Draft PCG 2025/D2 –Inbound Related Party Debt
Key
Aspects of Draft PCG 2025/D2
The Australian Taxation Office (ATO) released Draft Practical Compliance Guideline PCG 2025/D2 on 29 May 2025. This draft provides guidance on how taxpayers should determine the arm’s length amount of inbound cross-border related party debt under Australia’s transfer pricing framework. It requires entities to justify not just the pricing (interest rate, terms), but also the quantum (amount) of related-party debt.
Risk Assessment Framework
The draft PCG 2025/D2 introduces a risk assessment framework categorizing arrangements into four zones, indicating varying levels of risk, from low to high, and helps taxpayers self-assess their arrangements and correspondingly, the level of ATO scrutiny.
Risk Zone Risk Level
already reviewed and concluded with the ATO
Factors
Funding requirements
Group policies and practices
Return to shareholders
Cost of funds
Covenants
Explicit guarantees
ATO implications
The purpose of the debt informs the amount. The actual requirement may differ from the amount borrowed. Entities must consider the original purpose and historical context, not just current year metrics.
Treasury and dividend policies may influence financing decisions. For example, target leverage or credit rating floors may limit debt amounts; dividend expectations may restrict debt levels to preserve distributable profits.
The expected return from using the funds can affect the amount of debt. Higher financing costs reduce returns, impacting how much debt an entity would reasonably take on.
Entities aim to minimise funding costs. The amount of debt can affect credit metrics and thus influence future borrowing capacity and interest rates.
Existing loan covenants may restrict further borrowing. Borrowers must evaluate how new debt interacts with covenant thresholds, which can act as de facto limits on debt levels.
Guarantees can affect lender willingness, but do not fully determine debt sizing. The borrower’s own creditworthiness and capacity remain key
Factors ATO implications
Security
Serviceability
Leverage
Lenders assess available collateral, mainly tangible assets, to determine how much debt to offer. Intangibles are usually excluded from security valuation unless involving membership interests.
The borrower’s ability to service debt (e.g. use debt service coverage ratio) directly affects the amount lenders would provide. It’s a key “debt sizing” or ‘debt sculpting' metric used in structuring financing arrangements.
A borrower’s leverage ratio (e.g. leverage ratio, debt-to-equity, debt-to-assets or loan-to-value) is used by lenders to assess how much debt is reasonable. Higher leverage may reduce further debt capacity.
ATO Documentation & Evidence Requirements
The ATO expects taxpayers to maintain robust annual documentation to substantiate that their inbound, cross-border related-party financing arrangements are consistent with arm’s length conditions. This applies for each income year the arrangement is in place.
Documentation support details
Transfer Pricing Analysis
Realistic Funding Options
Return Analysis
Cost of Capital Impact
Purpose of Debt
Comparison of Alternatives
Group Policies & Practices
Facility Documentation
Payment Records
Evidence that the pricing and amount of the debt are arm’s length, including benchmarking studies.
Funding proposals or similar records showing that all realistically available funding options were considered (e.g. debt, equity, internal funds).
Calculations or workings showing how expected returns to shareholders/investors were considered in funding decisions.
Analysis or documentation showing the impact of the arrangement on cost of debt capital. May include correspondence with lenders, advisors, or credit agencies.
Clear explanation and supporting evidence of the use of funds, e.g. acquisitions, refinancing, working capital.
Evidence of negotiation processes, rejected offers, or other arrangements evaluated. Iterations and changes to terms should be retained.
Overview of group treasury and borrowing policies and how they influence the borrower’s capital structure.
All executed financing documents, including loan agreements, term sheets, guarantees, security documents, legal opinions, etc. This applies to both relatedparty and third-party arrangements.
Proof of interest and principal payments made to related parties, including dates, amounts, and recipients.
