certain other third party debt. For inbound loans, the “safest” outcome is interest that does not exceed 50 basis points over the cost of the “referable debt”. The higher the margin over the cost of the “referable debt”, the greater the risk score. The PCG does not explain how the ATO arrived at the 50 basis points for this purpose, nor rationalise this position in light of the decision in the Chevron case.
The other 10 risk indicators, in summary, are as follows:
- Leverage of borrower
- Interest coverage ratio
- Appropriate collateral
- Subordinated or mezzanine debt
- Headline tax rate of lender entity jurisdiction
- Currency of debt is different to operating currency
- Involves an arrangement covered by a Taxpayer Alert
- At least one party is a hybrid entity
- Presence of exotic features on loan
- Sovereign risk of borrower entity
The ATO says in the PCG that it expects “in most cases, the cost of the financing to align with the costs that could be achieved, on an arm’s length basis, by the parent of the global group to which the borrower and lender both belong. The indicators, and the weighting of the indicators, have been developed with this expectation in mind”.
The PCG is drafted with wholly-owned corporate groups most clearly in mind, but will also be relevant to other entities given the broad concept of “related parties”. For instance, the PCG will be relevant to the funding of private equity acquisitions and infrastructure projects, in which loans will often have features that may result in a high risk rating under the PCG regardless of the interest rate payable.
The PCG will put a considerable additional compliance load on Australian and foreign based companies to collect the required data, on a regular basis, to self-assess their risk levels.
When finalised, the PCG will have effect from 1 July 2017 and will apply to existing and new transactions.
Comments on the draft PCG are due by 30 June 2017.
We recommend that taxpayers who will be subject to the PCG immediately commence reviewing their existing (and any proposed) financing arrangements against the ATO’s risk indicators, to determine where they sit on the risk spectrum, whether they are comfortable with assuming that risk rating or what modifications could be made, and to assist in the completion of their RTPs in due course.
Please contact Tony Frost or Julian Pinson if you require assistance or would like to discuss the PCG.