ATO’s transfer pricing rules: how much cross-border debt is too much?

_{Thanks to Dritton Jemmalay and James Radford from TP Benchmark for their contributions to this article.}

The ATO recently released draft Practical Compliance Guideline PCG 2025/D2, outlining its views on the transfer pricing risks associated with the amount of cross-border, related party debt introduced into Australia. We step through the ATO’s practical views under the transfer pricing provisions, which the ATO will seek to apply before (and in addition to) the thin capitalisation rules.

The ATO released draft Practical Compliance Guideline PCG 2025/D2, Factors to consider when determining the amount of your inbound, cross-border related party financing arrangement – ATO compliance approach (PCG 2025/D2) on 29 May 2025. PCG 2025/D2 applies on a year-by-year basis in respect of multinational groups with in-bound, cross-border related party financing arrangements into Australia. It applies only in respect of the appropriate quantum of debt that the ATO considers may be appropriate under the Australian transfer pricing provisions. The ATO will use the PCG to review income years starting on or after 1 July 2023.

Key takeaways from PCG 2025/D2

PCG 2025/D2 positively acknowledges the diverse range of capital structures that independent parties may adopt based on their commercial circumstances, and that additional equity may be untenable in some circumstances. However, it contains a general undercurrent of aversion to the use of cross-border related party debt. This contrasts with recent case law that explicitly accepted the benefits of cross-border debt financing.[1]

The ATO has also provided a (non-exhaustive) list of considerations and documents that it will ordinarily seek to review to determine the risk that the quantum of a taxpayer’s debt may not be consistent with the transfer pricing provisions. This includes the taxpayer’s, and its broader group’s:

• funding requirements;
  
  
• policies and practices;
  
  
• returns to shareholders;
  
  
• cost of funds;
  
  
• covenants;
  
  
• explicit guarantees;
  
  
• security;
  
  
• serviceability; and
  
  
• leverage.

The ATO considers the following arrangements are high risk, to which it will prioritise audit resources:

• where a taxpayer argues that an explicit related party guarantee supports a higher quantum of related party debt being introduced into Australia;
  
  
• where a taxpayer receives cross-border related party loans and 30% or more of the funds from those loans are retained as cash, and that cash derives lower interest income (less than 90%) of the corresponding interest deductions paid for the financing; and
  

• where a taxpayer introduces related party debt to utilise excess capacity under the fixed ratio test (pursuant to the thin capitalisation provisions).

The ATO also provides limited guidance on what it considers to be low risk arrangements. The ATO considers the following two examples are low risk:

• where the taxpayer has made a choice under the thin capitalisation rules to apply the third party debt test for the relevant year; and
  
  
• where the taxpayer’s leverage and interest coverage ratios are equal to or better than those of both its global group and a set of comparable entities.

Taxpayers’ arrangements will also be low risk where they have already obtained an advance pricing arrangement, high assurance rating, settlement or court outcome, and there has been no material change in the arrangements.

Finally, the ATO considers that, where the transfer pricing provisions reduce the amount of a taxpayer’s debt, then debt deductions may be further denied through the debt deduction creation rules (if applicable) and the thin capitalisation rules. The ATO considers that the transfer pricing and thin capitalisation provisions can interact with one another and have ongoing effects over a number of years. It has stated that it may seek to revisit earlier circumstances where a later year is ‘in any way related to an earlier income year’. It will therefore be important for taxpayers to continue to maintain their documentation in respect of arrangements.

PCG 2025/D2 in detail

PCG 2025/D2 is the third and final of the ‘high priority’ public advice and guidance (PAG) topics which the ATO committed to developing. This was in response to stakeholder consultation submissions on the thin capitalisation regime amendments, which were effective from 1 July 2023. It accompanies PCG 2024/D3 Restructures and the thin capitalisation and debt deduction creation rules - ATO compliance approach and TR 2024/D3 Income tax: aspects of the third party debt test in Subdivision 820-EAB of the Income Tax Assessment Act 1997.

One of the key changes in law under the new thin capitalisation regime is that, whereas transfer pricing previously applied to adjust only the interest rate of debt, it will now operate to limit both the quantum of debt and the interest rate applicable to that debt. This new law raised concerns about how these rules would apply against existing transfer pricing PAG, e.g. PCG 2017/4 ATO compliance approach to taxation issues associated with cross-border related party financing arrangements and related transactions. Key themes that emerged from the stakeholder consultation process on this issue included the observation that the transfer pricing rules do not require entities to be associated or related, as well as concerns regarding the lack of guidance as to how the arm’s length debt amount should be determined. Both points have now been addressed.

