Finalisation of important ATO guidance has implications for intra-group cross border financing

9 mins  21.12.2017

Key takeouts


The recently finalised ATO guidance imposes a self-assessment obligation on taxpayers to assess the risk of their cross border financing arrangements.

Important amendments have been made to the risk indicator methodology which is now split between 'pricing' and 'motivational' risk indicators.

The new guidance coincides with an expansion of the Reportable Tax Position (RTP) schedule and 'justified trust' initiative. Cross border financing arrangements are 'reportable arrangements' under the RTP schedule, meaning many taxpayers may be required to state their risk profile to the ATO.

If your organisation has an intra-group cross border loan, you will need to re-assess the risk of each loan with reference to the finalised ATO guidance and ensure you possess the necessary evidence needed to defend your position.

This week the Australian Taxation Office (ATO) finalised its 'Practical Compliance Guideline 2017/4' (Guideline) which sets out how it will deal with cross-border related party financing arrangements from 1 July 2017. The Guideline applies to existing and newly created arrangements, covering both 'inbound' and 'outbound' financing. It is estimated that approximately 3,000 Australian taxpayers could be impacted by the Guideline.
In the 7 months since the draft ATO guidance was released for public consultation, the ATO has taken considerable feedback in finalising the Guideline. A common theme from the feedback was the low watermark to be rated 'high' or 'very high' risk, often regardless of the interest rate pricing on the financing arrangement. This was demonstrated in a Corporate Tax Association survey that estimated over half of the financing arrangements sampled had high risk ratings in the amber to red zones

In response to such feedback, the ATO's related party financing risk indicator guidance has now been bifurcated to separately assess 'pricing' and 'motivational' risk indicators. The final result is a more sophisticated ATO approach that is likely to partially calibrate the excessive risk ratings observed under the ATO's draft guidance.

The ATO is clearly emboldened by its Chevron win in the Full Federal Court and will rely on this Guideline to drive taxpayer change in how they price and evidence their cross border related party financing arrangements.

Related Party Financing Risk Indicator Guide

The Guideline includes an updated 'Related party financing risk indicator guide' which asks a series of revised 'pricing' and 'motivational' questions about each intra-group financing arrangement and assigns a specific alpha-numeric response which directly influences where the risk assessment of the financing arrangement.

For each financing arrangement, the determination of a taxpayer's risk zone is derived by combining outcomes under the pricing and motivational risk scoring tables (paragraphs 63 and 64 of the Guideline, respectively) according to the following matrix:

The ATO has stated that if a related party financing arrangement is rated as low risk, then taxpayers can expect the Commissioner will generally not apply compliance resources to review the taxation outcomes other than to validate the taxpayer's self-assessment of its financing arrangements. Importantly, the Commissioner will also not seek to apply the Diverted Profits Tax regime to the financing arrangements rated in the 'green zone'.

The higher the risk rating, the more likely the arrangements will be reviewed as a matter of priority. The overall risk zone for an income year will reflect the risk of the taxpayer's highest risk financing arrangement. For example, if you have entered into three related party financing arrangements, two of which you assess as being in the yellow zone and one you assess as being in the amber zone, your overall risk zone will be amber.

Whilst the Guideline does not constitute a 'safe harbour' from complying with existing Australian tax law, the ATO will also use the Guideline to inform how they dedicate their compliance activities. Importantly, very high risk cases are likely to proceed directly to audit and be subject to the increased prospect of litigation.

Key Pricing Indicators - what is your 'all in' cost of debt?

Where the price or cost on any intra-group borrowing exceeds a referrable debt cost by more than 200 basis points, the Commissioner considers this to be in the very high risk zone. This means the financing arrangement is likely to lead to further ATO scrutiny, even if the other factors are considered low risk.

In a significant shift from the previous draft guideline, the new pricing indicator framework turns on the assessment of an ‘all in’ cost of debt associated with the related party financing arrangement. So in addition to the underlying interest amount, this holistic assessment brings other ancillary financing costs into the risk assessment framework including:

  • guarantee fees,
  • associated hedging costs
  • line fees
  • any anticipated foreign exchange gains or losses.

