Factors to consider when determining the amount of your inbound, cross-border related party financing arrangement - ATO compliance approach

This draft Guideline [1] has been prepared following the enactment of the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share — Integrity and Transparency) Act 2024 (Act) on 8 April 2024. The Act applies to an entity that: • is a 'general class investor' [2] , or a 'financial entity' [3] that has chosen to apply the 'third party debt test' [4] in relation to an income year for the purposes of Division 820 of the Income Tax Assessment Act 1997 (ITAA 1997), and • has inbound, cross-border related party financing arrangements.

The Act amended section 815-140 of the ITAA 1997 such that the actual amount of a cross-border financing arrangement of such affected entities is no longer preserved when applying Subdivision 815-B of the ITAA 1997. Specifically, such affected entities will need to work out both the amount and rate of their cross-border financing arrangements as if arm's length conditions operated.

This Guideline outlines our compliance approach to assessing the tax risk associated with the amount of your inbound, cross-border related party financing arrangement under Subdivision 815-B of the ITAA 1997. A 'cross-border related party financing arrangement' in this context refers to an arrangement that is a 'financing arrangement' as defined in subsection 995-1(1) of the ITAA 1997 or a related transaction or contract, entered into with a cross-border related party. [5]

This Guideline only applies to inbound, cross-border related party financing arrangements. Practical Compliance Guideline PCG 2017/4 ATO compliance approach to taxation issues associated with cross-border related party financing arrangements and related transactions continues to set out our compliance approach to determining the rate (or pricing) of cross-border related party financing arrangements.

This Guideline does not cover financing arrangements between entities that are not related. While Subdivision 815-B of the ITAA 1997 is capable of applying to these arrangements, they are not within the scope of this Guideline.

You can use this Guideline to: • assess the transfer pricing risk in relation to the amount of your inbound, cross-border related party financing arrangement using our risk assessment framework • understand the compliance approach we are likely to adopt having regard to the circumstances surrounding your inbound, cross-border related party financing arrangement • mitigate the transfer pricing risk in relation to the amount of your inbound, cross-border related party financing arrangement.

All legislative references in this Guideline are to the ITAA 1997, unless otherwise indicated.

This Guideline is structured as follows: • our compliance approach and risk assessment framework • general factors relevant in determining and testing the amount of your inbound, cross-border related party financing arrangement • specific guidance and examples on how the indicators and factors are used by us in our compliance approach • documentation and evidence that we expect you to prepare in determining the amount of your inbound, cross-border related party financing arrangement.

When finalised, this Guideline is proposed to apply to income years commencing on or after 1 July 2023 and to existing and newly created financing arrangements.

This Guideline will be subject to review following final publication. Any revisions to improve its efficacy will be made where appropriate. We may also consider the addition of Schedules to this (or an associated) Guideline (for example, PCG 2017/4). We will undertake consultation in relation to any material changes proposed.

This Guideline is limited to risks relating to the application of the transfer pricing rules in Subdivision 815-B to affected entities referred to in paragraph 1 of this Guideline in relation to the amount of their inbound, cross-border related party financing arrangement.

For the avoidance of doubt, it does not set out our approach to reviewing other taxation issues that might arise in relation to cross-border related party financing arrangements such as the: • application of the transfer pricing rules in Subdivision 815-B to the pricing of an inbound, cross-border related party financing arrangement • application of the debt and equity rules in Division 974 • substantive deductibility of interest payments or other losses (for example, under subsection 230-15(2)) • application of the thin capitalisation rules in Division 820 • existence or otherwise of liability for interest withholding tax, and • application of Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936).

The Act amended section 815-140 such that the existing modification for thin capitalisation within the transfer pricing rules no longer applies to entities which, for the purposes of Division 820, are: • general class investors, or • financial entities that have made a choice under sections 820-85 or 820-185 to apply the third party debt test.

For these affected entities, prior to the amendment, section 815-140 modified the way in which an entity that gets a transfer pricing benefit worked out its taxable income or tax loss for an income year, if the operation of the arm's length conditions involved applying a rate to a debt interest to work out costs that are debt deductions of the entity. This provision required that the relevant rate was worked out on the basis that the arm's length conditions operated, and that arm's length rate was then applied to the debt interest actually issued by the entity, instead of the debt interest that would have been issued had the arm's length conditions operated. [6]

As the new thin capitalisation tests deny debt deductions on an earnings basis, the identification of arm's length conditions is not modified for affected entities (those using the new earnings-based tests or third party debt test). For these entities, the amount of debt is a relevant condition for the purpose of considering the commercial or financial relations that operate between the respective parties. [7]

The arm's length conditions applying to a debt interest are determined in accordance with the rules contained in section 815-130. [8] The identification of an arm's length amount of debt, as with the identification of the arm's length conditions, is based on an assessment of '… the conditions that might be expected to operate between independent entities dealing wholly independently with one another in comparable circumstances'. [9]

Affected entities can therefore get a transfer pricing benefit where: • the amount of their inbound, cross-border related party financing arrangement differs from the amount it would have been had arm's length conditions operated, and • if arm's length conditions operated, the entity's taxable income for an income year, or amount of withholding tax payable in respect of interest, would be greater, or its loss of a particular sort, or tax offsets, for an income year would be less.

