On 1 August 2018, the Australian Taxation Office (ATO) issued a draft "Schedule 2: Related party derivative arrangements" (the draft schedule) to be added to the ATO PCG 2017/4 "ATO compliance approach to taxation issues associated with cross-border related party financing arrangements and related transactions" (PCG).¹

The draft schedule (ATO link) is proposed to apply from 1 January 2019 and sets out 14 specific risk indicators for cross-border related party derivative arrangements that are used to hedge or manage the economic exposure of a company or group of companies. It follows the 2018 release of the PCG which set out the general ATO approach to risk assessment for cross-border related party financing transactions.

Taxpayers will be expected to self-assess the ATO perceived tax risk factors in relation to their related party derivatives. Depending on the answers, the risk assessments will range from green (low risk) to red (high risk). Taxpayers filing the Reportable Tax Position Schedule will need to disclose their risk assessment as part of the questions under Category C of that schedule.

It is important to note that a high risk assessment result under the draft PCG represents an indication of the ATO's perception of risk and will not necessarily indicate that the transaction is not arm's length. However, as with the PCG, taxpayers in the red zone can expect significant ATO examination of their positions.

Further to this, the draft schedule appears to take a broader approach to risk assessment for related party derivatives and escalates the tax risks of arrangements beyond the scope of the PCG.

EY has already highlighted initial concerns to the ATO. These include that the draft schedule:

• Has little regard to the concept in the PCG and finalized schedule 1, which identify motivational factors as relevant in risk assessment in addition to pricing. For example, there is no scope for even minimal divergence of related party derivatives in intermediary situations, consistent with appropriate arm's-length pricing.
• Is too broad in its application, specifically in regard to financial and insurance entities. Currently, only Australian Deposit-taking Institutions (ADIs) are exempt from the draft schedule's risk treatment of derivatives, which leaves the majority of financial service and insurance entities exposed to the risk framework and corresponding compliance actions. The draft schedule will require all non-ADIs to analyze every derivative, a significant if not impossible compliance burden both on taxpayers and the ATO. A broader exclusion of financial services entities is needed.
• Makes it very easy for entities to be considered to be in the red zone (high risk), due to multiple overlapping simultaneous indicators. The examples include a risk score of over 55 points, where merely 25 points causes a red zone classification.
• Affects derivatives entered into for purposes other than financing arrangements such as total return swaps or commodity hedges.
• Does not properly consider back to back arrangements, and in particular the pricing and margins. The draft schedule states that related party derivatives will be high risk unless the terms and conditions of both sides of the arrangement mirror each other, and any divergence will result in a high risk score. EY plans to raise that a derivative being broadly commercially equivalent would be more appropriate. Treasury centers typically aim to reach an overall net hedge position so it is important an interposed finance entity can pass on the risk entirely, but with different maturity dates and durations to enable hedging of the risks.

Given the current proposed start date of 1 January 2019 for the draft schedule, businesses should consider the potential impact, and consider issues to be raised as part of our formal EY submission, or have EY file a submission on their behalf.

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ENDNOTE

¹ See EY Global Tax Alert, Australian Taxation Office Cross-Border Related Party Risk Assessment Guide: A detailed review, dated 22 December 2017.

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CONTACTS

For additional information with respect to this Alert, please contact the following:

Ernst & Young (Australia), Sydney

• Sean Monahan
  sean.monahan@au.ey.com
• Anthony Seve
  anthony.seve@au.ey.com

Ernst & Young (Australia), Melbourne

• Andrew van Dinter
  andrew.van.dinter@au.ey.com

Ernst & Young LLP, Australian Tax Desk, New York

• David Burns
  david.burns1@ey.com

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ATTACHMENT

PDF version of this Tax Alert