A Guide to PCG 2025/D2
Navigating Related Party Debt Financing in Australia
For international businesses operating in Australia, understanding the tax implications of related party debt financing is crucial. The Australian Taxation Office (ATO) has recently updated its approach to these arrangements, as outlined in the draft Practical Compliance Guideline (PCG 2025/D2). This document provides a summary of these important changes and what they mean for your business.
Understanding “Draft” in the Tax Context
It’s important to note that PCG 2025/D2 is currently a draft guideline. In the context of Australian tax law, a “draft” document means:
- Preliminary Guidance: It represents the ATO’s current view and intended approach to a particular tax issue.
- Subject to Change: The ATO publishes draft documents to invite public and industry feedback. This feedback helps shape the final version, meaning the contents of PCG 2025/D2 could change before it is finalised.
- Not Final Law: While it provides strong indication of the ATO’s position, it does not have the force of law. However, taxpayers generally rely on draft guidelines for practical compliance, as they reflect the ATO’s likely compliance approach.
- Anticipated Finalisation: The final version of this guideline is expected from August 2025 onwards.
Core Legislative Change: Justifying Related Party Debt
Following the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share - Integrity and Transparency) Act 2024, certain businesses can no longer simply assume their related-party debt amounts are acceptable for tax purposes. These affected entities must now actively justify both the interest rate and the total amount of their inbound, cross-border related party loans. This justification must be based on the “arm’s length principle,” meaning what independent parties would have agreed to under similar circumstances.
This critical change primarily impacts:
- General class investors.
- Financial entities that have chosen to use the “third party debt test.”
ATO’s Risk Assessment Framework
The ATO has introduced a four-zone risk assessment framework to provide clarity on its compliance approach to related party debt arrangements:
| Zone | Discription | ATO Compliance Approach | |
|---|---|---|---|
| ⚪ | White Zone | Arrangements previously reviewed and approved by the ATO (e.g., through settlement, court decision, or advance pricing arrangement). | No compliance resources applied. |
| 🟢 | Green Zone (Low Risk) | Arrangements meeting specific low-risk examples, such as comparable leverage and interest coverage ratios to the global group and independent entities. | ATO generally only verifies self-assessment. |
| 🔵 | Blue Zone | Any arrangement not explicitly falling into the White, Green, or Red Zones. | ATO actively monitors these arrangements. |
| 🔴 | Red Zone (High Risk) | Arrangements with identifiable high-risk features. | Prioritised for ATO review or audit. |
Key Factors and Risk Examples
The guideline outlines several factors that independent parties would consider when determining the amount of a loan. Taxpayers are expected to consider these factors to support their arrangements.
Factors to Consider:
- Options Realistically Available: Was using internal funds (like cash reserves) or raising equity a more commercially sensible option than taking on debt?
- Funding Purpose: What is the genuine business need for these funds?
- Group Policies: What are the multinational group’s own rules regarding capital structure and treasury management?
- Financial Health: What is the borrower’s ability to service the debt (serviceability) and its overall level of debt (leverage)?
- Guarantees and Security: What is the effect of any related party guarantees or security provided for the loan?
Risk Examples:
- High-Risk examples include:
- Borrowing from a related party while holding significant cash reserves (more than 30% of the loan amount) that earn a low return.
- Using a guarantee from a related party to borrow a larger amount than would have been possible on a standalone basis.
- Entering into a financing arrangement primarily to use up available tax deductions (under the “fixed ratio test”) for a transaction that generates a below-cost return.
- Low-Risk examples include:
- An entity whose related party debt deductions are fully disallowed under thin capitalisation rules anyway.
- An entity whose leverage and debt serviceability ratios are equal to or better than both its global group and comparable independent companies.
Documentation Requirements
To support their transfer pricing position, taxpayers with inbound, cross-border related party financing are now expected to prepare and maintain extensive documentation. This includes, but is not limited to:
- Analysis of funding options considered.
- Evidence of negotiations and decision-making processes.
- Details of group treasury policies.
- Detailed financial calculations supporting the arm’s length nature of the arrangement.
Summary and Call to Action
The draft PCG 2025/D2 signals a significant shift in how the ATO will assess related party debt financing arrangements. It places a greater burden on taxpayers to justify both the quantum and interest rate of their inbound, cross-border related party loans against the arm’s length principle.
Understanding this new framework and proactively ensuring your documentation is robust will be critical for managing your tax risk. Given the complexity and potential for significant tax adjustments, it is highly recommended to seek professional advice and get in contact with your tax advisor. They can help you navigate these changes, assess your current arrangements, and ensure you are prepared for the final guideline.