Scope of PCG 2025/D2

PCG 2025/D2 outlines the Commissioner’s compliance approach to assessing the tax risk associated with the amount of taxpayers’ inbound, cross-border related party financing arrangements for Australian transfer pricing purposes. Once finalised, PCG 2025/D2 will apply retrospectively to income years commencing on or after 1 July 2023 – in line with the new thin capitalisation regime – as well as to both new and existing financing arrangements.

Notably, PCG 2025/D2 does not apply to financing arrangements between entities that are not related (despite this not being a requirement of the Australian transfer pricing rules generally). The practical implication of this is that taxpayers who solely rely on third party debt should generally not need to consider the application of PCG 2025/D2.

Consistent with the existing position, the ATO has reiterated that it will apply transfer pricing first and then the thin capitalisation rules on the remainder of any debt deductions. However, taxpayers should be wary that the ATO adopts the view that a prior transfer pricing application can affect future thin capitalisation outcomes, and that the ATO may consider or revisit earlier income years where the later years are ‘in any way related to an earlier income year’.

PCG 2017/4 will continue to apply regarding the rate/pricing of cross-border related party financing arrangements.

Available funding options

In considering the appropriateness of an arm’s length quantum of debt, the ATO has indicated it will focus on the range of options ‘realistically available’ to independent entities. In doing so, the ATO will consider the following funding options:

1. use of internally generated funds;
   
   
2. use of debt capital; and
   
   
3. use of equity capital.

The ATO’s comments on these sources of funding provide an insight into its current thinking as to the relevant factors underpinning a taxpayer’s choice of funding, and therefore the appropriate level of debt.

Risk zones

The ATO adopts a relatively limited range of risk zones and examples which is narrower than other PCGs (for example, the wider range of risk levels in PCG 2017/4).

A taxpayer will fall into the ‘high risk’ zone where their inbound, cross-border related party financing arrangement is covered by a ‘high risk’ example in the guideline (refer below) or the ATO has otherwise deemed such an arrangement to be high risk. Taxpayers should be aware that falling within the ‘high risk’ zone will prompt the ATO to prioritise resources to review a taxpayer's arrangements with the prospect of commencing a review or audit.

Factors to consider when determining the amount of debt

The ATO has also set out the following non-exhaustive list of factors to consider when determining the amount of an inbound, related party financing arrangement:

• funding requirements;
  
  
• group policies and practices;
  
  
• return to shareholders;
  
  
• cost of funds;
  
  
• covenants;
  
  
• explicit guarantees;
  
  
• security;
  
  
• serviceability; and
  
  
• leverage.

Low and high risk examples from the ATO

The ATO has set out five indicative examples to illustrate whether it will or will not commit compliance resources to evaluate the arm’s length conditions of an amount of inbound, cross-border related party financing. These fall starkly into ‘low risk’ and ‘high risk’ examples.

Low risk examples – the ATO will not commit resources

• Example 1 – entity has third party debt and related party debt and has made a choice to apply the third party debt test; and
  
  
• Example 2 – leverage and serviceability indicators (where leverage and interest coverage ratios are equal to or better than both its global group and a set of comparable entities).

High risk examples – the ATO will prioritise resources

• Example 3 – use of cross-border related party financing while holding cash reserves (i.e. 30% or more of the aggregate balance of all inbound, cross-border related party financing arrangements held in cash reserves, and 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);
  
  
• Example 4 – related party explicit guarantee in place to support the amount of an inbound, cross-border related party financing arrangement. This is where the guarantee is purported to enable the borrower to borrow a greater amount of debt than otherwise obtainable; and
  
  
• Example 5 – using cross-border related party finance to utilise excess capacity under the fixed ratio test.

Documentation and evidence requirements

The ATO has set out a wide list of documentation and evidence that it expects taxpayers to maintain to support their transfer pricing position. This list is informed by the factors listed above. The detail and range of evidence contemplated reflects the ATO’s expectation that entities undertake ‘detailed analysis to support’ a decision on the form of funding used.

Consultation on PCG 2025/D2

PCG 2025/D2 is a draft guideline. The ATO is consulting on the guideline until 30 June 2025.

_{[1] Mylan Australia Holding Pty Ltd v Commissioner of Taxation (No 2) [2024] FCA 253 (Mylan) at [252]: ‘…debt is significantly more flexible than equity and a mix of debt and equity is generally the preferred means of funding subsidiaries.’ Mylan cited flexibility as a key advantage of debt over equity as a form of funding, particularly where the debt is used by related parties in a multinational group – this flexibility was recognised as ‘a powerful commercial factor’ (at [439]) which may support a ‘commercial decision to… take on more, rather than less, debt’ (at [467]).}