Borrowing capacity and guarantees: ATO’s take on arm’s length debt amount

The Australian Taxation Office (ATO) has released their long-awaited draft guidance on determining the arm’s length debt amount for inbound loans from overseas related parties.

The draft guidance details extensive analysis that needs to be performed and places increased expectation on the information taxpayers need to gather to evidence the arm’s length quantum of inbound loans from related parties. Also of interest is the ATO’s difference of opinion on guarantees to boost borrowing capacity. It will be intriguing to see how this interplays with their long-standing position on implicit guarantees when pricing debt.

What’s new?

The Draft Practical Compliance Guideline PCG 2025/D2 ('PCG 2025/D2' or ‘the Draft Guideline’) responds to recent changes in thin capitalisation and transfer pricing laws, effective from 1 July 2023. The ATO clarifies that transfer pricing rules take precedence when applying the new thin capitalisation regime – meaning taxpayers must first prove their debt amount and interest rate are arm’s length.

If all or part of the debt amount is not considered arm’s length, the interest debt deduction associated with the excess debt is not deductible.

What you need to do now

For those managing inbound related party financing, here are some guidelines to comply with ATO expectations.

• Evaluate your risk: Understand how your arrangement stacks up against the ATO’s new framework.
• Tighten your documentation: Prove your debt quantum is arm’s length – backed by robust evidence.
• Rethink your structure: Consider aligning financing terms with the Draft Guideline.
• Close the gaps: Review your current documentation and close any gaps before the ATO comes knocking.

Who’s in scope?

PCG 2025/D2 applies to taxpayers that are general class investors that have entered inbound cross border related party financing arrangements. The draft guidance is also relevant to some financial entities that have chosen to apply the third-party debt test.

When will the PCG apply?

When finalised, the Draft Guideline is proposed to apply to income years commencing on or after 1 July 2023 to all new and existing arrangements.

Relevant factors for determining the arm’s length debt amount

The Draft Guideline advises taxpayers to evaluate financing options that are realistically available to them, such as relying on internally generated funds, raising equity capital, or securing debt capital. The Draft PCG 2025/D2 outlines several qualitative factors the ATO will consider:

• Funding requirements (i.e. purpose of the debt);
• Group policies and practices;
• Return to shareholders;
• Cost of funds;
• Covenants;
• Explicit guarantees;
• Security;
• Serviceability; and
• Leverage.

Risk assessment framework 

Similar to other Practical Compliance Guidelines issued by the ATO, PCG 2025/D2 contains a risk assessment framework. This outlines the ATO’s compliance approach to a taxpayer’s inbound cross-border related party funding arrangement based on the following four risk zones:

Evidencing the arm’s length debt quantum

The PCG 2025/D2 reiterates the importance of preparing and maintaining transfer pricing documentation along with detailed analysis to support the quantum of the taxpayer’s inbound, cross-border related party financing arrangement. Documentation that may be requested by the ATO includes:

• Funding proposals or similar documentation that demonstrates taxpayer’s consideration of the funding options realistically available.
• Calculations or workings that show the evaluation of returns to shareholders (or investors).
• Documentation or workings that consider the impact of the inbound, cross-border related party financing arrangement on the taxpayer’s overall cost of debt.
• Details about the purpose for which the proceeds were required.
• Correspondence that demonstrates consideration of other arrangements, including iterations of offers and negotiation of terms.
• Group policies, including an overview of how these policies and relevant practices influence the external borrowing practices of group members.
• Signed and executed facility documentation, including loan agreements, bond prospectuses, term sheets, guarantee agreements, any security documentation and supporting documentation such as legal opinions, authorised signatory lists and accession deeds.
• Evidence of payments to international related parties and associates including repayments of interest and principal.

The Draft Guideline provides clear insights into the ATO’s approach and expectations. Aligning existing financing arrangements to the ATO’s risk framework and documentation guidelines will be key to managing risks and avoiding penalties. 

If you would like to discuss any of the information contained in this article, please get in touch.

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