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

17 August 2020

In brief

On 12 August 2020, the Australian Taxation Office (ATO) released draft updated guidance to its Practical Compliance Guideline PCG 2017/4 which deals with tax issues associated with cross-border related party financing arrangements and related transactions. Specifically, the draft Schedule 3 of PCG 2017/4 provides additional guidance on the application of Schedule 1 of the PCG to cross-border outbound interest-free loans between related parties.

Under this latest release, the Commissioner seeks to provide greater guidance and clarity to taxpayers on issues associated with outbound interest-free related party debt. While the draft guidance concludes that such arrangements may be reasonable from a transfer pricing perspective based on specific factors and considerations which are covered by some worked examples, there remains a significant evidentiary burden for taxpayers to support such positions.

Although the updated PCG does not cover inbound interest-free loans, it would be reasonable to expect consistency in the manner in which the ATO considers such arrangements.

In detail

The ATO has released its long awaited guidance on its practical compliance approach to dealing with outbound interest-free loans between related parties - draft Schedule 3 to PCG 2017/4 (Schedule 3). This latest update outlines the factors under which the pricing risk score assigned under Schedule 1 to outbound interest-free loans between related parties may be modified.

The draft does not specify the proposed date of effect for this new Schedule, and the ATO has invited submissions on this as part of the consultation process. We expect that there may be a number of taxpayers who need to lodge income tax returns prior to the guidance being finalised and who may be faced with reporting high risk ratings in their Reportable Tax Position (RTP) Schedule that would potentially have been lower if this latest guidance had already applied.

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 the Schedule is an acknowledgement 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.

The draft guidance provides a few examples illustrating situations in which the ATO may or may not accept an interest-free loan as reasonable from a transfer pricing perspective. A few observations from these examples are as follows:

  • The ATO acknowledges that it may be reasonable to provide interest-free funds to a subsidiary involved in mining exploration activities which do not (and may never) generate income, as such an entity would be unlikely to be able to borrow from an arm’s length lender. 
  • On the other hand, the ATO would not consider an interest-free loan to be arm’s length in a situation where funds are provided to a subsidiary which is profitable and has a track record of borrowing from independent lenders. 
  • Similar to inbound financing arrangements, the analysis is heavily underpinned by commercial practices within the industry in question and the availability of evidence of financing transactions in same or similar circumstances (or the lack thereof). 
  • While the examples listed in Schedule 3 result in binary outcomes (i.e. the arrangement is treated as either interest free debt / quasi-equity or bona fide interest bearing debt), practically there may be many scenarios in which an outbound interest-free debt instrument could be bifurcated between debt and equity, with the debt amount being an amount an arm’s length lender would be willing to lend which also makes commercial sense from the perspective of the borrower, being less than the total amount of the interest-free debt.
  • In example four in which the criteria for interest free debt / quasi-equity is not satisfied, the ATO states that a taxpayer can transition to the green zone by charging an “appropriate arm’s length interest rate”, as opposed to a rate which at a minimum is equal to the cost of referrable debt.

The draft schedule is only focused on the pricing subfactor within Schedule 1, and also a reversal of the points allocated for the sovereign country risk of the borrower in order “to reflect the impact of the risk of the borrower appropriately” (read as, the higher the sovereign credit rating of the borrower’s country, the more probability that the borrower could obtain funds from a third party lender and therefore the greater the transfer pricing risk associated with an outbound interest-free loan). Outside of these two factors, it is acknowledged that points can still be scored for other factors (such as the currency of the loan, if this is inconsistent with the operating currency of the borrower and/or lender).

The ATO recommends that Schedule 3 is read in conjunction with TR 2014/6 (which covers the application of the reconstruction provisions set out in section 815-130 of the Income Tax Assessment Act (ITAA) 1997) and Taxation Determination TD 2019/10 (dealing with the interaction between the debt-equity rules in Division 974 and the transfer pricing rules), albeit the scope of Schedule 3 is limited to assessing the transfer pricing risk of interest-free loans and does not deal with other tax aspects associated with these instruments.

The risk assessment framework

Schedule 3 introduces a top-down approach to assess the risk of outbound interest-free loans. This is articulated below.

