PCG 2017/4 and Final Schedule 3 – interest-free loans between related parties
In the current economic environment, marked by increased regulatory scrutiny and a renewed global focus on base erosion and profit shifting (BEPS), cross-border related party financing remains a key area of compliance risk.
The Australian Taxation Office (ATO) has now finalised its position on interest-free loans between related parties through the release of Schedule 3 to Practical Compliance Guideline PCG 2017/4, which came into effect on 1 January 2024. This finalised guidance sets out the ATO’s compliance approach and risk assessment framework for outbound interest-free loans by Australian taxpayers to international related parties.
This long-awaited clarification replaces reliance on outdated materials and draft guidance and significantly shifts the compliance landscape. People with existing outbound interest-free loans must promptly assess their arrangements under the PCG framework, particularly given the high-risk categorisation that generally applies to such structures.
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.
What is the ATO targeting?
The ATO’s transfer pricing rules aim to prevent profit shifting through non-arm’s-length financing arrangements. Interest-free outbound loans present a particularly high risk, as they can facilitate the artificial deferral or avoidance of Australian tax. Schedule 3 of their PCG targets this risk directly, particularly where loans are made to related parties in low-tax or no-tax jurisdictions, or to entities with limited repayment capacity.
Risk assessment framework – PCG 2017/4 Schedule 3
The PCG applies a risk-based approach to related party financing arrangements, assigning risk ratings from green (low) to red (very high). In the case of outbound interest-free loans, the ATO starts from the presumption that these arrangements fall within the amber (high risk) zone.
Key factors that may elevate the risk rating to red include:
- The borrower being located in a low-tax jurisdiction
- Weak or non-existent documentation
- Loans denominated in foreign currencies
- No clear intention or capacity for repayment
Once flagged, these arrangements are more likely to be selected for audit or review, particularly given mandatory disclosures in the International Dealings Schedule (IDS) and the Reportable Tax Position (RTP) Schedule.
How to mitigate transfer pricing risk
The finalised Schedule 3 outlines circumstances where an outbound interest-free loan may qualify for a lower risk rating – typically the blue zone (moderate risk). Factors supporting a lower risk classification include:
- Where no formal agreement is in place but the loan is accounted for:
- The arrangement is more appropriately characterised as quasi-equity
- The parties had no commercial expectation of repayment
- Repayment is contingent on the borrower’s future financial capacity
Note: Recharacterising amounts as equity has broader tax implications, including treatment under thin capitalisation, dividend withholding tax and controlled foreign company rules.
- Where a legally documented loan exists:
- The non-charging of interest can be supported as an arm’s length condition
- The borrower could not secure external funding on commercial terms
- The arrangement aligns with group treasury policy and industry norms
In all cases, robust documentation is critical – including loan agreements, group funding policies, board minutes and evidence of decision-making processes.
Next steps for businesses
With Schedule 3 now finalised, businesses must take urgent steps to:
- Review all outbound interest-free loan arrangements currently in place
- Assess each arrangement against the PCG risk framework
- Document supporting evidence to justify the structure and terms
- Consider restructuring arrangements to reduce tax risk (e.g., by introducing commercial interest or formalising terms)
For taxpayers with high or very high-risk ratings, early engagement with the ATO may be advisable.
In an era of heightened transparency, economic substance requirements, and real-time compliance monitoring, interest-free related party loans are squarely in the ATO’s sights.
If you’d like help with the ATO’s guidance on Interest-Free Related Party Loans, contact your local William Buck Advisor.
