In brief
The ATO released Draft Practical Compliance Guideline PCG 2025/D2 Factors to consider when determining the amount of your inbound, cross-border related party financial arrangement – ATO compliance approach (the draft PCG) for consultation on 29 May 2025. The draft PCG sets out the ATO’s compliance approach to the application the transfer pricing rules to the amount of a taxpayer’s inbound cross-border related party debt, provides a framework for taxpayers to self-assess the risk of their arrangements, and sets out factors that are relevant in determining and testing the amount of inbound cross-border related party debt. It also outlines the ATO’s expectations regarding documentation and evidence in relation to the amount of inbound cross-border related party debt.
This guidance specifically addresses the arm's length assessment of related party debt amounts under the current transfer pricing framework. The ATO has provided a well-considered and informed summary of the key factors that treasury and finance functions, as well as independent lenders, consider when evaluating debt capacity. The guidance acknowledges the commercial and economic advantages of engaging in debt financing and recognizes that determining an appropriate debt level involves various considerations that depend on specific circumstances. We believe this guidance provides taxpayers with an indication that the ATO will not determine the arm's length amount of debt for transfer pricing purposes solely based on 'one size fits all' financial ratios. Instead, this guidance suggests a comprehensive evaluation of the commercial arrangements and options available to the taxpayer.
In detail
As part of the package of amendments to Australia’s thin capitalisation rules enacted in 2024, changes to the transfer pricing provisions were made to ensure that, for most taxpayers, the quantum or amount of cross-border related party borrowings must be consistent with arm’s length conditions (that is, the conditions that might be expected to operate between independent entities dealing wholly independently with one another in comparable circumstances). Prior to this amendment, for taxpayers subject to the thin capitalisation rules, the amount of debt was limited by the thin capitalisation rules only, and was not affected by the requirement in the transfer pricing rules that arm’s length conditions must exist between related parties.
This amendment applies to income years commenting on or after 1 July 2023 and broadly applies to all taxpayers other than:
inward and outward investing financial entities that use the safe harbour debt test or worldwide gearing debt test for thin capitalisation purposes, and
inward and outward investing ADIs.
This means that all general class investors under the new thin capitalisation rules, and financial entities that chose to use the new third party debt test, will now need to consider whether the quantum of any cross-border related party borrowings is consistent with an arm’s length amount of debt, in addition to assessing whether the price or interest rate on the debt is at arm’s length.
The draft PCG is the final of three priority areas the ATO flagged last year for guidance in respect of the new thin capitalisation rules. It applies to inbound, cross-border related party financing arrangements only, and does not deal with pricing matters, which continue to be dealt with in PCG 2017/4 ATO compliance approach to taxation issues associated with cross-border related party financing arrangements and related transactions.
The draft PCG is now open for consultation, with submissions due by 30 June 2025.
ATO compliance approach and risk assessment framework
The draft PCG contains a risk assessment framework and ATO compliance approach that is designed to help taxpayers manage the compliance risk, and therefore the compliance costs, associated with determining an arm’s length amount of inbound cross-border related party debt. It does not constitute a ‘safe harbour’ and does not replace, alter or affect the ATO’s interpretation of the law, nor does it relieve taxpayers of their legal obligation to self-assess their tax position in accordance with the relevant laws. It does, however, provide an indication of the ATO’s approach to assessing the risk attached to different types of inbound cross-border financial arrangements.
Similar to other PCGs, the draft PCG provides risk zones – white, green, blue and red – and the ATO’s compliance approach to arrangements in each zone. This is summarised in the table below.
| Risk zone and level |
Criteria |
ATO compliance approach |
|---|---|---|
White
Arrangements already reviewed and concluded
|
Your inbound, cross-border related party financing arrangement satisfies any of the following criteria:
AND
|
You do not need to self-assess your inbound, cross-border related party financing arrangement against this risk assessment framework and the ATO will not have cause to apply compliance resources in relation to the amount of your inbound, cross-border related party financing arrangement.
|
| PwC comment: Taxpayers should ensure they have appropriate documentation and evidence to support their debt quantum prior to being subject to ATO compliance reviews. We expect over time many taxpayers will fall into this category given the frequency and coverage of the ATO’s compliance programs. | ||
| Risk zone and level |
Criteria |
ATO compliance approach |
|---|---|---|
Green
Low risk
|
Your inbound, cross-border related party financing arrangement satisfies either of the following criteria:
AND
Notably, there is no indication that inbound related party loan arrangements that are eligible for the ATO’s simplified transfer pricing record keeping option for low level inbound loans will be able to benefit from a ‘low risk’ outcome under this draft PCG. |
The ATO will generally only apply compliance resources to verify your self-assessment.