The taxpayer's 'all in' cost of financing is then compared to three specific referrable debt pricing points. In the Guideline, the ATO prescribes the hierarchy in which only one of the three options needs to be considered in the following pecking order:

  1. Traceable third party debt
  2. Relevant third party debt
  3. Global group cost of funds

This means that where traceable third party debt is available, it must be used by the taxpayer for risk zone assessment purposes. This is regardless of the strengths and weaknesses of the other options available, which may yield more comparable or commercially realistic pricing reference points. This prescriptive approach fails to best achieve consistency with the OECD transfer pricing guidelines.

The Guideline also highlight the risks associated with financing arrangements which fall outside of a 'vanilla' loan arrangement, for example the use of promissory notes, convertible debt and other financial derivatives. If you have such an arrangement in place, you will automatically have a high rating of risk and can expect to be hearing from the ATO.

The Guideline has also maintained its contentious position in relation to the currency of the borrowing. The ATO take the view that the currency of any borrowing should be the same currency as the 'operating currency'. The definition of operating currency has been broadened since the previous draft guidance and now means the currency in which the borrower earns the majority of its revenues, or any currency where the borrower has free cash flow greater than or equivalent to 150% of the anticipated interest expense in that particular currency.

Other pricing indicators such as subordination and the presence of exotic loan features need to be considered, but now only to the extent these factors have been taken into account in pricing the financial arrangement. This specific change delivers a significant improvement to the way in which the risk scoring mechanism is calculated.

Key Motivational Indicators

The finalised guidance tempers the way in which 'motivational' factors are reflected in the overall loan risk rating. This effectively means that factors such as the tax rate of the lender or existence of a hybrid arrangement cannot in of themselves give rise to a high risk rating, where the pricing indictors do not present risk. In addition, the ATO has recast their metric ranges and definitions related to factors such as leverage and interest coverage.

Transitional arrangements

The Commissioner will give taxpayers 18 months to make voluntary disclosures which adjust pricing levels for back years so that they fall within the green zone. Provided full and true disclosure is made in that time, the Commissioner will remit penalties and shortfall interest in full.

The ATO also invite taxpayers to engage on various matters related to their financing arrangements. Those wishing to transition their financing arrangements to a low risk category must notify the ATO and provide:

  • Details of existing arrangements and their compliance with the Guideline
  • Proposed new financing arrangements and their compliance with the Guideline
  • How the transition will be executed (including any tax consequences), and
  • Any proposal for resolution of relevant open years (those years within the amendment period).

Each existing financing arrangement or new arrangement you enter into with a related party (that is not a resident of Australia) will need to undergo a risk assessment on a recurring basis as new and relevant information comes to light, but at least once per income year.

In performing this self-assessment, taxpayers are encouraged to proactively approach the ATO if they consider certain features of their business or circumstances give rise to a risk zone that is not reflective of the underlying risk. The ATO highlight participants in capital intensive industries as those potentially impacted by such a mismatch.

Action steps

If your organisation has an intra-group cross border loan, you need to critically re-assess your loan arrangements making sure you have all the necessary evidence and legal documentation you need to defend your position.

This is not just an academic question, the Guideline states you may be required to disclose whether you have self-assessed the risk rating of your related party financing arrangement as part of the extended Reportable Tax Position regime. Additionally, the ATO will likely require evidence to 'fact-check' the assessment of the risk zone. Specific examples of the types of evidence required for various indicators are outlined at paragraph 65 of the Guideline. If appropriate evidence is unable to be provided the ATO will likely undertake further compliance activity.

As such, you should start reviewing existing financing arrangements as soon as possible to determine what level within the Guideline risk matrix your financing arrangements currently sit and whether any changes are necessary. Additionally, you should seriously consider whether it would be beneficial to take advantage of the Commissioner's 18 month 'grace period'.

MinterEllison were instructing solicitors for the Commissioner in the Chevron litigation. Our clients have said that this puts us in a unique position to assist them to meet the compliance challenges which have been bought to the forefront as a result of the finalised Guideline and the Commissioner’s intention to ensure cross border financing arrangements are compliant with Australian tax law. We are here to help.

A link to Practical Compliance Guideline PCG 2017/4 is here.

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