ATO draft Practical Compliance Guideline - Determining ‘debt quantum’ in the context of Australia’s thin capitalisation rules

At a glance

• A draft Practical Compliance Guideline (draft PCG) outlines the Australian Taxation Offices’ (ATO’s) compliance approach to transfer pricing analyses undertaken to evidence that the quantum of debt borrowings in Australia are arm’s-length, as required under Australia’s thin capitalisation rules.
• The draft PCG is narrow in scope relative to transfer pricing analyses likely to be required more broadly in relation to the thin capitalisation provisions. In particular, the PCG is applicable only to inbound cross-border related party debt, despite the ATO acknowledging the rules also apply to third-party debt.
• The format of the PCG is similar to other transfer pricing-focused PCGs issued by the ATO, including color-coded ‘risk zones’ and simplified illustrative examples of ‘low’ and ‘high’ risk scenarios, with the important exception that changing a taxpayer’s “risk-score” can only be achieved by reducing debt quantum.
• The guidance is primarily qualitative in nature only, with matters such as the ‘group policies and practices’ presented as one of a series of ‘factors that an entity may reasonably be expected to consider’ as part of the determination of sources of funding.
• The PCG also outlines ATO expectations regarding the documentation expected in support of the transfer pricing position.

The Australian Taxation Office (ATO) has released (29 May 2025) 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 regarding transfer pricing analyses undertaken in the context of Australia’s earnings-based thin capitalisation rules. Notably, the draft PCG addresses issues associated with one fact pattern only – scenarios involving inbound related party debt, despite the ATO acknowledging the rules also apply to third-party debt. The draft PCG is open for comment until 30 June 2025.

Earnings-based tests now underpin Australia’s thin capitalisation 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 evidence 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 capitalisation rules apply, it is recommended that a transfer pricing analysis including an evaluation of the entity’s ‘arm’s length capital structure’ is undertaken.

The application of ‘arm’s length conditions’ transfer pricing rules where the thin capitalisation 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 capitalisation rules and associated changes). For covered entities with a substituted accounting period, this therefore first impacts income tax calculations for example in respect of 31 December 2024 income tax returns.

The draft PCG provides examples of two low-risk and three high-risk scenarios relating to inbound cross-border related party debt only. The examples are highly simplified, and therefore not overly informative and unlikely to be widely applicable. The broader ‘risk assessment framework’ provides some general qualitative signposts regarding certain of the factors the ATO considers to be relevant to the determination of ‘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 categorised into color-coded ‘risk zones’ which determine the ATO’s compliance approach.