Australia Signals Tighter Scrutiny of Arm’s-Length Conditions

The Australian Taxation Office in May released draft Practical Compliance Guideline 2025/D2, setting out its evolving approach to determining acceptable levels of debt in cross-border related party financing arrangements.

The PCG doesn’t provide prescriptive risk factors, leaving most taxpayers falling under a category where compliance risk isn’t assessed.

The draft guidance reinforces the increased compliance burden for taxpayers and need for robust documentation. Taxpayers in the blue zone—where the ATO hasn’t yet assessed compliance risk—must prepare comprehensive records that address a wide range of qualitative and quantitative factors.

This documentation goes beyond basic financial metrics and requires a more holistic and detailed analysis of the commerciality and arm’s-length nature of related party financing arrangements.

Risk Zones

The ATO’s position is that transfer pricing compliance must address both the interest rate (pricing) and amount of debt (quantum). PCG 2025/D2 provides guidance on the ATO’s accepted quantum of debt for transfer pricing purposes. This is the third piece of ATO guidance after PCG 2024/D3 on debt restructuring and TR 2024/D3 concerning the third-party debt test.

The latest guidance outlines a four-tier risk framework: white, green, blue, and red. Most taxpayers are likely to fall in the blue zone, meaning their compliance risk hasn’t been assessed. In this category, arrangements are still subject to ATO scrutiny, and taxpayers are expected to maintain comprehensive documentation.

The ATO won’t apply compliance resources to the white zone (arrangement already reviewed and concluded), which applies to previously reviewed arrangements where no material changes have occurred.

It is particularly difficult to qualify for the green zone (low risk), which requires the taxpayer to either elect to apply the third party debt test or borrow less than the global group and a set of “comparable entities.” These thresholds imply that taxpayers must already have undertaken detailed transfer pricing reviews and have access to robust benchmarking data—and practically shouldn’t be subject to the PCG.

The ATO may commence review or audit for the red zone (high risk). This includes structures where the taxpayer holds cash reserves exceeding 30% of debt while earning lower returns than the debt interest cost.

It also includes taxpayers that borrowed more with parent guarantee. It is commercially reasonable for a taxpayer to borrow more where a parent entity provides an explicit guarantee, so such arrangements shouldn’t in themselves be considered indicative of high risk.

Another red-zone factor is that the taxpayer increases gearing up to fixed ratio and on-lends the borrowed funds earning less than the cost of the borrowed funds.

Defense File

PCG 2025/D2 clarifies that documentation is no longer optional for taxpayers. They must prepare a defense file covering a range of qualitative and quantitative factors and documentation on whether the quantum of cross-border related party debt is consistent with arm’s-length conditions, including:

• whether funding options are realistically available (such as use of internal generated funds or a commercially viable mix of debt capital and equity capital)
• commercial justification for the financing arrangement
• group-wide financing policies and external borrowing practices
• impact on the return to shareholders
• cost of funds, impact on the borrower’s credit, and competitive benchmarks
• correspondence showing consideration of other arrangements, including negotiation of terms, explicit guarantees, security offered to the lender, serviceability of the loan, and borrower’s existing leverage
• signed loan agreements and supporting documentation

Outlook

It is difficult for taxpayers to rely solely on any safe-harbor thresholds. Most will fall into the blue zone, where detailed documentation is critical to mitigate audit risk.

The ATO’s new approach reflects a shift from narrow financial ratio testing to a holistic review of commerciality and comparability. This marks a significant step in its ongoing campaign to align related party financing with arm’s-length principles.

Taxpayers are encouraged to review their related party financing structures and prepare comprehensive supporting files. guidance will apply to both existing and new arrangements from July 1, 2023, once finalized.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Amy Liu is special counsel in the corporate and commercial team at Colin Biggers & Paisley. Her practice includes income tax, international tax, goods and services tax, and stamp duty.

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