We understand that there are a diverse range of capital structures that independent parties may adopt depending on their respective commercial circumstances. This Guideline is designed to help you manage the compliance risk and therefore the compliance costs associated with determining the amount of your inbound, cross-border related party financing arrangements.

This Guideline sets out general factors relevant in determining and testing whether the amount of your inbound, cross-border related party financing arrangement is consistent with arm's length conditions.

It also provides a risk assessment framework that we will use to assess risk and tailor our engagement with you based on your circumstances. The tax risk associated with your inbound, cross-border related party financing arrangement is assessed having regard to the examples we have set out in paragraphs 101 to 112 of this Guideline.

Ordinarily, we will consider the application of the transfer pricing rules in Subdivision 815-B, before taking account of any interaction with the thin capitalisation rules in Division 820. Debt deductions remaining after the application of the transfer pricing rules, if required, may be further disallowed by the thin capitalisation rules. That being said, in assessing the compliance risk associated with your inbound, cross-border related party financing arrangement for an income year, you can expect us to have regard to the practical effect of the interaction of the transfer pricing and thin capitalisation rules.

This compliance approach is limited to considering the outcomes in an income year. The practical effect of the interaction between Subdivision 815-B and the thin capitalisation rules may have consequences that impact more than one income year. If the practical effect of the interaction between the transfer pricing rules and thin capitalisation rules is such that the tax outcomes in a later income year are in any way related to an earlier income year, we may have regard to or revisit that earlier income year regardless of the stated compliance approach.

With respect to documenting your arrangement, we have set out the types of documentation and evidence that we expect you to prepare in determining the amount of your inbound, cross-border related party financing arrangement. We will request you provide these documents to us should we undertake a review.

This Guideline is general in nature, does not constitute a 'safe harbour' and does not replace, alter, or affect our interpretation of the law in any way. It does not relieve you of your legal obligation to self-assess your compliance with all relevant taxation laws. You should have regard to the relevant provisions contained in Division 815 and other provisions to the extent they are relevant (for example, the debt deduction creation rules in Subdivision 820-EAA, the thin capitalisation rules generally in Division 820 and the general deductibility rules).

Our compliance approach will vary depending on the risk rating of your inbound, cross-border related party financing arrangement. The following principles will assist you to understand how we assess risk in relation to the amount of your inbound, cross-border related party financing arrangements and generally allow you to assess your compliance risk.

If you fall within the high-risk zone, there is no presumption you have obtained a transfer pricing benefit in relation to the amount of your inbound, cross-border related party financing arrangement. However, this means we consider there is a risk that the amount of your inbound, cross-border related party financing arrangement is not consistent with arm's length conditions for the purposes of Subdivision 815-B and you may have obtained a transfer pricing benefit. Therefore, we will generally conduct some form of compliance activity to further test the taxation outcomes of your arrangement.

If we conduct a review of your inbound, cross-border related party financing arrangement, we may take account of other indicators and factors beyond those contained in this Guideline. This is because we will need to evaluate, among other things, evidence that supports whether your arrangement is consistent with arm's length conditions.

Our risk assessment framework for the purpose of evaluating the amount of your inbound, cross-border related party financing arrangement is made up of 4 risk zones: Table 1: Risk zones Risk zone Risk level White Arrangements already reviewed and concluded Green Low risk Blue Compliance risk not assessed Red High risk

We may revisit these zones to ensure that they continue to be an accurate reflection of our understanding of the transfer pricing risks associated with the amount of your inbound, cross-border related party financing arrangement. We will consult on any material changes proposed.

You are in the white zone if your inbound, cross-border related party financing arrangement satisfies any of the following criteria: • there is a settlement agreement between you and the ATO entered into since enactment of the Act on 8 April 2024, where the terms of the settlement cover the Australian tax outcomes and specifically address and provide an agreement on the amount of your arrangement for the purposes of Subdivision 815-B • there is a court decision in relation to the Australian tax outcomes of the arrangement, including under the Act, where you were a party to the proceeding • there is an advance pricing arrangement between you and the ATO and the terms of that advance pricing arrangement specifically address and provide an agreement on the amount of your arrangement for the purposes of Subdivision 815-B or the Associate Enterprises article of the relevant double-tax agreement, or both, or • we have conducted a review of your arrangement in relation to its amount (where the review commenced on or after 1 January 2025) and provided you with a 'low risk' rating for the arrangement, AND • there has not been a material change in the conditions of the inbound, cross-border related party financing arrangement since the time of the agreement, decision or review.

