This article was written by Jerome Tse & Dioni Perera.
On Monday 18 December 2017, the Australian Taxation Office (ATO) finalised Practical Compliance Guideline PCG 2017/4 (PCG) outlining its compliance approach to cross-border related party financing arrangements. It is a substantial re-write of the draft PCG, which we discussed in an earlier alert over 6 months ago. The relatively simple risk rating table in the draft has been replaced with two separate tables that must be read together in order to determine the risk rating of the financing arrangements.
Overview of final PCG
- The related party financing schedule has effect from 1 July 2017 to existing and new financing arrangements.
- Businesses can still transition to the low risk green zone to eliminate tax penalties and reduce shortfall interest charges to the base rate, so long as the transition occurs within 18 months from 18 December 2017.
- The PCG now requires businesses to apply two tables to determine their risk rating:
- a pricing risk scoring table comprising of the following indicators:
- the all-in cost of the actual financing arrangement compared to the cost of referrable third party debt;
- whether the actual financing arrangement has appropriate collateral, is subordinated or has “exotic features”
- whether the operating currency is the same as the currency of the actual financing; and
- for outbound loans, the sovereign risk of the borrower.
- a motivational risk scoring table comprising of the following indicators:
- the leverage of the borrower;
- the interest cover ratio;
- the tax rate in the lender’s jurisdiction; and
- whether the arrangement is covered by a taxpayer alert or involves hybrids.
- It is only once separate scores for “pricing” and “motivational” factors are determined that the risk rating can be ascertained through the application of the following matrix:
Many of our earlier observations remain relevant in relation to the final PCG. We make the following additional observations:
- The PCG acknowledges that where a factor has not been taken into account in pricing the financing arrangement, it should not be included in the scoring process. For example, an arrangement that is priced as if it were senior debt even though it is subordinated will be scored under the PCG as senior debt. This is a welcome clarification.
- The ATO remains of the view that a margin of 50 bps or less over the cost of referrable debt will translate to a low risk rating. A margin higher than 50 bps will move the rating out of the green zone.
- As stated in our earlier alert, the PCG is a compliance tool for the ATO. It does not constitute a safe harbour. Businesses are still required to comply with Australian transfer pricing laws and maintain proper transfer pricing documentation. Importantly, the ATO acknowledges that just because a financing arrangement falls outside the low risk zone doesn’t mean that it is uncommercial or otherwise fails to comply with Australian tax law. However, the higher the risk zone, the more likely that the financing arrangement will be reviewed by the ATO.
- Contemporaneous documentation remains critical, both in terms of traditional transfer pricing documentation and documentation to support a self-assessed risk rating. Such documentation must take into account how Australia’s transfer pricing regime has developed over the last few years (especially post-Chevron). Mere reliance on a traditional benchmarking approach may no longer be appropriate.
- The final PCG is also likely to be relevant to businesses requiring Foreign Investment Review Board (FIRB) approval. In the past 18 months, we have been involved in many FIRB applications where applicants have been required to self-assess their rating pursuant to the draft PCG. We expect this to continue, especially for high profile and high value transactions.
Businesses with related party financing arrangements (both inbound and outbound) should review their positions having regard to the PCG. Those who are considering transitioning to the green zone should consider the impact that the transition may have, not only in relation to Australian related party financing arrangements, but from a whole of global group perspective. The transition may involve the execution of settlement deeds, which should be reviewed by experienced in-house or external legal advisors.
ATO work program
The PCG currently only comprises of one schedule, being guidance on related party financing arrangements. The following additional schedules are likely to be issued in 2018:
- Related party derivative financial arrangements schedule (current expected completion by 2 March 2018); and
- Related party financing – interest free loans schedule (current expected completion by 30 March 2018).
The ATO is also considering the following tax determinations:
- Interaction between Division 974 and Subdivision 815-B (current expected completion by 30 March 2018); and
- Transfer pricing benefit from interest free loans (current expected completion by 30 March 2018).
It is also hoped that further guidance on the application of guarantee fees will be issued in 2018.
Taxpayers with financing arrangements involving these features should stay abreast of further developments over the coming months.