The Tax Office has shed further light on its compliance approach towards cross-border related party financing arrangements in a recent practical compliance guideline.

The ATO recently issued Draft Practical Compliance Guideline PCG 2025/D2, which outlines the factors an organisation should consider when determining the amount of its inbound, cross-border related party financing arrangements.

When finalised, the guideline is intended to apply to income years commencing on or after July 2023 and to existing and newly created financing arrangements.

RSM Australia said the draft guideline provides important details about the ATO’s proposed compliance approach in relation to assessing the tax risk associated with the quantum of debt associated with inbound, cross-border related party financing arrangements.

Before the enactment of the new thin capitalisation rules last April, RSM Australia said the transfer pricing provisions were effectively ‘switched off’ to determine the arm’s length amount of debt for an entity, rendering the former asset-based thin capitalisation rules the sole determinant of such matters.

“With the shift to the new earnings-based thin capitalisation regime and debt deductions no longer being disallowed on a quantum of debt basis, accompanying amendments were made to section 815-140 of the ITAA 1997 to ‘switch on’ the transfer pricing provisions for the purposes of determining the arm’s length amount of debt for an entity”, it said.

The accounting firm said the practical compliance guideline provided welcome guidance on the earnings-based thin capitalisation regime and the ATO’s intended approach to applying the transfer pricing provisions in this context.

“Positively, the draft guideline recognises that there are a diverse range of capital structures that independent parties may adopt depending on their respective commercial circumstances, albeit with a less than subtle preference for anything that is not cross-border related party debt,” RSM said.

The draft guidance explained that the ATO’s proposed compliance approach will be based on four risk zones.

The white zone generally includes arrangements that have already been reviewed and concluded. For this zone, taxpayers do not need to self-assess under the draft guideline, and there is no cause for the ATO to apply compliance resources, provided no material change in relevant conditions.

The green zone is for low-risk arrangements. For this zone, the ATO will generally apply compliance resources only to verify taxpayers’ self-assessments under the draft guideline.

Taxpayers will be in the blue zone if their inbound, cross-border related party financing arrangement is not covered by a low-risk or high-risk example in the 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,” the ATO said.

Taxpayers would be in the red zone if their inbound, cross-border related party financing arrangement is covered by a high-risk example in the guideline. They would also be included in this zone where the ATO conducted a review of their inbound, cross-border related party financing arrangement in relation to its amount and provided the taxpayer with a 'high risk' rating.

If the arrangement was in the red zone, the Tax Office warned taxpayers that it would prioritise resources to review these arrangements.

“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,” it said.

The draft guideline also non-exhaustively details the considerations, factors and documents to which it will have regard in assessing the level of risk associated with an inbound, cross-border related party financing arrangement.

These include funding requirements, group policies and practices, returns to shareholders, cost of funds, covenants, explicit guarantees, security, serviceability and leverage.

The detailed guidance provided by the ATO would give taxpayers insight into the practicalities of its proposed compliance approach and the evidentiary points the ATO would consider.

RSM Australia said the draft guideline puts taxpayers on notice regarding its proposed compliance approach in relation to the quantum of inbound, cross-border related party financing arrangements.

“It emphasises the primacy that the transfer pricing rules now have on any thin capitalisation analysis and makes it clear that taxpayers not falling into the white or green ‘risk zones’ will need to be able to demonstrate that the quantum of their cross-border related party borrowings are arm’s length and commercially justified,” it said.

“To demonstrate this, taxpayers will likely need to bolster the level of quantitative analyses (if any) that may have been historically performed.”