Practical Compliance Guideline

PCG 2017/4EC


Relying on this Compendium

This Compendium of comments provides responses to comments received on draft Schedule 3 (Interest-free loans between related parties) to Practical Compliance Guideline PCG 2017/4DC2 ATO compliance approach to taxation issues associated with cross-border related party financing arrangements and related transactions. It is not a publication that has been approved to allow you to rely on it for any purpose and is not intended to provide you with advice or guidance, nor does it set out the ATO's general administrative practice. Therefore, this Compendium does not provide protection from primary tax, penalties or interest for any taxpayer that purports to rely on any views expressed in it.

Summary of issues raised and responses

Issue number Issue raised ATO Response
1 The ATO has not provided a proposed date of effect for the final Schedule 3. Schedule 3 will have effect from 1 January 2020 and will apply to existing and newly-created related party interest-free outbound loans (see paragraph 201 of the final Guideline).
2 When finalised, Schedule 3 should apply prospectively. Retrospective application will create substantial work for taxpayers. Having retrospective application will also mean taxpayers will need to re-examine positions from previous years in which contemporaneous analysis and documentation has been prepared and finalised. Schedule 3 provides a risk assessment framework outlining when we will dedicate compliance resources to review interest-free outbound loans between cross-border related parties.

Schedule 3 operates to reduce the risk rating for an outbound interest-free loan in certain circumstances. It does not increase the risk rating otherwise provided by the Guideline. Accordingly, Schedule 3 can only operate favourably to taxpayers and it is not considered necessary to apply it prospectively only.

3 The final Guideline should state that ATO will not issue penalties or interest on the basis that a taxpayer has not applied the concepts in Schedule 3. As noted in the response to Issue 2 of this Compendium, our position regarding these arrangements has not changed. Hence, it is not considered necessary to provide any general concessions regarding penalties or interest.
4 The final Guideline should clarify whether the risk assessment should be updated in future when facts and circumstances change, or if the initial characterisation will apply for life of the arrangement. We do not generally expect the characterisation to change over the life of the arrangement, unless there are material changes to the arrangement or there are material changes to the circumstances of the borrower. Risk assessments may need to be updated if such material changes occur.

We have made further amendments to Schedule 3 to clarify this position (see paragraph 222 of the final Guideline).

5 In relation to the factor that requires evidence of rights and obligations of the provider of funds being effectively the same as the rights and obligations of a shareholder, it was observed that all the examples in the draft Schedule are based on 100% direct ownerships. It is recommended to provide different examples of situations where this factor could be met, for example if an indirect parent-subsidiary relationship will meet the criteria.

Note: Additional examples were requested for controlled but not fully owned entities which hasn't been specifically covered in the point above.

We have amended Example 3 of the final Schedule 3 to address an indirect parent-subsidiary relationship where the criteria prescribed in this factor is met (see paragraphs 255 and 262 of the final Guideline).

It is not possible to provide examples covering all situations. Taxpayers with unique circumstances should engage with us if they require certainty regarding their arrangements.

6 In relation to factors that require evidencing of intention of the parties, additional guidance and/or examples are sought to clarify how such intention can be evidenced and what would constitute sufficient evidence. The intention of the parties can be evidenced by way of written documentation which could include agreements, emails or memorandums. As this is dependent on the facts and circumstances of each arrangement, we do not believe further guidance is necessary.
7 The final Guideline should clarify whether taxpayers completing the Reportable Tax Position (RTP) schedule will be required to include responses to this Guideline, and whether this will be part of Question 14 in respect of Schedule 1 of this Guideline or a separate question.

If so, the ATO should provide advance notice and from which income year reporting period.

Taxpayers will be required to include responses to Schedule 3 as part of updated Question 14 of the 2021 RTP schedule. External consultation will be conducted for the changes to the 2021 RTP schedule.

There have been no specific changes made to Schedule 3 as the content of the final Guideline has been amended to address the potential changes.

8 Guidance is sought on inbound interest-free loans in the context of withholding tax transfer pricing benefit. Inbound interest-free loans have not been included in the scope of Schedule 3 on the basis that the standard criteria should apply and therefore, specific guidance is unnecessary.