If you are in the white zone, you do not need to self-assess your inbound, cross-border related party financing arrangement against this risk assessment framework and we will not have cause to apply compliance resources in relation to the amount of your inbound, cross-border related party financing arrangement.

You are in the green zone if your inbound, cross-border related party financing arrangement satisfies either of the following criteria: • your arrangement is covered by one of the low-risk examples set out in this Guideline (and not also covered by a high-risk example set out in this Guideline), or • we have conducted a review of your arrangement in relation to its amount and provided you with a 'low risk' rating (or 'high assurance' under a justified trust review) for the arrangement AND • there has not been a material change in the arrangement which informed the basis of our risk or assurance rating in the review or audit.

If your inbound, cross-border related party financing arrangement is in the green zone, we will generally only apply compliance resources to verify your self-assessment.

You are in the blue zone if your inbound, cross-border related party financing arrangement is not covered by a low-risk or high-risk example in this Guideline or the white zone criteria. If you are in the blue zone, we will actively monitor your arrangements using available data and may review your arrangement to understand any compliance risks.

You are in the red zone if your inbound, cross-border related party financing arrangement satisfies either of the following criteria: • your inbound, cross-border related party financing arrangement is covered by a high-risk example in this Guideline, or • we have conducted a review of your inbound, cross-border related party financing arrangement in relation to its amount and provided you with a 'high risk' rating (or 'low assurance' under a justified trust review).

If your inbound, cross-border related party financing arrangement is in the red zone, we will prioritise our resources to review your arrangement. This may involve commencing a review or audit. The red zone is a reflection of the features that we consider indicate greater risk; however, it is not a presumption that you have obtained a transfer pricing benefit in relation to the amount of your inbound, cross-border related party financing arrangement.

As explained at paragraph 16 in this Guideline, to determine whether the conditions that operate between you and your related party in relation to your inbound, cross-border financing arrangement differ from arm's length conditions you will need to have regard to the conditions that might be expected to operate between independent entities dealing wholly independently with one another in comparable circumstances.

Independent entities that require funding will consider all available sources in light of the total funding requirement. The main sources of funding are debt capital [10] , equity capital and internally generated funds (for example, expected free cash flow, retained earnings and cash reserves).

The decision to raise debt capital, equity capital or rely on internally generated funds, will be based on accessibility, relative advantage, and the specific circumstances of the entity at that time. Entities will undertake detailed analysis to support this decision, such as cash flow and liquidity analyses, credit assessments, compliance and regulatory checks as well as an evaluation of macroeconomic conditions (for example, the interest rate environment).

Entities will consider all of the options realistically available to them when considering funding requirements. The OECD Transfer Pricing Guidelines [11] provides the following commentary in relation to this principle [12] : Independent enterprises, when evaluating the terms of a potential transaction, will compare the transaction to the other options realistically available to them, and they will only enter into the transaction if they see no alternative that offers a clearly more attractive opportunity to meet their commercial objectives. In other words, independent enterprises would only enter into a transaction if it is not expected to make them worse off than their next best option.

The options realistically available to a borrower will be based on the facts and circumstances as they apply to that entity. The consideration of these options may be reflected in concerted efforts on the part of the borrower to explore alternative arrangements and leverage its bargaining power to negotiate better outcomes. Generally, these considerations, including the pursuit and evaluation of alternative arrangements, will be documented.

The purpose of the proceeding sections is to set out, non-exhaustively, factors that an entity may reasonably be expected to consider as part of determining the most appropriate source of funding.

You should consider these factors for the purpose of contextualising your inbound, cross-border related party financing arrangement. If we review the amount of your inbound, cross-border related party financing arrangement, we will have regard to these (and where necessary, other) factors.

Internally generated funds are a common source of financing for entities. The advantages of internally generated funds include, but are not limited to: • being readily available, in particular cash reserves (or free cash flow arising from the day-to-day business operations) • they incur minimal to no costs, in that there is no interest or dividend payable, advisory fees and establishment costs • they provide financial flexibility, as there are no ongoing financial or operational obligations, such as covenants and undertakings that impose financial operating thresholds and constrain certain activities, and • they are replenishable, whether through strong cash flow performance or funding an investment that produces near-term or sufficient returns.

