ATO releases final guidance on cross-border related party interest-free loans

11 December 2020 

In brief

The Australian Taxation Office (ATO) has finalised its guidance on outbound interest-free loans between related parties. The final guidance takes the form of a new Schedule 3 to its Practical Compliance Guideline PCG 2017/4 on cross-border related party financing arrangements. The guidance in Schedule 3 has retrospective effect from 1 January 2020, applying to existing and newly created related party interest-free loans.

The finalised Schedule 3 incorporates minor changes from the previously issued draft guidance (released in August 2020) and includes amendments to reflect the requirement for taxpayers to disclose their self-assessed risk zone rating in the 2021 Reportable Tax Position (RTP) Schedule that is required to be lodged with the annual income tax return for many companies. The most significant change from the draft guidance is the removal of the ‘sovereign risk of borrower entity’ indicator from the pricing risk scoring table.

PwC’s Tax Alert of 17 August 2020 provided a detailed review of the implications of the draft Schedule 3 of PCG 2017/4, and remains relevant in respect of the finalised guidance, subject to minor points of modification or clarification.

In detail

The final Schedule 3 to PCG 2017/4 outlines the factors under which the pricing risk score assigned under Schedule 1 to outbound interest-free loans between related parties may be modified to achieve a lower risk score outcome, subject to satisfying certain criteria and collating relevant evidence to support this position.

The ATO’s general view is that there exists a high level of transfer pricing risk associated with outbound interest-free loans between related parties on the basis that these arrangements are typically not observed between third parties. Notwithstanding this, the purpose of Schedule 3 is to acknowledge that there are particular circumstances where an outbound interest-free loan is not considered as high a risk because it can be evidenced that a zero interest rate is an arm’s length condition of the loan, or alternatively, the loan is in substance an equity contribution.

Schedule 3 provides examples illustrating situations in which the ATO may or may not accept an outbound interest-free loan as reasonable from a transfer pricing perspective.

Our comments on the application of the Schedule 3 risk assessment framework contained in our previous Tax Alert dealing with the draft guidance remain relevant to the final Schedule 3. However, the following points of modification or clarification have been made in the final guidance:

  • Taxpayers are no longer required to consider the ‘sovereign risk of borrower entity’ when applying the Schedule 3 pricing risk scoring table. This is a helpful change as the draft Schedule 3 assigned higher risk to outbound interest-free loans where the borrower was located in a jurisdiction with a high sovereign credit rating, even if the circumstances of the loan and the borrowing entity would otherwise satisfy the criteria to demonstrate low risk;
  • For the avoidance of doubt, the ATO has clarified that taxpayers are still required to apply the motivational risk scoring table (as contained in Schedule 1) when self-assessing a risk score outcome for outbound interest-free loans. That is, Schedule 3 only modifies the pricing risk scoring table. This clarification is unlikely to impact many taxpayers because only two motivational risk factors can potentially apply to outbound loans, and these are unlikely to be relevant for most interest-free loans; and
  • There is an indication that taxpayers will, under the application of each of the Schedules in PCG 2017/4, be required to disclose the risk zone outcomes of their three largest related party financing arrangements (formerly the single highest risk scoring arrangement) in the RTP Schedule. This change is expected to be reflected in the instructions to the 2021 RTP Schedule. It remains to be seen whether the ATO will add a targeted question specifically addressing Schedule 3 risk zone outcomes, or if this will form part of the RTP Schedule disclosures in relation to Schedule 1 of the PCG.

Most importantly and consistent with the draft guidance, Schedule 3 acknowledges that there are qualitative factors which will need to be considered on a case by case basis having regard to the commercial and financial relations between the parties. Therefore, it is critical that taxpayers undertake appropriate analyses and furnish corresponding evidence to support the satisfaction of the relevant factors which reduce the level of risk associated with an outbound interest-free related party loan.

The takeaway

The key takeaway which emerges from Schedule 3 of the PCG is that, whilst the ATO may consider economic arguments to support outbound interest-free loan arrangements persuasive, reliance on the modifying factors outlined in Schedule 3 will primarily turn on available evidence which may be called upon to support a taxpayer’s self-assessed risk outcome (and ultimately, its transfer pricing position). It is therefore recommended that taxpayers consider a detailed analysis and compilation of corresponding evidence to support outbound interest-free positions, with reference to considerations contained within Schedule 3.

For taxpayers required to lodge an RTP schedule, there will be disclosure obligations to consider. Absent consideration of the modifying factors contained in Schedule 3, existing and future outbound interest-free loans would be considered “high” or “very high” risk. Schedule 3 may allow the risk score of these arrangements to be reduced to a lower risk rating in some cases. Judgement will be required to apply some aspects of the new guidance, and taxpayers will need to take care that they can support the judgment calls they make with appropriate evidence.