Now that the ATO’s updated views in respect of interest free loans have been published (even if in draft form), any existing interest free loan arrangements that do not fall within the lower risk zone in the schedule should be revisited as a matter of urgency as they present a high risk from a tax and transfer pricing perspective.
PCG 2017/4DC2 – Draft Schedule 3: Interest-free loans between related parties
On 12 August 2020, the ATO released an updated draft practical compliance guideline with 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.
This guidance from the ATO has been a long time coming and many taxpayers have been relying on old guidance to establish the level of transfer pricing risk in respect of outbound interest free loans. Now that the draft guidance has been issued, taxpayers can reassess their outbound interest free loans and collate relevant evidence e.g. legal agreements, group treasury policies, etc., to establish their risk rating under the PCG.
This means any existing interest free loan arrangements that do not fall within the lower risk zone in the schedule should be revisited as a matter of urgency as they present a high risk from a tax and transfer pricing perspective.
PCG 2017/4DC2 is proposed to apply from 1 July 2017.
What is this guidance targeting?
Australian transfer pricing rules aim to prevent the artificial profits shifting out of Australia to lower tax rates jurisdictions. Particularly in respect of related parties loan arrangements, this can be achieved by advancing funds with low or zero interest rate terms. This PCG targets the risk of interest-free loans, especially outbound interest-free loans.
Assessing risk under PCG 2017/4DC2 framework
The draft Schedule outlines the framework under which the risk score assigned to particular outbound interest-free loan arrangement between cross-border related parties.
In general, the ATO considers that there is a high transfer pricing risk with an outbound interest-free loan between related parties. Essentially, having an outbound interest-free loan with a related party immediately places you in the amber zone (high risk) at the outset. Other factors, such as the currency of the loan advance and the sovereign risk of the borrower entity, can increase your risk rating to red (very high risk).
Once the arrangements are identified as red, the ATO will likely review the arrangements as a matter of priority. This is triggered through disclosures in the International Dealings Schedule (IDS), along with the Reportable Tax Position Schedule which becomes mandatory for many entities.
What existing factors will reduce the risk rating?
The draft schedule states that certain additional factors can lower your risk rating, resulting in the loan arrangement moving from the amber zone to the to the blue zone (moderate risk). Below are some examples of low risks arrangements. If the client has evidence showing:
1) Where no documentation or agreement in place but accounted for as a loan:
- The rights and obligations of the provider of funds are effectively the same as the rights and obligations of a shareholder (i.e. the amount is more akin to equity rather than debt); or
- The parties had no intention to create a debt with a reasonable expectation of repayment; and
- 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; or
- The borrower is in a position where it has questionable prospects for repayment and is unable to borrow externally.
Note: Characterising an amount as equity has flow-on effects for other tax matters for the lending entity in Australia
2) Where a legally documented loan agreement is in place:
- The ATO’s assessment of the non-charging of interest is an arm’s length condition (i.e. after an ATO audit or Transfer Pricing review only);
- It is customary in the applicable industry to enter into longer-term investments;
- It is unlikely that the borrower would be able to secure funds externally; and
- It was aligned with the group’s policies and practices in respect of funding needs.
Where to go from here?
Now that the ATO’s updated views in respect of interest free loans have been published (even if in draft form), any existing interest free loan arrangements that do not fall within the lower risk zone in the schedule should be revisited as a matter of urgency as they present a high risk from a tax and transfer pricing perspective.
