17 July 2017

The Final Leg: Cross-border related party financing and PCG 2017/D4

This article was written by Jerome Tse, Calum Sargeant and Alexey Monin.

On 16 May 2017, within a month of the Full Federal Court handing down judgment in Chevron Australia Holdings Pty Ltd v Commissioner of Taxation [2017] FCAFC 62 (Chevron), the Australian Taxation Office (ATO) released PCG 2017/D4: ATO compliance approach to taxation issues associated with cross-border related party financing arrangements and related transactions (PCG).

The PCG has been of keen interest to the tax and finance teams of Australian operations of multinationals since it was issued. It is the first guidance published by the ATO in a number of years on the application of Australia’s transfer pricing laws to cross-border related party financing, and importantly, the first since Chevron. For those unfamiliar with the PCG, a summary of the document can be found below.

What has become clear in discussions with our clients over the last two months is that the PCG, in its current form, raises many issues for multinationals with overseas related party debts to consider. Many of those issues have also been raised with the ATO in the consultative process, which ended on 30 June 2017. We understand that the ATO received about 20 substantive submissions. Our observations in this regard, as well as our views on what changes may be made in finalising the PCG, can be found below.

In summary, it is apparent from the PCG and the ATO’s recent public comments that the ATO regards Chevron as an occasion to reset its approach to determining the arm’s length conditions applicable to cross-border related party financing arrangements. Broadly, the ATO has telegraphed that its approach will focus on:

  • ensuring that debt pricing aligns with the external borrowing costs of the parent of the multinational group;
  • preventing the use of excessive or inappropriate amounts of debt to distort pricing outcomes; and
  • closely examining so-called “exotic features” which may indicate an absence of commerciality to the arrangements or the presence of aggressive tax structuring.

The PCG

Overview

The PCG outlines the ATO’s risk-based approach to considering cross-border related party financing transactions. The PCG has effect from 1 July 2017.

Importantly, the PCG does not constitute a “safe harbour” and does not relieve taxpayers from being required to self-assess their compliance with Australia’s taxation laws. Rather, the PCG is a component of a risk differentiation suite of tools and resources used by the ATO which allows it to focus its resources on higher risk taxpayers and tailor its engagement depending on the risk category of the taxpayer. The PCG also allows taxpayers to better understand their risk category.

The risk rating scorecard

The PCG provides a framework for taxpayers to assess the risk rating of their cross-border financing transactions.

Taxpayers will be able to rate themselves based on six risk zones ranging from white to red. If they are required to complete the Reportable Tax Schedule as part of their income tax return, they will be asked whether they have self-assessed their rating, and if so, what it is.

Risk zone

Risk rating

PCG risk profile

White zone

N/A

Not scored – Transactions already reviewed by ATO*

Green zone

0 to 4 points

Low risk

Blue zone

5 to 10 points

Low to moderate risk

Yellow zone

11 to 18 points

Moderate risk

Amber zone

19 to 24 points

High risk

Red zone

25 to 101 points

Very high risk

* Note comments below regarding the white zone, however

The highest level, red, commences at 25 points out of a maximum of 101. To stay in the low risk green zone, a score of 4 or less is required.

What does each risk rating category mean?

Broadly, a low risk rating will mean that the ATO will generally not apply compliance resources to examine the tax outcomes of the related party financing arrangement. The ATO’s activities will be focussed on verifying the accuracy of the rating. Compliance resources will generally only be used in exceptional circumstances such as where the taxpayer changes their transactions to ‘drift’ to the higher end of the low risk zone or makes errors in calculating or determining its risk rating.

Higher risk ratings will increase the likelihood that the ATO will review or audit the taxpayer. At the highest risk rating, litigation is a significant risk and the ATO will not consider entering into an advanced pricing agreement with the taxpayer.

In all but the highest risk ratings, the ATO considers alternative dispute resolution mechanisms such as mediation or expert determination as potentially appropriate to resolving disputes.

Where a financing transaction has already been considered by the ATO (eg. through a recent review or an APA), a separate “white zone” risk rating is assigned which results in no compliance activity by the ATO (as the transaction has already been considered). However, according to the PCG, only reviews that occur after the publication of the draft PCG will count. We understand this is because, in the ATO’s view, most financing arrangements in prior years have not been tested under the current legislative framework (Subdivision 815-B), or in light of Chevron, and accordingly, the positions expressed in previous reviews may need to be revisited.