As an initial observation, there is a level of overlap between the factors listed in the analysis below and the prior ATO guidance on outbound interest-free loans found within Taxation Ruling TR 92/11, which has been the only ATO guidance available before Schedule 3. We note also that the OECD’s financial transactions guidance released in February 2020 also acknowledges there may be some situations in which interest-free loans may be appropriate for funding that is equity-like in substance. The OECD guidance is less detailed than the ATO’s position, but it may be reassuring for some taxpayers that the concepts in the ATO and OECD guidance are broadly aligned.

1. The base risk of outbound interest-free loans is ‘High’

Under the framework of Schedule 3, outbound interest-free related party loans are considered to achieve a base ‘Amber’ risk rating under the PCG, just one notch below the highest risk rating (‘Red’) (although the Red zone risk rating can still arise based on scoring of other factors such as currency and sovereign risk rating of the borrower).

2. Conditions reducing the base risk to ‘low to moderate’ risk (the ‘minimum required factors’)

The base risk rating of an outbound interest-free loan can be reduced to ‘Blue’ (low to moderate risk) if the taxpayer can demonstrate that the arrangement presents/meets the following features/conditions which would support its interest-free nature.

The rights and obligations of the provider of funds are effectively the same as the rights and obligations of a shareholder.


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.






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.


The borrower is in a position where it has questionable prospects for repayment and is unable to borrow externally.


Schedule 3 articulates the level of evidence expected to support the reasonableness of the above positions, with particular focus on the evidence required to demonstrate the inability of the borrower to borrow interest-bearing debt from a third party lender. Broadly, a detailed analysis of the actual facts and circumstances in which the arrangement arises must be considered, including common funding practices in the industry, the activities of the business and the financial position of the borrower.

3. Further conditions reducing the base risk to ‘low’ risk

Schedule 3 then proceeds to outline circumstances which may contribute to further reduce the risk assessment of an outbound interest-free loan (from three points to zero representing green zone / low risk). These factors need to be considered beyond the minimum required factors, and subject to a detailed case by case analysis. In this regard, the Schedule provides some examples / conditions:

  • If the taxpayer is able to demonstrate (by providing evidence of real market transactions) that independent parties in same or similar circumstances would have entered into an interest-free loan based on the options realistically available to both parties. Off-take arrangements are called out as an example where the commercial benefit of interest could be substituted for consideration in another form (i.e. the delivery of a commodity/resource being extracted). 
  • The lack of a maturity date or lender’s right to enforce payment
  • The deep subordination of the arrangement to other lenders’ claims
  • The lack of conditions for a short repayment period or an ability to demand repayment
  • The presence of restrictions (e.g., regulatory impediments) on an investment of additional equity into the country of which the borrower is resident.

Furthermore, the Schedule further states that where interest-free loans have been legally documented as debt, a low risk rating would be achieved if the taxpayer can demonstrate:

  • that the purpose of the loan was to acquire capital assets for the expansion of the core business 
  • where it is customary in the applicable industry to enter into longer-term investments
  • there is evidence that the borrower is not in a position to repay the loan until the project turns cash flow positive over the long term
  • it is unlikely that it would be able to secure funds externally, and
  • the purpose was aligned with the group’s policies and practices in respect of funding needs.

The Commissioner confirms the expectation of consistency and alignment of the characterisation of the instrument under Subdivision 815-B and for all other income tax purposes, which would lead to further support for an overall low risk score.

Most importantly, the Schedule acknowledges that many of the factors listed which need to be considered in order to reduce the risk rating (and also defend a taxpayer’s transfer pricing position under Subdivision 815-B) are based on qualitative considerations which will need to be considered on a case by case basis based on 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 factors listed above which reduces the level of risk associated with an outbound financing arrangement.

The takeaway

Taxpayers continue to welcome guidance from the Commissioner around the area of cross-border financing, particularly since this is the first guidance of its sort since the transfer pricing laws were revised in 2013. The key takeaway in connection with the proposed Schedule 3 is that while the ATO considers economic arguments persuasive, the modifying factors outlined above will primarily have regard to 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. Currently all outbound interest-free loans would be considered “high” or “very high” risk, and the new guidance may allow this 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.