Despite these benefits, internally generated funds may not suit all entities. For example, entities that are subject to earnings volatility or cash flow cycles would be expected to maintain adequate cash reserves to ensure they can operate through volatility or cyclical pressures. For these entities, other sources of capital, such as debt or equity, may be preferred where additional investment activity is undertaken.

Third-party debt capital plays a pivotal role in the global financial markets, serving a key mechanism for corporations to raise necessary funding.

Debt financing has the following advantages: • depending on the price of the debt, it can have a lower cost of capital • debt does not dilute ownership and voting rights • principal and interest repayments are predictable, therefore allowing for better cash flow management, and • debt capital markets are liquid and can be more readily accessible depending on the facts and circumstances of an entity.

Debt financing can have many disadvantages such as: • limited control over borrowing costs, where movements in interest rates can raise the overall cost of borrowing • increased risk of financial distress, correlating to incremental increases in the borrower's leverage • limitations or requirements (for example, covenants) imposed on the borrower by the lender which impact on the financial autonomy of the borrower, and • constrained access to some debt markets, which for smaller or unrated borrowers will limit the available sources of debt capital.

Equity is a common source of funding for entities. The advantages of raising equity capital include, but are not limited to: • no fixed repayment schedule which, in turn, provides greater flexibility for cash flow management • lower financial risks, as equity does not create liability obligations, allowing for the maintenance of a healthier balance sheet, and • suitability for longer-term investments, where returns are not immediate or returns are low in the short term, as it provides cash flow flexibility and is likely to attract investors with a longer return horizon.

The specific circumstances of the entity may also play a role in the decision to use equity capital. A common circumstance would be where the entity is not able or willing to make periodic loan repayments. This could arise because of poor earnings performance, or similarly, where projected earnings are far from certain.

Despite these benefits, the use of equity capital beyond a particular threshold may be untenable for some shareholders. This is because as the number of shares issued increases, the return to shareholders (assuming all else remains equal) decreases. Moreover, if these additional shares are offered to new investors, the control interests or rights of the original investors, or both, can become diluted. Where shareholders are sensitive to share dilution, other funding sources, such as debt or internally generated funds, may be preferred.

When independent entities raise debt capital, the amount (or quantum) of a financing arrangement will be a function of various and often interrelated considerations.

The purpose of the following section is to set out, non-exhaustively, factors that are observed among independent borrowers and lenders, which may have a bearing on the amount of a financing arrangement. You should consider these factors in determining and testing whether the amount of debt of your cross-border related party financing arrangement is consistent with the conditions that might be expected to operate between independent entities dealing wholly independently with one another in comparable circumstances. If we do review the amount of your inbound, cross-border related party financing arrangement, we will have regard to these (and where necessary, other) factors.

The purpose for which the debt capital is required will inform the amount of a financing arrangement. Generally, it would be anticipated that any financing raised will be for a defined, pre-agreed purpose.

The respective cost, expenditure, or refinance requirement will be the starting point from which decisions regarding the use of debt capital will be made. It should not be assumed that the funding requirement and the amount of debt capital raised will be the same. For example, borrowers may provide a portion of the total funding requirement from other sources, including cash or equity capital. In some respects, there may also be a requirement to do so due to board, investor or stakeholder conditions that have been imposed. For example, where the prospective financing arrangement will be subject to a loan-to-value ratio (LTV), it would not be the case that the entire funding requirement will be met with debt capital.

Group policies and practices influence the decisions a borrower will make in relation to the amount of a financing arrangement.

Group policies provide a framework of operating parameters, procedures and objectives that support the business activities of an entity. These will often be documented and formalised as part of a policy manual or analogous document that is to be adhered to in respect of those business activities.

On the other hand, group practices are the actions taken to achieve or support the objectives set out as part of the group policies. These may or may not be documented within the group policies or as a stand-alone procedure. However, to the extent any (undocumented) practices are widely accepted or commonly occurring actions, it is reasonable to expect that they too will also have a bearing on the decisions affecting the amount of a financing arrangement.

The purpose of group policies and practices is to regulate the decision-making of an entity (primarily to manage risks), guide or prescribe relevant activities and delegate responsibilities (including approvals).

Group treasury [13] policies and practices can influence the decisions a borrower, usually at board or executive management level, will make in relation to the amount of a financing arrangement. Examples of treasury policies (and their associated parameters) that might be expected to have a bearing on the amount of a financing arrangement, include: • leverage or credit rating policies, that encourage or mandate a particular leverage, target rating or 'floor', as achieving this leverage or target will place limitations on the amount of debt within a capital structure • dividend policies which set expectations in relation to dividend payments as ordinarily, entities will ensure that their debt repayment obligations do not erode profits and imperil commitments made to shareholders.

