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The ATO has raised concerns about some businesses claiming excessive debt deductions and shifting profits overseas in the property and construction space.
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Tax Office flags concerns with related-party financing in construction
11 December 2024
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Privately owned and wealthy groups have been reminded about some of the basics of inbound related-party financing where they receive funding such as a loan from an overseas related entity or associate to acquire or develop property.
Where this applies, the ATO said these groups may need to consider the application of the transfer pricing rules as this may affect their tax outcomes.
The ATO said it had concerns that some businesses may be claiming excessive debt deductions and shifting profits overseas.
“They are doing that by setting unrealistic interest charges for funding received from overseas related entities,” the Tax Office said.
“We are also concerned when businesses claim interest deductions but incorrectly defer or avoid interest withholding tax.”
The ATO reminded privately owned and wealthy groups that the transfer rules apply the arm's length principle, which determines the terms and conditions, such as pricing, for cross-border arrangements between related entities.
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“These rules also apply to cross-border arrangements between unrelated parties that are not acting at arm’s length,” it said.
When applying the arm’s length principle, the ATO said it expected businesses and groups to consider whether their funding is obtained on arm’s length terms and conditions.
“These are terms and conditions that would be expected if you and the lender were both independent of each other and acting at arm’s length,” it said.
To demonstrate the commerciality and arm’s length nature of the funding arrangement, the ATO said it expected businesses and groups to explain their funding arrangements, maintain evidence and understand and comply with their tax obligations.
“We expect you to explain your consideration of the funding options realistically available to you at the time of entering into an arrangement and any later refinancing decision, and also the commercial rationale for choosing a particular funding option,” the Tax Office said.
The ATO said it also expected businesses and groups to be able to explain how they structured their funding, including the mix of debt and equity and the types of debt used.
“Once you have entered into an arrangement, we expect you to maintain evidence to support the ongoing commerciality and arm’s length nature of your arrangement,” it said.
Factors attracting the ATO’s attention
The ATO warned businesses that they will be at risk of review if their business has significant related-party financing arrangements, factors that attract its attention, low tax performance or thinly capitalised Australian operations.
It also issued a list of the factors that may attract its attention with related-party funding arrangements which includes funding structures that have no or limited equity contributed by the investor or developer or funding that appears to be equity under arm's length conditions but is treated as debt.
“This is a risk because insufficient equity (capital) or excessive debt may result in excessive interest deductions,” it said.
Another factor that may attract the ATO’s attention is where there is insufficient evidence to support the arm’s length nature of related-party loans.
The ATO would also closely monitor related-party loans that are priced as subordinated debt, including where:
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There is no senior debt at all.
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More reasonable funding options were realistically available such as additional senior debt or equity.
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Group funding practices don't demonstrate the use of third-party subordinated debt in comparable circumstances.
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Used at the land acquisition stage, or in relation to stabilised assets (for example, existing income-producing property).
Interest expenses on related-party loans that would cause an investment or development to have questionable viability or not meet its profitability expectations would also attract attention.
“This is a risk because the use of non-arm's length terms and conditions (such as subordination) to justify higher interest rates may result in excessive interest deductions,” the ATO said.
“[Another] factor attracting our attention is an amount of related-party debt that exceeds what might be expected between parties acting at arm’s length in comparable circumstances.
“This is a risk because a non-arm’s length amount of related-party debt may result in excessive interest deductions.”
The ATO said it would also pay close attention to related-party loans that are not denominated in the operating currency of the Australian borrower as inconsistent borrowing currency may result in greater deductions to the Australian borrower.
The deferred payment or crediting of interest when the borrower has the financial capacity to meet payment obligations on related-party loans would also attract scrutiny.
The ATO would also pay attention to certain factors relating to the terms of the financing including:
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Misalignment between the funding needs of the investment or development, and the term of the related-party loan.
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Unpaid principal and accrual of interest on related-party loans beyond the investment period or project completion.
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Unpaid principal and accrual of interest beyond the term of the related-party loan.
The ATO would also closely monitor related-party loans priced as unsecured debt and whether related-party loans were repaid after the property was sold or when it generated sufficient cash flow.
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