Low-Risk Examples in Draft PCG 2025/D2
Example Scenario
Example 1
(Third-party debt test applied)
Example 2
(Leverage and serviceability indicators)
The entity has both thirdparty and related-party debt, and it has elected to apply the third-party debt test under the thin capitalisation rules.
The Australian entity’s leverage and interest coverage ratios are equal to or better than those of its global group and thirdparty comparables.
ATO Risk View Key Considerations
Low risk – since deductions for relatedparty debt will be effectively denied, there should be no further transfer pricing concern regarding the debt amount.
Low risk – ratios are consistent with arm’s length behaviour.
High-Risk Examples in Draft PCG 2025/D2
Example 3
(Significant cash reserves)
The Australian entity has a material level of inbound related-party debt despite holding significant cash reserves. The interest deductions from the debt far exceed interest income on the cash.
Example 4
(Related-party explicit guarantee)
Example 5
(Use of excess capacity under fixed ratio test)
The Australian entity’s related-party financing is supported by an explicit related-party guarantee, making the transaction a composite of multiple controlled dealings.
The Australian entity borrows via a relatedparty inbound loan and on-lends at a rate below its borrowing cost, while using available debt capacity under the fixed ratio test.
Entities in this category will likely be excluded from further review under the PCG as no benefit is gained from the related-party debt.
Must conduct a transfer pricing benchmarking study to compare Australian entity’s financial ratios with those of independent entities and the global group.
This may suggest that the Australian entity has not realistically considered alternative funding options, such as using internal funds. Indicates taxdriven debt structuring.
Increased likelihood that the arrangement is not arm’s length, particularly where the guarantor's role is not priced or considered properly. This complexity adds transfer pricing risk.
Indicates a potential tax-motivated structure to maximise deductions despite a commercially uneconomic return. The ATO may view this as nonarm’s length behaviour.
Pitcher Partners Observation
The draft PCG outlines the ATO’s compliance approach, including:
A risk assessment framework (e.g. low vs high risk indicators);
Key factors for evaluating and testing the quantum of related-party debt; and
Documentation expectations to support debt levels and terms.
The ATO stresses the importance of a detailed, case-specific analysis, similar to how independent lenders and treasury teams assess debt capacity.
There is a clear move away from rigid reliance on financial ratios alone.
Instead, the ATO encourages a holistic review of the commercial and economic context of the debt arrangement.
Implications for Taxpayers:
Taxpayers with inbound, cross-border related-party debt will need to justify both the price of the debt and the quantum of debt under the arm’s length principle. This essentially expands compliance beyond traditional pricing to capital structure justification.
Even compliant pricing may be challenged if the quantum is deemed excessive compared to arm’s length expectations (as determined by the ATO in the event of a review).
Recommendations to Taxpayers:
Transfer pricing benchmarking will be key to substantiating the arm’s length nature of the debt quantum and terms.
Taxpayers should ensure that the amount of related party debt is commercially justifiable and supported by robust contemporaneous documentation. Review existing related-party financing arrangements for quantum justification.
Use the ATO’s risk zones to self-assess and prepare for potential ATO engagement.
Applies to income years starting on or after 1 July 2023, and to existing and newly created financing arrangements.
The ATO will scrutinise whether taxpayers have genuinely considered all realistically available funding options, such as equity or internal cash, rather than defaulting to debt.
Update transfer pricing documentation with specific focus on debt amount justification.
Groups with multinational dealings should ensure global coherence in policies.
Taxpayers should also consider the thin capitalisation rules. This is especially relevant where debt deductions are being capped. Related party debt needs to be justifiable both for thin capitalisation and transfer pricing purposes.
Please get in touch if you require any clarification or further information on Draft PCG/D2 and how it might affect you.
Simon Chun Tax Partner
p +61 7 3222 8447
e schun@pitcherpartners.com.au
Tom Splatt Tax Partner
p +61 7 3222 8308
e tsplatt@pitcherpartners.com.au
Murray Graham Tax Partner
p +61 7 3222 8470
e mgraham@pitcherpartners.com.au
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