We recognise that this may result in high risk ratings, however given the associated risk profile of these transactions, this is considered to be an appropriate outcome.

9 It is recommended to make it clear that while the motivational risk indicators have not been modified for Schedule 3, these indicators still need to be considered to determine the overall risk rating. We acknowledge it would be beneficial to include clearer wording regarding the motivational risk indicators being relevant for the risk assessment of outbound interest-free loans.

We have updated Schedule 3 to provide clearer guidance on the relevance of motivational risk indicators (see paragraph 205 of the final Guideline).

10 The application of the sovereign risk indicator should be reconsidered as it raises concerns in relation to funding to entities in high credit-rated jurisdictions.

It is observed that the application of this indicator could result in inappropriate risk scores being allocated to arrangements that fund activities/projects in high-rated countries but have a low prospect of raising interest-bearing third-party debt due to the nature and stage of the project or the circumstances of the borrower. Hence, the sovereign risk of the country is not a reliable indicator.

We acknowledge this concern and have removed sovereign risk from the pricing indicator table for the purpose of assessing interest-free loans (see paragraphs 203 and 209, and examples of the final Schedule 3).

The sovereign risk indicator will continue to apply for interest-bearing loans.

11 The draft Schedule 3 does not address the assessable/deductible nature of realised foreign exchange gains/losses on the arrangements that are treated as akin to equity.

Concern has been expressed the ATO may seek to review and challenge tax deductions for foreign exchange losses that arise from interest-free outbound funding to related parties that would not have previously been considered.

The arm's length conditions that are taken to operate by virtue of section 815-115 of the Income Tax Assessment Act 1997[1] apply for all parts of the income tax assessment legislation. As such, all tax consequences will follow depending on the characterisation determined by applying Subdivision 815-B.

For example, we expect the tax treatment of foreign exchange gain/losses on an interest-free loan that is characterised as equity to be the same as any other equity instrument.

We do not consider it necessary to make any further changes to Schedule 3.

12 The level of analysis and requirement to demonstrate evidence under Schedule 3 is subjective will place extensive burden on taxpayers (particularly for smaller taxpayers with less resources/experience) and is disproportionate to the actual level of risk posed. Subdivision 815-B requires taxpayers to self-assess the arm's length nature of their cross-border arrangements. This self-assessment necessitates a certain level of analysis and evidencing.

We believe that the risk assessment required under Schedule 3 does not impose additional burden on taxpayers over and above the self-assessment requirements of Subdivision 815-B.

13 The current approach to score reduction using the two-step framework may not be consistent with arm's length conditions and may lead to unintended outcomes.

It is possible that in some circumstances the minimum required factors are not met although arm's length conditions may support a zero-interest rate or an equity contribution. For example, it is possible in certain circumstances that the rights under an instrument are different from the rights of a shareholder and there is an intention of creating a debtor-creditor relationship. If this was to occur, even though the 'additional factor' would be evidenced, Schedule 3 would not apply to reduce the score, because the minimum required factor would not be evidenced. In short, ten points would apply, even though the arm's length conditions could otherwise be considered to exist between the parties that support a zero-interest rate/equity contribution.

We consider the two-step framework a practical approach to risk assess interest-free outbound loans. It is possible that the approach will not fit all circumstances.

Taxpayers with unique circumstances should engage with us if they require certainty regarding their arrangements.

14 A specific pricing risk scoring table should be included in the final Schedule 3 to clarify its operation. A new table could be included which sets out the broader spectrum of points. Alternatively, a different approach could be adopted which relies on negative scores or score reductions (for example, '-3') where certain factors are present. The operation of the pricing risk scoring table in Schedule 3 of the Guideline has been clearly defined. Further changes are not considered necessary.
15 With respect to the additional factors in Step 2 of draft Schedule 3, it is not clear whether only one of the factors in this section is sufficient to satisfy the reduction in the score, or whether several, or all. It would appear that only one factor may be sufficient. However, whether and when this will be the case should be clarified. Consideration should be given as to whether a more definitive view could be expressed, to provide greater certainty and clarity. For example, more definitive guidance could be offered in relation to particular factors. The Step 2 factors in the final Schedule 3 are highly dependent on the facts and circumstances of each case. It is not possible to provide prescriptive guidance.