Group treasury practices reflect the functions of the respective business units responsible for the development of funding proposals and sourcing of funds. Ordinarily, this function will undertake sufficient analysis to determine the optimal size of a proposed financing arrangement. For example: • considerations regarding the type of capital (that is, debt or equity) – entities will evaluate whether it is optimal to take on debt, or whether it is preferable to issue further equity • analysis of the existing debt profile of the entity – this might focus on exploring the available senior debt capacity with a view to utilising cheaper finance, as well as debt maturities to ensure that any repayment obligations do not exceed the available cash flow during a particular period. These considerations will influence decisions made in respect of a financing arrangement, including the amount.

While it is noted that policies and practices will vary between groups and across industry, their function is the same in so far as managing the group's capital and associated risks. To this end, group treasury policies and practices can influence the decisions a borrower will make in relation to the amount of a financing arrangement.

The return or financial benefit achieved on a particular investment or use of funds interacts with and may have a bearing on the amount of a financing arrangement.

When an entity raises and invests debt capital, it generally does so with the expectation of generating a return in the form of a financial benefit. This measure will vary across entities, industries, and purposes for which debt capital is required. Examples might include a return expressed as a proportion of equity or value of investment, or based on a valuation, such as a discounted cash flow and expressed as an internal rate of return.

The amount of a particular financing arrangement as well as the cost of servicing that arrangement will have a bearing on the expected return, as these will directly impact other financial items used to calculate that return.

Subsequently, the decisions made in respect of a financing arrangement (including its amount) will give due consideration to generating an appropriate return to shareholders.

The commercial imperative to minimise the cost of funds or otherwise utilise the cheapest source of funds may have a bearing on the amount of a financing arrangement.

The amount of debt capital held by an entity will impact the price at which it can obtain funding. This is because a borrower's leverage is an important input into the determination of its creditworthiness. The creditworthiness of an entity may be reflected in a public credit rating or an obliger risk rating (or similar), as determined by the lender or third party, such as a credit rating agency.

Importantly, it is the creditworthiness of the entity that forms the basis or anchor on which the cost of funds is based. An entity will be cognisant of the amount of debt capital it holds and its associated impact on credit metrics or measures relied upon by lenders.

Covenants within existing loan agreements may directly or indirectly impose restrictions on the use of debt capital which can impact the amount of a financing arrangement.

Covenants reflect agreements made by the borrower to operate within certain financial parameters (for example, gearing, interest coverage ratio). These may also include undertakings on the part of the borrower that prohibit various actions (that is, negative pledges), including asset sales, mergers, issuance of debt and repatriation of dividends or compel certain actions (that is, affirmative covenants), such as the maintenance of insurance. Generally, covenants fall into the following categories: • incurrence – which is triggered only upon a specific set of actions by a borrower, such as the issuing of new debt, the disposal of assets or payment of an extraordinary dividend, and • maintenance – which requires the borrower to operate within and observe predetermined thresholds for a specific set of financial metrics, to be reported upon at agreed intervals.

Covenants are the outcome of negotiation between the borrower and lender. Borrowers will naturally seek favourable terms, including ample 'headroom', being the agreed amount by which a financial covenant may deteriorate before it exceeds (or breaches) the respective threshold. The consequences of breaching (or violating) a covenant range in severity. A breach of a covenant will typically constitute an event of default as prescribed in the loan agreement, which might attract: • penalty interest provisions (that will increase the cost of the financing arrangement) • restrictions on corporate actions such as the payment of a dividend • enforcement of security over any pledged assets, and • the acceleration of repayment – that is, the full and immediate repayment of the financing arrangement including any accrued interest and fees.

Some financial covenants will be directly tied to the amount of debt held by a borrower. Therefore, when contemplating additional debt capital, borrowers will need to evaluate the impact of further indebtedness against their existing covenants. Generally, we observe that a borrower will be reluctant to: • encroach upon 'headroom' as this will reduce the buffer available to the entity such that any financial volatility raises the prospect of a breach, or • re-negotiate financial covenants (outside of exceptional circumstances), as this may be perceived negatively by the market as a sign of poor financial performance. This might also result in additional costs being borne by the borrower, as the lender will require additional compensation (for example, a higher interest rate) for accepting less advantageous terms (especially if they are to be exposed to increased credit risk).

While covenants are not static, they do impact the behaviour, including the investment decisions, of entities. Therefore, covenant compliance will have a direct bearing on decisions pertaining to the amount of a financing arrangement.

An explicit guarantee may have a bearing on the amount of funds a lender would be willing to provide. There are, however, limitations as to the amount of debt that an explicit guarantee might support.

