Using these scenarios
If you receive funding from an overseas related entity or associate to acquire or develop property, these scenarios provide guidance. They show funding arrangements and behaviours including what we consider to be low risk and high risk scenarios.
These scenarios use companies to illustrate various funding scenarios, but the same principles apply to other entities such as trusts.
If you adopt funding arrangements and behaviours with higher risk factors, you are more likely to attract compliance activity.
Low risk scenario
Scenario 1
Project details
An Australian resident private company connected to a foreign individual investor was undertaking a residential development in Australia. The company acquired land for the development and sale of medium-rise residential apartments. The development project had a construction period of 2 years.
Funding
The company received funding in the form of equity (additional shares were issued to its shareholders) to fund the land acquisition. To fund construction and other development costs, they obtained external senior debt funding from a local Australian bank. The external debt was secured by a first (senior) ranking mortgage over the property. They had additional senior debt capacity available at the time.
During construction, the company obtained a loan from a foreign related party to fund the balance of construction costs. The total amount of debt obtained didn't exceed the senior debt capacity that was available. The terms and conditions of the external debt and related-party loan were comparable and included the following features:
- The pricing of the related-party loan was the same as the external senior debt.
- The loans were denominated in Australian dollars.
- Interest was
- payable regularly
- only capitalised into the principal amount during the construction period when there was insufficient cash flow from the project.
- The term of the loans aligned with the proposed duration of the development project.
- The loans were repaid from net sales proceeds soon after the completion of the development.
Documentation and compliance
The commercial nature of the funding structure and gearing levels were documented and could reasonably be explained. The related-party loan was contemporaneously formalised in a written and executed loan agreement. The agreement:
- set out the key terms and conditions
- reflected the substance of the arrangement.
The company assessed its compliance with Australia’s transfer pricing rules. It maintained transfer pricing documentation and evidence. This was to support the arm’s length nature of the related-party loan. It did so before lodging its tax return. The documents included transfer pricing analysis that:
- addressed Subdivision 815-B of the Income Tax Assessment Act 1997
- met the requirements of Subdivision 284-E of Schedule 1 to the Taxation Administration Act 1953.
The company monitored and reviewed its funding arrangements throughout the project lifecycle and as business circumstances changed. They kept contemporaneous records of all realistically available funding options they considered.
Conclusion
We consider this scenario low risk because:
- the company used equity (cash) to fund the land acquisition
- as they had senior debt capacity available, they didn't take on related-party debt on less favourable terms than it could have otherwise obtained using external senior debt
- they maintained evidence to support the commerciality of the funding structure including a combination of equity, external debt and related-party debt
- the pricing of their related-party loan was comparable to its external secured debt
- the form of the related-party loan as a debt interest was consistent with its substance.
High risk scenarios
Scenario 2
Project details
An Australian resident company was undertaking a residential development in Australia. They acquired land for the development and sale of medium-rise residential apartments. The development project commenced one year after the land was acquired and had a construction period of 2 years.
Funding
The company obtained funding for the land acquisition from a foreign related party. The funding was treated as a subordinated and unsecured loan. They had no other funding facilities at the time and didn't consider other options realistically available, such as the use of equity or senior debt funding.
To fund construction and development costs, the company:
- obtained external senior debt from a local Australian bank secured over the property
- increased the loan from its foreign related party.
The company did not invest any equity for the project including the land acquisition or development. There was no evidence to support a conclusion that:
- the financing arrangement was on commercial terms
- independent parties acting at arm’s length would have entered into an arrangement like this.
The related-party loan:
- had a term of 3 years
- attracted a higher fixed interest rate than the external debt.
During the development, interest was capitalised into the loan principal amount. The additional interest expense from the related-party loan caused the project to have poor expected profitability at the time of entering into the loan. The company didn't review the related-party arrangement throughout the project lifecycle.
All loans were repaid soon after the conclusion of the development.
Conclusion
We consider this scenario high risk because:
- the company invested no equity (such as unencumbered funds or cash) during the land acquisition or development
- the related-party funding for the land acquisition was treated as a subordinated and unsecured loan, despite the company having no senior ranking debt and the availability of security at the time
- the company was unable to demonstrate the commercial nature of its approach to funding the project (including the timing and amount of its subordinated debt)
- the interest rate charged on the related-party funding was higher than the interest rate on the external debt without justification for the arm’s length nature of the approach
- the company didn't review the related-party arrangement to ensure the transfer pricing treatment was appropriate each year.
Scenario 3
Project details
An Australian resident company connected to a foreign privately owned group undertook a residential development in Australia. They acquired land for the development and sale of medium-rise residential apartments. The development project had a construction period of 2 years.
Funding
The company contributed its own funds to acquire the land. To fund construction and development costs, it obtained a 2 year external senior debt facility and additional funding from a foreign related party. The related-party funding was treated as an interest-bearing loan with a term of 9 years. There was no evidence to support a conclusion that the 9-year term was appropriate. Nor was there evidence that independent parties acting at arm’s length would have entered such a loan given the:
- purpose of the funding
- proposed construction period at the time of entering into the related-party arrangement.
After the conclusion of the development, the company didn't repay the related-party loan. Interest accrued beyond project completion. The company used the net proceeds from the sale of properties to:
- repay the external bank loan
- fund another development project undertaken by an associated entity.
The company didn't review the related-party arrangement throughout the project lifecycle or once the properties were sold.
Conclusion
We consider this scenario high risk because:
- the term of the related-party loan was significantly longer than the duration of the external debt and development project
- the conduct of the parties was inconsistent with the purpose of the loan as
- the related-party loan remained unpaid beyond project completion and sales
- interest and deductions continued to accrue.
- the company didn't review the related-party arrangement to ensure the transfer pricing treatment was appropriate
- each year
- when business circumstances changed including once the properties were sold.
Scenario 4
Investment details
An Australian resident company was part of a privately-owned property investment group operating in Australia. They acquired a commercial investment property to earn rental income and generate capital growth. They intended to hold the asset for 5 years.
Funding
The company invested capital and obtained funding from a foreign associate to acquire the property. The funding from its associate was treated as an interest-bearing loan. A fixed interest rate was payable monthly for a term of 5 years. The loan was subordinated and provided without security to justify the high interest rate charged. They documented the terms and conditions of the related-party loan in a written loan agreement.
The company had no other funding facilities at the time. They didn't consider other options realistically available, such as the use of equity or senior debt funding. There was no evidence to support the commerciality of the funding structure.
The company generated sufficient cash flow from rental income to meet interest payment obligations. They claimed interest as a deduction as it accrued. However, they didn't pay the interest when it was due and payable.
After 5 years, they sold the property. However, they didn't repay the amounts owing on the loan at that time. Interest continued to accrue on the loan. They used the proceeds from the sale of the property to acquire another property. They didn't review the related-party arrangement throughout the investment period or once the property was sold.
Conclusion
We consider this scenario high risk because:
- the company was unable to explain and demonstrate the commercial nature of its funding structure
- the related-party loan was priced as subordinated debt even though the company had no senior ranking debt
- the related-party loan was priced as unsecured debt even though security (the property) was available
- the company didn't meet interest payment obligations despite its ability to service the related-party loan from cash
- the company claimed interest deductions but deferred payment, contrary to the lender’s entitlement to the interest under the agreement
- the company didn't review the arrangement to ensure the transfer pricing treatment was appropriate
- each year
- when business circumstances changed including once the property was sold
- the conduct of the parties was inconsistent with the terms and conditions of the loan as
- the related-party loan principal remained unpaid
- interest continued to accrue and was deducted beyond the documented term of the loan.