Executive summary

The Australian Taxation Office (ATO), on 29 May 2025, released a draft Practical Compliance Guideline (draft PCG 2025/D2), "Factors to consider when determining the amount of your inbound, cross-border related-party financing arrangement — ATO compliance approach," to provide risk-based guidance on the ATO's expectations for transfer pricing analyses undertaken in the context of Australia's earnings-based thin-capitalization rules. Notably, the draft PCG addresses issues associated with one fact pattern only — scenarios involving inbound related-party debt, despite the ATO's acknowledging that the rules also apply to third-party debt. The draft PCG is open for comment until 30 June 2025.

Earnings-based tests currently underpin Australia's thin-capitalization rules. One significant implication is that the transfer pricing provisions must now be applied and "arm's-length conditions" assessed in relation to both the price of any intercompany debt and the debt quantum. That is, Australia's transfer pricing rules must now be applied to show that the quantum of all debt borrowings in Australia are arm's-length. Draft PCG 2025/D2 provides some insight into the ATO's approach to the transfer pricing issues, albeit only in relation to arrangements involving inbound cross-border financing. Where the thin-capitalization rules apply, a transfer pricing analysis, including an evaluation of the entity's arm's-length capital structure, should be undertaken.

The application of "arm's-length conditions" transfer pricing rules for which the thin-capitalization rules apply is required from income years starting on or after 1 July 2023 (the same application date as for the new "general class investors" thin-capitalization rules and associated changes). For covered entities with a substituted accounting period, this would first affect income tax calculations in respect of 31 December 2024 income tax returns.

The draft PCG provides examples of two low-risk and three high-risk scenarios relating solely to inbound cross-border related-party debt. The examples are highly simplified, and therefore not highly informative or likely to be widely applicable. The broader "risk-assessment framework" provides some general qualitative signposts regarding certain factors that the ATO considers relevant to determining "the amount of a financing arrangement" — such as group policies and practices and the return to shareholders.

Consistent with other transfer pricing PCGs, arrangements are categorized into color-coded "risk zones" that determine the ATO's compliance approach.

Overview of draft PCG 2025/D2

This draft PCG is the latest in a series of transfer pricing-focused PCGs released by the ATO. Consistent with the structure of prior PCGs, it contains examples designed to highlight features and characteristics of arrangements with different risk profiles from the ATO's perspective, together with illustrative examples.

As set out in an earlier EY tax alert, the move to earnings-based thin-capitalization rules had a direct transfer pricing impact. (See EY Global Tax Alert, Australian thin-capitalization changes and new subsidiary disclosure rules — December 2023 update, dated 15 December 2023.) As a first step, before the ratio tests are applied, it is necessary to demonstrate that the entity's capital structure (i.e., its amount of debt borrowings relative to equity capital) meets arm's-length requirements. The earnings ratio tests are therefore best thought of as representing a cap on available debt deductions and not a safe harbor.

How the transfer pricing rules will apply in relation to the determination of the quantum of debt is analogous (but not identical) to the arm's-length capital structure analysis required under the predecessor provision arm's-length debt test in Division 820 ITAA 1997. This would typically involve analyzing borrowing capacity by referring to relevant financial ratios that an independent lender would consider, as well as to a debt/equity and risk profile that would be acceptable in the market.

The draft PCG does not contain quantitative indicators; rather, the guidance is focused on qualitative and directional pointers regarding factors that may inform risk. For example, it is anticipated that "options realistically available" to the Australian taxpayer are considered with regard to the following:

• Circumstances in which the use of internally generated funds would be preferred in light of the taxpayer's situation
• Scenarios in which the use of debt capital may be appropriate
• Specific circumstances in which the use of equity capital would be preferred

Factors relevant to the determination of the amount of any financing arrangement are specified in the draft PCG as involving:

• The funding requirement or purpose for which the debt capital is required
• Group policies and practices relevant to the borrowing decisions of the Australian taxpayer
• The return to shareholders in light of the financing arrangement
• The need to minimize the cost of funds relevant to the quantum of debt
• The existence of financial covenants relevant to decisions regarding the quantum of debt
• Any explicit guarantees relevant to the taxpayer's borrowing capacity
• Forms of security provided relevant to a lender's decision

The draft PCG refers to quantitative approaches in two places. First, with regard to the borrower's ability to service its debt obligations ("serviceability"), interest coverage and debt service coverage ratios are characterized as common-use approaches adopted by lenders. Second, with regard to leverage ratio, debt-to-equity, debt-to-assets and loan-to-value approaches are the indicators referenced.

Compliance approach

Consistent with other transfer pricing PCGs, the draft PCG's risk assessment framework provides guidance on the level of compliance resources the ATO will apply in relation to the following four "risk zones":

Guidance in relation to low-risk and high-risk zones is limited in the highly simplified examples. For example, Example 1 (low-risk) outlines a scenario in which no interest is deducted on related-party debt with the unremarkable conclusion this would be low-risk from the ATO's perspective. At the other end of the spectrum, the high-risk examples are also limited in their usefulness:

• Example 3 involves a scenario in which 30% of the inbound related-party debt is held in cash reserves; with the cash reserve attracting interest that is <90% of the "cost" of the related-party debt. Unremarkably, a "high-risk" scenario is one in which the interest deduction exceeds the interest income.
• Example 4 involves the existence of a formal guarantee that has enabled the Australian taxpayer to borrow a greater amount of debt than it would have been able to borrow absent the guarantee. This is also presented as "high risk."
• Example 5 describes a high-risk fact pattern similar to Example 3 while adding an arbitrary (and restrictive) AU$30m debt deduction threshold as relevant to the "high-risk" conclusion.

Thus, it seems reasonable to assume that most taxpayers with inbound related-party debt would \be located in the "blue" zone. Note that there is no specific guidance further differentiating those that fall outside the low- or high-risk examples.

Documentation and evidence

Based on the general recordkeeping rules, the draft PCG instructs taxpayers with inbound cross-border financing arrangements to "maintain documentation and evidence to support your transfer pricing position, for each income year that financing arrangement remains on issue." Additionally, the draft PCG lists detailed and specific documents and workings that the ATO may request. These include:

• Documents reflecting any transfer pricing analysis undertaken
• Information (e.g., funding proposals) demonstrating consideration of the "realistically available" funding options
• Calculations or workings that show the evaluation of returns to shareholders (or investors) or other financial benefits
• Documentation or workings that consider the impact of the debt on the overall cost of (debt) capital (including correspondence with third parties, such as lenders or credit rating agencies)
• Information regarding the purpose for which the funds were required

Other comments

Currently, there is uncertainty regarding the circumstances in which transfer pricing analyses would be required in the context of the third-party debt test. It cannot be assumed that electing the third-party debt test obviates the need for a transfer pricing analysis in support. Notably, the draft PCG is limited solely to inbound cross-border related-party debt arrangements.

As noted, the examples illustrating low- and high-risk scenarios are of limited utility and there is no guidance on attributes that may mean relatively more or less in terms of expected levels of analysis and documentation.