Explicit guarantees can provide varying degrees of legally binding commitments that are made by a guarantor to remediate a specified loss or assume a specific repayment obligation of the borrower in the event of a default.

Like security, lenders may require explicit guarantees as a form of protection to ensure that the funds will be repaid. In this respect, an explicit guarantee exposes the lender to the credit risk profile of the guarantor. Where the credit profile of the guarantor is superior to that of the primary obligor, the lender may be willing to advance more favourable terms and conditions than the primary obligor could have obtained on a stand-alone basis.

Although the credit profile of the guarantor will be a relevant consideration (in negotiating terms and conditions), this does not mean that the amount of a particular financing arrangement is 'sized' based on the debt capacity of the guarantor. This is because it is uncommon for guarantors to encumber their remaining debt capacity, and lenders undertake due diligence to satisfy themselves that the 'size' of the financing arrangement is one that can be serviced and repaid by the primary obligor.

Operational or regulatory requirements compel lenders to undertake due diligence to know and understand their customers. This entails both quantitative and qualitative assessments made at the outset of the negotiation process and throughout the life of the subsequent financing arrangement, and might include: • forward-looking credit analysis • legal and regulatory compliance, including material disputes with revenue or taxation authorities, and • assessment of operational (or other) risks.

Regardless of whether a guarantee is available, the amount of funds a lender would be willing to provide will be based on sound fundamentals explored as part of the due diligence process.

Security may affect the amount of funds a lender would be willing to provide in relation to a financing arrangement.

Security, also referred to as collateral, is granted by the borrower to the lender. It provides the lender with recourse to the assets of the borrower in the event of default. The most common forms of security include: • mortgages • fixed or floating charges • pledges, and • liens.

Lenders take security as a form of protection, while borrowers might offer security to enhance the terms and conditions of the financing arrangement (for example, a lower interest rate). Security enhances the credit profile of the financing arrangement because it reduces the loss attributable to the lender in the event of default.

Generally, the assets a lender will have regard to for the purpose of taking a security interest will be the tangible assets of the borrower to the extent they are saleable and for which a market exists. The amount recognised as security will be based on a valuation method such as fair value or market value. Ordinarily, lenders will not have regard to the intangible assets of the borrower or whole of business valuations with the exception of security interests that are membership interests.

The amount of funds a lender would be willing to provide in relation to a secured financing arrangement will correlate to the value of security provided by the borrower. Lenders will determine this amount with reference to a measure, such as an LTV ratio. The relationship between the value of security and the amount of the funds provided may also persist throughout the duration of the financing arrangement. For example, should the value of the underlying security depreciate there is often a provision for the borrower to prepay an amount of the financing arrangement to ensure that the agreed LTV ratio is maintained.

The ability of a borrower to service its debt obligations has a direct bearing on the amount of funds a lender would be willing to provide in relation to a financing arrangement.

A lender's business model is predicated on generating a return on its debt capital. Generally, this return is based on the risk profile (that is, creditworthiness) of the borrower and the degree of protections afforded in the loan agreement. A key consideration in this regard will be the ability of a borrower to service its debt obligations, that is, both interest and principal.

To evaluate the ability of a borrower to service its debt obligations, a lender will use coverage ratios. The most common of these ratios include: • interest coverage ratio = earnings before interest and taxes (EBIT) ÷ interest expense • debt service coverage ratio = earnings before interest, taxes, depreciation, and amortisation (EBITDA) ÷ debt service (interest expense + principal repayment).

A coverage ratio will measure the ability of a borrower to repay its obligations based on its cash flows (or similar measure), expressed as a multiple.

While EBITDA is one of the more common proxies for cash flow, these ratios may also adopt income, profit, or cash flow items as the numerator, as well as include adjustments to remove the effect of non-recurring items. The iteration that is ultimately relied upon will tend to reflect the most appropriate measure based on the commercial attributes of the borrower (including industry).

Lenders will use a debt serviceability measure in a variety of ways, including as a financial maintenance covenant within a loan agreement or as an input into the obligor risk rating (or credit rating). However, the use of debt serviceability measures (such as a debt service coverage ratio) is most influential in its role as a 'debt sizing' or 'debt sculpting' metric, used in determining the amount to be provided under a financing arrangement or the debt capacity of the borrower.

The leverage of a borrower will have a bearing on the amount of funds a lender would be willing to provide in relation to a financing arrangement.

This is because (as with debt serviceability) the leverage of a borrower is used as a 'debt sizing' or capacity metric, against which lenders will determine the amount of funds they would be willing to provide.

The leverage of a borrower is usually expressed as a ratio but can also be expressed as a relative proportion (that is, percentage).