The table below summarises what each risk rating category might mean for individual businesses:

Risk zone

PCG risk profile

ATO behaviour

ATO reviews and/or audits

ADR

White zone

Not scored

No further reviews will be conducted

N/A

N/A

Green zone

Low risk

Limited compliance activity except to verify rating or in exceptional circumstances

ATO will review by exception

ADR might be effective

Blue zone

Low to moderate risk

ATO will actively monitor arrangements

ATO will review by exception

ADR might be effective

Yellow zone

Moderate risk

ATO will work with taxpayer to understand and resolve issues

ATO may consider review*

ADR might be effective

Amber zone

High risk

ATO will work with taxpayer to understand and resolve issues

Reviews likely to commence as a matter of priority

ADR might be effective

Red zone

Very high risk

ATO will likely use formal powers for information gathering

Ineligible for APA

Reviews likely to commence as a matter of priority

Cases may proceed directly to audit

Increased risk of litigation

May be difficult to resolve dispute using ADR


Calculating your own risk rating

Taxpayers wishing to calculate their own risk rating can do so by reference to a series of questions which ask about the following indicators:

  • the pricing of the debt relative to the global group cost of debt, traceable third party debt or relevant third party debt of the borrower;
  • the leverage of borrower;
  • the interest coverage ratio;
  • the collateral on the financing arrangement;
  • the status of the debt as being subordinated or mezzanine;
  • the headline tax rate of the lender’s jurisdiction;
  • whether the currency of the debt is different to the borrower’s operating currency;
  • whether the arrangement is covered by an ATO Taxpayer Alert;
  • whether any hybrid entities are a party to the transaction;
  • whether there are any exotic features on loan (such as payment deferral or conversion features); and
  • the sovereign risk of borrower entity’s jurisdiction.

The matrix for scoring a taxpayer’s risk rating for inbound and outbound loans is shown below. If taxpayers have more than one related party financing, the taxpayer’s risk rating is the highest score of its individual related party financing arrangements.

Inbound loans

Score

0

1

3

10

15

Price relative to:

  • global group cost of debt
  • traceable third party debt
  • relevant third party debt of borrowing tax entity

50 bps over cost of referrable debt (or less)

51 to 100 bps over cost of referrable debt

101 to 150 bps over cost of referrable debt

151* to 200 bps over cost of referrable debt

More than 201 bps over cost of referrable debt

Leverage of borrower

Consistent with global consolidated leverage

Greater than global leverage but less than 60% leverage

 

More than 60% leverage

 

Interest coverage ratio

Consistent with global consolidated group

Lower than global consolidated group ratio but equal to or greater than 10

3.3 to 9.9

Below 3.3

 

Appropriate collateral

Yes

 

No

 

 

Subordinated or mezzanine debt

No

 

Yes

 

 

Headline tax rate of lender entity jurisdiction

Over 30%, or lender entity is global parent

21% to 29%

16% to 20%

1% to 15%

0%

Currency of debt is different to operating currency

No

 

 

Yes

 

Involves an arrangement covered by a tax payer alert

No

 

 

Yes

 

At least one party is a hybrid entity

No

 

 

 

Yes

Presence of “exotic features”

No

 

 

Yes

 

* Note the PCG states this is 150 to 200 bps, overlapping with the prior column

Outbound loans

Score

0

1

3

10

Price relative to:

  • global group cost of debt
  • traceable third party debt
  • relevant third party debt of borrowing tax entity

Cost of referrable debt or higher

 

Less than the cost of referrable debt

No interest charged

Currency of debt is different to operating currency

No

 

 

Yes

Involves an arrangement covered by a tax payer alert

No

 

 

Yes

At least one party is a hybrid entity

No

 

 

Yes

Sovereign risk of borrower entity

AAA, AA

A, BBB

BB

B, CCC


Transitional relief

The Commissioner has recognised that as a result of the publication of the PCG, certain taxpayers may seek to re-structure their riskier financing arrangements so as to obtain a lower risk rating. Accordingly, the Commissioner has undertaken to remit interest and penalties in respect of prior years if:

  • a taxpayer makes full and true voluntary disclosure of the prior years of the financing arrangement and adjusts the arrangement to fall within the low risk green category going forward; and
  • the taxpayer has no carried forward tax losses at the time the disclosure is made.

The PCG states that taxpayer disclosures must be made within 18 months of the publication of the PCG (16 May 2017) or the effective date for any schedule to the PCG. We understand that the final PCG may allow for disclosures to be made within 18 months of the finalisation of the PCG.

Limits on PCG and exclusions

Several types of financing transaction are excluded from the operation of the PCG. These are:

  • transactions entered into by a member of a wholly owned group containing an authorised deposit-taking institution;
  • transactions entered into by a member of a wholly owned group containing an Australian resident securitisation vehicle;
  • transactions entered into by a member of a wholly owned group that contains an Australian resident taxpayer eligible to apply the simplified transfer pricing record keeping options; and
  • Islamic finance transactions.

The ATO has explained that these types of financing transaction have been carved out of the PCG because the nature of the transactions contains a high degree of inherent risk.

Observations

The PCG is not a safe harbour

A practical compliance guidance document does not have the same effect as a tax ruling or determination. It is therefore important to reiterate that the PCG does not constitute a safe harbour.

