By Leslie Prescott-Haar & Sophie Day at TP EQuilibrium | AustralAsia LP
On 12 August, the Australian Taxation Office released new risk assessment guidance for outbound interest-free ‘loans’ made by Australian taxpayers to international related parties.
New draft Schedule 3 of Practical Compliance Guideline 2017/4DC2 outlines key factors to consider when determining the transfer pricing risk of such outbound interest-free advances. In particular, the draft sets out how the risk indicators in Schedule 1 to the Practical Compliance Guideline apply to outbound interest-free loans.
The risk assessment approach for intercompany loan spreads under Practical Compliance Guideline 2017/4 has effect from 1 July 2017 and applies to both existing and newly created financing arrangements from that date, whereas the effective date of draft Schedule 3 will be set upon the draft’s finalisation.
This draft schedule applies solely for purposes of risk assessment under Australia transfer pricing provisions. Taxpayers are required to “self-assess” their risk position in the light of the guidance.
Risk ratings
The Australian Taxation Office considers that outbound interest-free loans are prima facie high risk on the basis that loans are generally not provided by independent parties on an interest-free basis, unless it can be demonstrated that the loan should be treated as equivalent to a subscription of shares or other equity contribution under arm’s length conditions.
An outbound interest-free related party loan will have a base ‘risk score’ of 10 (in the high-risk zone) under the Practical Compliance Guideline, prior to consideration of any other factors listed in the risk assessment table.
Draft Schedule 3 recognises that there are circumstances where the risk profile may be lower because the advance is more akin to an equity contribution, rather than a loan. Paragraph 207 of draft Schedule 3 provides that the risk rating can be reduced if it can be evidenced that: (i) the zero interest rate is an arm’s length condition of the loan, or (ii) the loan is in substance an equity contribution, or (iii) independent entities would not have entered into the actual loan and would have entered into an equity funding arrangement. As third party bank lenders are more likely to either provide finance or not, rather than consider the provision of either a loan or equity, the wording of (iii) will hopefully be amended upon finalisation.
Step 1 – minimum required factors
Under draft Schedule 3, the risk score for outbound interest-free advances may potentially be reduced to 3 points (in the moderate risk zone), rather than a base risk score of 10 points, if it can 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; or (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; and (a) 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 (b) the borrower is in a position where it has questionable prospects for repayment and is unable to borrow externally.
Step 2 – additional factors
In general, the more evidence available supporting equity delineation, the lower the risk score may be under draft Schedule 3 for outbound interest-free loans. Draft Schedule 3 provides further additional factors which may support equity characterisation and, therefore, may potentially reduce the risk score from 3 points to zero (in the low-risk zone). In this regard, draft Schedule 3 provides in paragraph 222 that interest-free loans legally documented as debt will be considered low risk if evidence demonstrates that: (i) the purpose of the loan was to acquire capital assets for the expansion of the core business; (ii) it is customary in the applicable industry to enter into longer-term investments; (iii) the borrower it is not in a position to repay the loan until the project turns cash flow positive over the long term; (iv) it is unlikely that the borrower could secure funds externally; and (v) the purpose was aligned with the group’s policies and practices in respect of funding requirements. Certain additional factors are also covered under Step 2 of this Schedule.
Draft Schedule 3 builds on previous guidance issued by the Australian Taxation Office in paragraph 60 of Taxation Ruling 92/11, with relevant factors for consideration broadly aligned. The factors also broadly align with the ‘‘economically relevant characteristics’’ for accurately delineating an advance of funds in Chapter X of the OECD Transfer Pricing Guidelines released on 11 February 2020, including; the right to enforce payment of principal and interest, the presence or absence of a fixed repayment date, the status of the funder in comparison to regular corporate creditors, the ability of the recipient of the funds to obtain loans from unrelated lending institutions, and the extent to which the advance is used to acquire capital assets.
Whilst such relevant factors are similar between this early Australian Taxation Ruling and draft Schedule 3, the latter is more prescriptive and demonstrates progression over time to a more substance-based delineation approach.
Emphasis on evidence
The Australian Taxation Office in draft Schedule 3 lists a number of documents to prepare and maintain to substantiate self-assessment of the risk score. Whilst the emphasis on evidence within the draft Schedule 3 is informative, arguably, draft Schedule 3 goes beyond current OECD guidance for purposes of risk assessment. Hopefully the Australian Taxation Office will conform Schedule 3 more closely to the recently released OECD guidelines upon finalisation thereof.
Timing matters
At paragraph 199, the draft schedule states that it does not set out the parameters for when a transfer pricing analysis of an outbound interest-free loan should be conducted. However, the draft schedule also provides in paragraph 223 that any risk assessment conducted should be based on the relevant commercial or financial relations ascertained at the time the transaction was entered into. Thus,
the arrangement would not be expected to change over the life of the transaction.
Examples
Four illustrative examples are included in the draft Schedule 3, each highlighting issues associated with factors relevant for the consideration of whether the underlying transaction should be delineated as an equity contribution.
Closing remarks
At present, the Australian transfer pricing provisions under Subdivision 815-B do not include the reference to the Chapter X of OECD TP Guidelines issued in February 2020, but rather to the 2017 OECD Guidelines. Accordingly, the updated guidelines currently do not explicitly apply in an Australian context; however, it is reasonable to presume that future amendments to the law will refer the 2020 OECD Guidelines, with retrospective application. As such, draft Schedule 3 to Practical Compliance Guideline 2017/4DC2 should currently be regarded as the primary source of guidance on matters concerning outbound interest-free loans within Australia.
With the finalisation of this Schedule 3 forthcoming, queries relating to outbound interest-free advances will likely arise during the Australian Taxation Office’s assurance-based reviews under the Top 1000 Tax Performance Program. These reviews will resume in October 2020.
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