The most common leverage ratios are: • leverage ratio = debt ÷ EBITDA • debt to equity = total debt ÷ total equity • debt to assets = total debt ÷ total assets • LTV = loan value ÷ investment.

Some leverage ratios will measure 'how many times' a borrower can pay off its debt relative to its cash flow (or similar measure), while others will express the value of a company (for example, assets or equity) as a multiple of its debt amount.

The calculation or iteration that is ultimately relied upon will tend to reflect the most appropriate measure based on the commercial attributes of the borrower. For example, lenders might consider the leverage of a borrower that operates in a capital-intensive industry and holds significant plant, property, and equipment in terms of debt to total assets.

Examples 1 to 5 of this Guideline are indicative only and do not cater for every fact pattern. The intention of these examples is to illustrate where we will (or will not) have cause to commit compliance resources to evaluate whether the amount of your inbound, cross-border related party financing arrangement is consistent with the arm's length conditions.

As outlined in paragraphs 21 to 22 of this Guideline, we will have regard to the practical effect of the interaction of the transfer pricing and thin capitalisation rules, taking into account any impacts on tax outcomes in later income years, this does not imply an interpretive approach to the application of those rules (which require Subdivision 815-B to be applied by affected entities covered by this Guideline before Division 820). These examples are solely concerned with how we will allocate our compliance resources.

Examples 1 to 5 of this Guideline, apply in relation to an income year. If your circumstances change and you are subject to compliance activity in a later year, we may have regard to those earlier years regardless of the stated compliance approach.

Examples 1 to 2 of this Guideline reflect our view of risk associated with the amount of an inbound, cross-border related party financing arrangement. Generally, we consider either of the following circumstances to be low risk: • for an entity choosing to use the third party debt test – where its related party debt deductions are not included in its third party earnings limit [14] (for the purpose of Subdivision 820-EAB) • for any other entity – where the leverage and interest coverage ratios are equal to or better than its global group and comparable entities.

The following facts apply: • For an income year, Aus Co makes a choice (including a deemed choice) to apply the third party debt test. • Aus Co, among its other financing arrangements, has on issue an inbound, cross-border related party financing arrangement. • The debt deductions in relation to the inbound, cross-border related party financing arrangement are not included in Aus Co's third party earnings limit. • Aus Co's debt deductions are disallowed in proportion to the amount of debt deductions for the income year that exceed the third party earnings limit.

As the amount of debt deductions disallowed by the thin capitalisation provisions effectively include the whole amount of debt deductions Aus Co incurs on the inbound, cross-border related party financing arrangement, we will not have cause to devote compliance resources to consider transfer pricing risks associated with the amount of that related party arrangement. This is a low-risk arrangement for the purpose of this Guideline.

The following facts apply: • Aus Co has on issue an inbound, cross-border related party financing arrangement. • Aus Co's leverage and interest coverage ratios are equal to or better than: - its global group, and, - a set of comparable entities.

As Aus Co's financial ratios (as defined in Table 2 of this Guideline) are equal to, or better than independent comparable entities and its global group, the ATO will not have cause to devote compliance resources to consider transfer pricing risks associated with the amount of that arrangement. This is a low-risk arrangement for the purpose of this Guideline.

Examples 3 to 5 of this Guideline reflect our view of risk associated with the amount of an inbound, cross-border related party financing arrangement. Generally, we consider any of the following circumstances to be high risk: • an entity that may not have had regard to options realistically available in view of significant cash reserves • an entity relies on an explicit guarantee to obtain an amount of debt greater than it could have borrowed without the guarantee • inbound, cross-border related party financing arrangements that absorb available capacity under the entity's 'fixed ratio earnings limit' [15] to generate a return below that of the expected return.

The following facts apply: • Aus Co has on issue an inbound, cross-border related party financing arrangement. • Aus Co holds at least 30% of the aggregate balance of all inbound, cross-border related party financing arrangements in cash reserves. [16] • The average weighted interest rate on the cash reserves is less than 90% of the average weighted interest rate on the inbound, cross-border related party financing arrangements.

As Aus Co holds significant cash reserves relative to the amount of its inbound, cross-border related party financing arrangements, and debt deductions generated from those arrangements materially exceeds the interest income earned on an equivalent amount of the cash reserves, there is an increased likelihood that it has not considered its options realistically available. This is a high-risk arrangement for the purpose of this Guideline.

The following facts apply: • Aus Co has on issue an inbound, cross-border related party financing arrangement. • The inbound, cross-border related party financing arrangement is also the subject of a related party explicit guarantee. • The guarantee has, or is purported to have, enabled Aus Co to borrow a greater amount of debt than it could have otherwise obtained without the guarantee.