|
PwC comment: The two limbs to the green zone are likely to cause many taxpayers to fall outside the zone. In our experience, we expect a lot of Australian subsidiaries of MNE’s will not be able to demonstrate that they have stronger leverage and interest coverage ratios across income years than the global group, including for reasons such as the Australian debt may relate to a new acquisition, volatility of earnings across a diversified group vs single Australian business, etc. Accordingly, while taxpayers may be able to support their debt quantum against comparable companies (noting there is often disagreement around the choice of comparables when it comes to related party financing), they may find the green zone is not available as a result of requirement of the draft PCG to also align with the global groups ratios. For private equity portfolio companies or consortium owned investments which are often subject to investment accounting or not consolidated into any foreign accounting group, it would appear these will be more likely to satisfy the green zone on the basis their debt levels are reflective of their global group. For these groups it will be important to demonstrate their capital structure is consistent with industry practice, and the factors outlined in the draft PCG (from paragraph 52) will be helpful to inform what evidence will be required. |
||
| Risk zone and level |
Criteria |
ATO compliance approach |
|---|---|---|
Blue Compliance risk not assessed |
Your inbound, cross-border related party financing arrangement is not covered by a low-risk or high-risk example in the draft PCG or the white zone criteria. | The ATO will actively monitor your arrangements using available data and may review your arrangement to understand any compliance risks. |
| PwC comment: We expect this category will apply to most taxpayers who are able to demonstrate that their debt quantum is not impacted by a parental guarantee, however they are unable to fall into the green zone due to their debt ratios being higher than their global group. | ||
| Risk zone and level |
Criteria |
ATO compliance approach |
|---|---|---|
Red
High risk
|
Your inbound, cross-border related party financing arrangement satisfies either of the following criteria:
|
The ATO will prioritise its resources to review your arrangement. This may involve commencing a review or audit. The red zone is a reflection of the features that the ATO consider indicate greater risk, however, it is not a presumption that you have obtained a transfer pricing benefit in relation to the amount of your inbound, cross-border related party financing arrangement. |
| PwC comment: Taxpayers will need to be mindful of how the ATO defines the scope of Example 4 of the draft PCG (related party borrowing with a parental guarantee). For many taxpayers, whether or not an explicit guarantee has been entered into, the analysis will inevitably have regard to a hypothetical involving a guarantee – which means, depending on how the ATO seeks to administer the PCG, taxpayers may find they are through the gateway of Example 4. The question then of whether the guarantee allows for a greater borrowing than it would on a stand-alone basis can be complex and/or subjective, and opens up a myriad of questions – such as transfer pricing reconstruction and deductibility of the guarantee fee, amongst others. The ATO provides helpful commentary (at paragraph 80) to remind taxpayers that the borrowing entity will need to demonstrate sound fundamentals around the borrowing (i.e. the borrower will need to be able to demonstrate it can service and manage the funding on its own, despite the benefit of the parental guarantee). | ||
Relevant factors in determining an arm’s length amount
The draft PCG highlights that when its considering funding requirements, entities are expected to consider all options realistically available to them, in line with the OCED Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. This may include debt capital, equity capital and internally generated funds.
The draft PCG sets out a non-exhaustive list of factors that the ATO considers an entity should reasonably be expected to consider as part of determining the most appropriate source of funding. These are also the factors that the ATO will have regard to if it reviews the amount of an entity’s inbound, cross-border related party financing arrangements.
| Factor | ATO comments in draft PCG |
|---|---|
Funding requirements
|
|
Group policies and practices
|
|
Return to shareholders
|
|
Cost of funds
|
|
Covenants
|
|
Explicit guarantees
|
|
Security
|
|
Serviceability
|
|
Leverage
|
|
In our experience, many taxpayers have typically considered these factors when performing transfer pricing analysis to evaluate the arm’s length nature of their cross-border related party borrowings, even before this draft guidance was released. Therefore, the ATO’s commentary is helpful to ensure all taxpayer are aware of these important factors to consider, and provides a checklist to work through for preparing robust TP documentation.
We expect that the ATO will likely evaluate the arm’s length debt amount for transfer pricing purposes based on a totality of commercial factors and not solely based on financial ratios. Taxpayers that have previously sought to support the level of their related party borrowings based on financial ratios alone should consider supplementing that analysis with a broader assessment of the commercial factors contained in this draft PCG.
Low and high-risk examples
The draft PCG contains two low risk examples and three high risk examples.
The low-risk examples are:
Example 1 – entity has third part debt and related party debt and has made a choice to apply the third party debt test. This is a low-risk arrangement as the thin capitalisation provisions will effectively disallow all deductions on the inbound cross-border related party financing arrangement.
Example 2 – leverage and serviceability indicators. In this example, Aus Co, which has an inbound, cross-border related party financing arrangement, has leverage and interest coverage ratios equal to or better than its global group and a set of comparable entities. This is therefore a low-risk arrangement.
Taxpayers looking to benefit from 'low risk' treatment should evaluate the debt levels and interest costs that will qualify them for Example 2. It is important to note that this example requires a comparison of the Australian entity's leverage and interest coverage ratios with those of 'comparable entities'. Therefore, a transfer pricing benchmarking analysis should be undertaken.
