Australia: related party financing faces heightened tax scrutiny

by Zara Ritchie and Natalya Marenina

The Australian Taxation Office (ATO) on May 16 issued a long rumoured and awaited draft guidance which sets out the ATO’s risk assessment framework for cross-border related party financing.

The guidance, Draft Practical Compliance Guideline 2017/D4, comes mere weeks after Chevron Corporation lost its appeal in the Full Federal Court in a landmark transfer pricing case on intragroup financing. It applies from 1 July and the ATO is seeking feedback, with the consultation period to close 30 June.

Although Chevron has requested leave to appeal to the Australian High Court, the new guidance highlights the ATO’s confidence to tackle similar issues and we can expect an increase in allocation of resources and significantly higher level of activity from the ATO in reviewing cross-border financing arrangements.

It should be noted that the new release does not provide guidance on the application of Australian legislation or application of the arm’s length principle, nor does it provide a safe harbour. Instead, it aims to highlight to taxpayers what arrangements the ATO is likely to consider as being high risk.

Arrangements that result in a ‘high risk’ rating applying the ATO criteria may still have applied the arm’s length principle correctly but the rating would mean that a taxpayer would need to be prepared for possible ATO attention and increase the level of documentation and evidence supporting the arrangement.

 Risk ratings

Australia’s related party financing guidance follows a “traffic light” risk rating approach and allows the taxpayer to derive a risk rating, ranging from “green zone” (i.e., safe from the ATO review apart from exceptional circumstances) to “red zone” (i.e., likely to be subject to immediate ATO review or audit).

The risk assessment will not be compulsory for all taxpayers. Rather, businesses notified by the ATO to complete the Reportable Tax Position Schedule or by other means must self-assess the risk rating of the related party financing arrangement.

The ATO will allow taxpayers an 18 months grandfathering period in which to self-assess and amend the related party debt (both existing and newly created) to fall into the ‘green zone’ with zero penalties.

The framework is structured as a checklist; it is not straightforward and concentrates on a number of factors including:

  • Terms of the debt (i.e., subordinated or senior; collateral; currency; exotic features, such as payment-in-kind or redeemable preference shares).
  • Interest cover and leverage ratios compared to global group ratios and compared against certain criteria.
  • Interest rate on the loan as compared to various third-party debt held within the global group or by the taxpayer, at arm’s length.
  • Headline tax rate of the lender.

Australia related party financing – in practice

As the new Australian related party financing guidance was designed as a risk assessment tool, it overlooks the complexity and wide spectrum of arrangements that can exist in the market in an arm’s length situation and, as such, it can result in puzzling outcomes on application.

A number of factors noted in the guidance as falling within “green zone” can only be seen in taxpayers with a very strong credit rating, i.e., A to AAA categories.

If one wanted to apply the criteria outlined in the guidance to unrelated loans, there would be numerous taxpayers with loans from third-party banks that would fall outside of the ‘green zone’ for commercial reasons alone, highlighting arguably a lack of commerciality in the ATO risk assessment framework.

Due to this discrepancy, companies that have applied the transfer principles and prepared transfer pricing analysis to support their financing arrangements can find themselves in the ATO spotlight and the impact of the new approach will be far reaching, affecting all types of taxpayers and industries.

It would be unreasonable to expect all taxpayers to restructure their arrangements to fall within the ‘green zone’ risk rating as that maybe uncommercial, not only in the context of the affairs of the Australian taxpayer, but also in the context of the entire multinational group.

Nevertheless, it is recommended that taxpayers review their cross border financing arrangements with the new Australian tax guidance in mind and, depending on the outcome, focus on the extent of support and documentation available in the context of the risk rating.

Inbound vs. outbound loans

It should also be noted that there is a lack of consistency in how the ATO risk assesses inbound loans versus outbound loans; it’s likely that loans following the same policy can be assigned a different risk rating depending on whether they are inbound or outbound.

This, of course, raises a question as to what the international response will be to such a risk assessment tool and also highlights the one-sided nature of the new tax guidance.

Only time will tell whether other tax authorities and the OECD will adopt similar views to the ATO.

If they don’t, the risk of double taxation for multinationals may increase yet again.

The OECD is poised to issue its first ever guidance on financing arrangements over the next few months and so perhaps MNEs will find more tax certainty as a result – or will they?

— Zara Ritchie is Partner and Head of BDO’s Global Transfer Pricing Services. She can be reached at +61 3 9605 8019.

— Natalya Marenina is Principal at BDO Sydney. She can be reached at +61 2 8264 6649.

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