As the amount of Aus Co's inbound, cross-border related party financing arrangement is the product of more than one controlled transaction, there is an increased risk that the arrangement is not consistent with arm's length conditions. This is a high-risk arrangement for the purpose of this Guideline.

The following facts apply: • Aus Co enters into an inbound, cross-border related party financing arrangement. • The amount of debt deductions generated by the cross-border related party financing arrangement is more than $30 million. • Aus Co on lends part of the proceeds to a related party for an expected return that is below the total costs it expects to incur in relation to the inbound, cross-border related party financing arrangement. [17]

As Aus Co has utilised excess capacity under the fixed ratio test to generate an expected below cost return, there is an increased likelihood that the arrangement is one that has been undertaken to maximise the amount of its debt deductions. This is a high-risk arrangement for the purpose of this Guideline.

If you have entered into an inbound, cross-border related party financing arrangement, you should maintain documentation and evidence to support your transfer pricing position, for each income year that financing arrangement remains on issue. [18] If we review your arrangement, we will request to see your transfer pricing documentation.

We may also request the following documentation: • transfer pricing analysis to support the arm's length nature of your inbound, cross-border related party financing arrangement • funding proposals or similar documentation that demonstrates your consideration of the funding options realistically available to you • 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 inbound, cross-border related party financing arrangement on your overall cost of (debt) capital (this might include correspondence with third parties, such as lenders or credit rating agencies) • 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 (that is, both related and third party), 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.

Our view on transfer pricing documentation and a suggested framework for satisfying Subdivision 284-E of Schedule 1 to the Taxation Administration Act 1953 is set out in Taxation Ruling TR 2014/8 Income tax: transfer pricing documentation and Subdivision 284-E.

Table 2 of this Guideline defines terms and financial metrics that are relevant to the examples contained in this Guideline. Table 2: Definitions Concept Definition Cash reserves For the purpose of the examples set out in this Guideline, 'cash reserves' are to be determined based on the sum of the opening and closing balance of the accounting line item 'cash or cash equivalents', or similar, divided by 2. Where, according to the financial statements: • opening balance = the prior year 'as at' balance • closing balance = the current year 'as at' balance. To the extent, any outbound, intercompany loans are being held on deposit as part of a global group cash management or cash pooling arrangement are not reflected in 'cash or cash equivalents', include those amounts in calculating 'internally generated funds', on the same measurements basis as otherwise set out in this Table. Comparable For the purpose of the examples set out in this Guideline, a 'comparable' is an independent entity that exhibits 'comparable circumstances' as set out in subsection 815-125(3), as supported by Chapter III (Comparability Analysis) of the OECD Transfer Pricing Guidelines. Consortium or joint venture For the purpose of the examples set out in this Guideline, a 'consortium or joint venture' is an association of 2 or more entities. Interest coverage ratio For the purpose of the examples set out in this Guideline, the interest coverage ratio is calculated as follows: Interest coverage ratio = EBIT ÷ interest expense Where, according to the relevant financial statements: • EBIT = pre-tax income + interest + non-recurring expenses (gains) • interest expense = gross interest expense + other borrowing expenses • gross interest expense = interest paid or credited It includes amounts accrued, accumulated, or capitalised. • other borrowing expenses = fees and swap costs Note that interest income is not included. • financial statements = those mentioned in subsection 820-935(2). Global group For the purpose of the examples set out in this Guideline, the definition of 'global group' will differ based on the structure of the group. For: • publicly listed companies – as per the definition of a member of a group of entities consolidated for accounting purposes in accordance with paragraph 960-555(2)(a) [19] • privately owned companies – includes the taxpayer and their associates as defined in section 318 of the ITAA 1936 • consortium or joint venture – where a joint venture partner or consortium member with more than 20% direct or indirect interest in the entity has provided capital by way of debt, that particular instrument is assessed against the global group of that particular joint venture partner or consortium member. Leverage ratio For the purpose of the examples set out in this Guideline, the leverage ratio is calculated as follows: Leverage ratio = debt ÷ EBITDA Where, according to the relevant financial statements: • debt = short-term debt + current portion of long-term debt + long-term debt (net of current portion) + liability for capital leases (if not already included in debt) • EBITDA = pre-tax income + interest + non-recurring expenses (gains) + depreciation expenses + amortisation of intangibles • financial statements = those mentioned in subsection 820-935(2).

You are invited to comment on this draft Guideline. Please forward your comments to the contact officer by the due date.

A compendium of comments is prepared when finalising this Guideline, and an edited version (names and identifying information removed) may be published to the Legal database on ato.gov.au. Please advise if you do not want your comments included in the edited version of the compendium. Due date: 14 July 2025 Contact officer details have been removed as the comments period has ended.