As noted earlier, we anticipate that many corporate groups with related party debt used for material transactions may have difficulties meeting the financial ratios of the global group, despite being aligned with comparable companies in their industry and/or with similar circumstances. For taxpayers who fall outside the Green Zone, when identifying comparables for otherwise supporting the arm’s length quantum of the debt, it will be important to have regard to the purpose of the debt as well as the nature and circumstances of the borrower. For instance, debt utilised for acquisitions might initially be associated with above-normal leverage levels. Similarly, debt profiles for a private equity-owned group aiming to repay debt through a liquidity event may differ from those of a publicly listed corporation. Assessing what comparability adjustments are required will be critical and involving debt advisory experts will often be necessary in more complex cases.
The high-risk examples are as follows:
Example 3 – use of cross-border related party finance while holding significant cash reserves. In this example, the ATO considers that there is an increased likelihood that Aus Co has not considered its options realistically available as it holds significant cash reserves relative to the amount of its inbound, cross-border related party financing arrangements, and debt deductions generated from those arrangements materially exceeds the interest income earned on an equivalent amount of the cash reserve. This is therefore a high-risk arrangement.
Example 4 – related party explicit guarantee in place to support the amount of an inbound, cross-border related party financing arrangement. In this example, Aus Co’s inbound, cross-border related party financing arrangement is the product of more than one controlled transaction. The ATO therefore considers that there is an increased risk that the arrangement is not consistent with arm’s length conditions, making this a high-risk arrangement.
Example 5 – using cross-border related party finance to utilise excess capacity under the fixed ratio test. In this example, Aus Co has inbound cross-border related party financing arrangement and on-lends part of the proceeds to a related party for a return that is below the costs it incurs in relation to the inbound, cross-border related party financing arrangement. As Aus Co has utilised excess capacity under the fixed ratio test to generate an expected below cost return, the ATO considers there is an increased likelihood that the arrangement is one that has been undertaken to maximise the amount of its debt deductions, resulting in this being a high-risk arrangement.
In our view, it is commendable that the ATO has not opted to use a numeric scoring method based on standard ratios for risk assessment. By adopting an approach that focuses on the specific facts and circumstances, the ATO acknowledges the market and industry dynamics of debt transactions, which makes their assessment better aligned with the real-world conditions. However, the examples provided are quite fact specific, and do not provide much insight into how a more traditional analysis of related party debt should be approached under the risk assessment framework.
Documentation and evidence
The ATO expects taxpayers that enter into inbound, cross-border related party financing arrangements to maintain documentation and evidence to support their transfer pricing positions for each income year that the financing arrangement remains on issue. This should include:
transfer pricing analysis to support the arm’s length nature of all inbound, cross-border related party financing arrangement
funding proposals or similar documentation that demonstrates the entity considered all the funding options realistically available to it
calculations or workings that show the evaluation of returns to shareholders (or investors) or other financial benefits
documentation or workings that consider the impact of the inbound, cross-border related party financing arrangement on the overall cost of (debt) capital (this might include correspondence with third parties, such as lenders or credit rating agencies)
details about the purpose for which the proceeds were required
correspondence that demonstrates consideration of other arrangements, including iterations of offers and negotiation of terms
group policies, including an overview of how these policies and relevant practices influence the external borrowing practices of group members
signed and executed facility documentation (that is, both related and third party), including loan agreements, bond prospectuses, term sheets, guarantee agreements, any security documentation and supporting documentation such as legal opinions, authorised signatory lists and accession deeds, and
evidence of payments to international related parties and associates including repayments of interest and principal.
The ATO’s view on transfer pricing documentation and a suggested framework for satisfying Subdivision 284-E of Schedule 1 to the Taxation Administration Act 1953 is set out in Taxation Ruling TR 2014/8 Income tax: transfer pricing documentation and Subdivision 284-E.
Whilst the draft PCG includes no mention of a de minimis threshold or interaction with the ATO’s Simplified transfer pricing record-keeping options set out in PCG 2017/2, we expect that the low-level inbound loans option should remain available.
The takeaway
PCG 2025/D2 offers a first look into how the ATO may the apply transfer pricing rules to assess an arm’s length level of debt. In forming their guidance, the ATO appears to have consulted extensively with debt experts, providing helpful detail that addresses issues previously encountered in audits and disputes concerning pricing. Despite including only a small number of examples compared with the ATO’s other recent guidance, this draft PCG presents important factors that should be assessed, similar to how any independent parties would evaluate lending situations. In our view, this draft PCG sends a clear signal to taxpayers that they should involve treasury and financing experts and consider all relevant commercial factors when implementing cross-border related party debt.
From a practical standpoint:
Prudent taxpayers aiming to minimise their transfer pricing risk should consider the debt levels and interest costs that would qualify them for a green (low risk) zone. This will likely require a transfer pricing benchmarking analysis to determine the leverage and interest coverage ratios of comparable entities.
Taxpayers not eligible for a green (low risk) zone should be prepared to demonstrate that their debt levels are arm’s length and commercially justifiable. An arm’s length assessment of the amount of cross-border related party borrowings should consider a wide range of commercial factors, including those mentioned in this draft PCG. In many instances, this should extend beyond a mere quantitative analysis of financial ratios.
Taxpayers who have previously relied solely on financial ratios to justify their level of related party borrowings should consider enhancing their analysis by incorporating a broader evaluation of the commercial factors outlined in this draft PCG.
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