Taxpayers are still required to comply with Australian transfer pricing laws and ensure that they prepare and maintain proper transfer pricing documentation. The PCG is merely a risk assessment tool for the ATO and taxpayers, and a resource allocation tool for the ATO. It remains open for a taxpayer to be able to successfully defend a transaction that is rated in the higher risk zones and does not remove the obligation of taxpayers in low risk zones to comply with the law.

Approximately two thirds of taxpayers may be outside of the white and green zones

We understand the ATO believes approximately two-thirds of businesses may currently sit outside the white and green zones. This is not surprising as the PCG scorecard shows how difficult it may be for multinationals to sit in the lower risk rating categories, even if their arrangements are compliant with Australia’s transfer pricing laws. Taxpayers need only score 25 out of a total 101 to be rated “very high risk”.

Further, it is understandable that taxpayers with commercially driven financing structures that comply with Australia’s transfer pricing laws will find it difficult to explain to their internal stakeholders why those same structures are now considered “high risk” by the ATO, especially if they have been rated as low risk in prior ATO audits.

Foreign currency related party financings

There are often valid commercial reasons for taxpayers to enter into loans in a foreign currency. In our view, the PCG strongly criticises the use of foreign currency related party financing by designating them with significantly higher risk ratings.

First, related party financings where the currency of the debt is different to the currency in which the borrower earns the majority of its revenues attracts a risk rating of 10. Secondly, if the currency of that same loan in the legal documentation differs to the currency actually transferred or lent by the lender to the borrower, the risk rating will increase by 10 points again. This “double hit” automatically puts the taxpayer into the second highest amber zone. If the related party financing were then the subject of a taxpayer alert, the taxpayer would fall squarely within the red zone and, according to the PCG, should expect ATO reviews “as a matter of priority”, even if no other risk indicators are present. Relevantly, the ATO has published a taxpayer alert on related party foreign currency financing with cross currency interest rate swaps (TA 2016/3).

In our view, to the extent that a foreign currency financing requires a risk rating in the first place, it would be appropriate for the final PCG to be amended so that it is only risk rated once.

Cost of referrable debt

Generally speaking, the ATO expects an entity’s cost of financing to align with the external borrowing costs of the parent of the multinational group (cost of referrable debt). The PCG provides three options for determining the cost of referrable debt. These are:

  • global cost of funds, which is calculated as either:
    • the sum of the gross interest expense and associated borrowing costs of the group divided by the average of the opening and closing debt balances of the group; or
    • for a newly issued instrument, the cost of debt that would have applied if the group had obtained the debt instead of the subsidiary;
  • the cost of traceable third party debt, when the debt can be traced to external borrowing by the group on the same terms and conditions; and
  • the cost of relevant third party debt of the borrower (that is, external debt obtained by the same group member that is of the same nature as the financing in question).

Currently, the PCG states that taxpayers should select the “most relevant” option for determining the cost of referrable debt. We understand the ATO is considering adopting a hierarchy rather than allowing taxpayers to select the most relevant option.

Hybrid entities are discouraged

The involvement of a hybrid entity (including a “check the box entity” under US tax law) as a party to the transaction is the risk indicator that attracts the highest standalone risk rating of 15. It automatically places taxpayers with hybrid entities into the yellow zone. We understand that this risk indicator will be removed, however, once Australia passes its anti-hybrid legislation.

Calculation of leverage

We understand that the calculation of leverage for the purposes of the PCG may be changed to align with Australia’s thin capitalisation provisions, which measure leverage by reference to the taxpayer’s asset base.

Exotic features

The PCG increases the risk rating of a financial transaction when it has certain exotic features. These are described in the PCG to include:

  • interest payment deferral mechanisms;
  • promissory notes or other similar instruments;
  • options which give rise to premiums on interest rates;
  • convertibility to equity or other exchange;
  • contingencies; and
  • as noted above, where legal currency in the agreement and the currency actually transferred or lent by the lender to the borrower differ.

We understand the ATO is considering whether to require taxpayers to only reflect an increase to their risk rating if the pricing of the transaction reflects the exotic features of that transaction. Therefore, if exotic features are present, but they are not reflected in the pricing of the financing arrangement, the risk indicator should not be engaged.

Other schedules to PCG 2017/D4

In addition to the current “Schedule 1 – Related party debt funding”, we understand the ATO is considering issuing supplementary schedules to the PCG to cover the use of derivatives, interest-free loans, guarantee fees and the arm’s length debt test. We are informed that some of these supplementary schedules may be issued for consultation later this year. Taxpayers with financings involving these features should stay abreast of further developments over the coming months. To the extent that these schedules raise important issues of law, we would hope that the ATO considers issuing binding tax rulings or determinations in addition to the schedules to assist taxpayers in complying with their obligations under the law and providing certainty for them.

When might the PCG be finalised?

We currently expect the PCG to be finalised in August/September 2017.

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