However, it is important to note that any evidence supporting a Step 2 assessment is not determinative in isolation and has to be considered along with the factors and evidence for Step 1.

16 Convertible debt should be expressly dealt with in the final Schedule 3. We consider that the examples provided are sufficient to explain the application of Schedule 3. It is not possible to provide examples covering all situations.

Taxpayers with unique circumstances should engage with us if they require certainty regarding their arrangements.

17 Clarification should be provided of how Schedule 3, and the Guideline more generally, may apply to private groups. Schedule 3 would apply equally to all taxpayers that have outbound interest-free loan arrangements that meet the requirements of the cross-border test in Subdivision 815-B.
18 Clarification should be provided regarding the average cost of debt and non-interest related costs of debt. We acknowledge the use of cost of debt can cause confusion as it is not a factor directly used in the risk framework. We have removed references to cost of debt in all examples.
19 Draft Schedule 3 goes further than a risk assessment and suggests elements of how the reconstruction provision in section 815-130 should be interpreted on the matter. However, it does not fully explain the technical analysis of the reconstruction provisions. The purpose of Schedule 3 is to provide a risk assessment framework for interest-free outbound loans. We have outlined the framing considerations and factors it considers relevant for such risk assessment. It is not the purpose of this Schedule to provide guidance regarding the technical application of Subdivision 815-B.

Taxation Ruling TR 2014/6 Income tax: transfer pricing - the application of section 815-130 of the Income Tax Assessment Act 1997 provides guidance on the application of section 815-130. This Schedule should be read in conjunction with TR 2014/6.

Accordingly, any technical law interpretation is not considered necessary for the purpose of this Schedule.

20 The experience in engaging with ATO case teams in reviews is that case officers will often expect taxpayers to produce its analysis of the matter consistent with how it is specified in the relevant Guideline.

It is recommended the ATO include an introductory paragraph to Schedule 3 to state more explicitly that this guidance is not merely a risk assessment and provides a documentation framework that the ATO expects taxpayers to follow.

As noted in response to Issue 19 of this Compendium, the purpose of Schedule 3 is to provide a risk assessment framework for interest-free outbound loans. We have outlined the framing considerations and factors we consider relevant in order to provide a practical approach for such risk assessment. The Schedule does not prescribe a documentation framework.

As the scope and purpose of this Schedule is clearly defined, no additional explanation is considered necessary.

21 The examples are all relatively simple and it is suggested to include some examples to cover other common scenarios, including:

finance companies providing funding rather than the parent entity, and/or
ultimate parent companies providing funding to subsidiaries further down the organisational structure, rather than providing the funding to immediate subsidiaries.

We consider the examples in the final Schedule 3 to be sufficient to assist taxpayers in understanding the application of the risk framework. It is not possible to provide examples covering all situations. However, it is noted that Example 3 of the final Schedule 3 has been amended to address an indirect parent-subsidiary relationship.

Taxpayers with unique circumstances should engage with us if they require certainty regarding their arrangements.

22 The draft Schedule 3 does have not provide any de minimis thresholds. It is recommended that the ATO implement a de minimis threshold (for example, balances of $2 million or less). No de minimis thresholds are considered necessary for Schedule 3 as self-assessment is voluntary. However, we may consider a de minimis standard for reporting purposes.
23 There is an overlap within Step 1 and Step 2 of the risk framework in Schedule 3, and there is also an overlap within the factors contained in Step 1.

It is recommended that the ATO provide a clearer distinction between the two steps, and a clearer explanation of what Step 2 involves (as these factors appears less well defined than the Step 1 factors), as well as refine language for paragraph 214(b)(ii) in Schedule 3 which requires taxpayers to demonstrate 'the borrower is in a position where it has questionable prospects for repayment and is unable to borrow externally'.

We do not believe further changes are required to the two-step framework. Taxpayers can exercise their judgment in determining if, in their circumstances, evidence provided in Step 1 will also be relevant for Step 2.

All legislative references in this Compendium are to the Income Tax Assessment Act 1997.

Relevant guidelines
PCG 2017/4DC2
PCG 2017/4