Build to rent exposure draft legislation released

On 9 April 2024 Treasury released exposure draft legislation that aims to encourage investment in new build-to-rent (BTR) housing developments that were announced on 28 April 2023. The exposure draft is open for consultation for 14 days.

In summary:

  • The draft legislation proposes two main tax concessions for eligible BTR developments:
    1. Increasing the capital works deduction rate from 2.5% to 4% per year. This allows investors to depreciate the construction costs of a BTR project over 25 years instead of 40 years and applies for the life of the project (provided certain conditions are met for 15 years).
    2. Reducing the withholding tax rate on fund payments from managed investment trusts (MITs) that invest in BTR from 30% to 15%, but only for a 15 year period once operations commence (and there may not be taxable income in early years in any event given depreciation and financing costs). The rules assume BTR projects can be held by managed investment trusts, which is not something the ATO has always accepted in the past. However, there is no concessional withholding rate on the distribution of any capital gain on disposal.
  • The eligibility conditions are quite prescriptive. The requirements for 15 year single ownership, 3 year lease offers and 10% affordable housing across a mix of dwelling types set a high bar.
  • The accompanying ‘misuse’ measures impose significant penalties in the event that the building ceases to be an active BTR development within 15 years.
  • Finally, there are still GST and state tax issues with BTR that are yet to be addressed.

 BTR Eligibility Criteria

To qualify for the BTR tax incentives, developments must meet the following conditions:

  • Construction must have commenced after 7:30pm AEST on 9 May 2023;
  • The development must include at least 50 dwellings offered for rent to the public;
  • All dwellings and common areas must be owned by a single entity for at least 15 years;
  • Dwellings must be offered for lease terms of at least 3 years (unless a shorter term is requested by the tenant); and
  • At least 10% of the dwellings must be affordable housing (defined as dwellings rented for 74.9% or less of the market rent for comparable dwellings), and there must be a ‘matching’ affordable dwelling for each category of dwelling available (eg if a development includes 2 penthouses, one must be affordable housing)

BTR projects can include new builds as well as substantial renovations that convert existing buildings like warehouses into rental apartments.

Meeting the eligibility criteria in aggregate across multiple co-located buildings is permitted. For example, two towers on one plot of land could qualify as a single BTR development if they collectively meet the criteria, even if one tower falls short on its own.

The single ownership requirement may present issues where direct income from tenants is attributable to common areas. There is an additional requirement to access the lower MIT rate under the exposure draft that the relevant part of the fund payment by the MIT is attributable to rental income “under a lease of a dwelling”. Accordingly; in cases where an explicit licence over common areas is recognised, even if a separate licence fee is not provided for, there may be a need to consider if this portion of rental income would arise under a lease of the dwelling, instead of under a licence of separate common areas.

Maintaining Active BTR Status

The legislation introduces the concept of an “active BTR development”. Once a development first meets all the eligibility criteria, it commences being an active BTR development and the 15-year compliance period begins. The development must continue to satisfy the eligibility criteria for the full 15 years to maintain its active status and the associated tax concessions.

Some allowances are made for temporary vacancies to renovate or repair dwellings. Adding new dwellings to an active BTR development is also permitted. The new dwellings are subject to a fresh 15-year compliance period while the pre-existing dwellings remain subject to the original compliance period.

If a BTR development ceases to be active within the 15 years (eg some dwellings are sold or offered only on short leases), the “BTR misuse tax” is triggered to claw back the tax benefits obtained to that point, plus an additional 8% penalty / interest component. The development is also treated as only ever being entitled to the standard 2.5% capital works deduction rate rather than the 4% BTR rate.

Affordable Housing Requirements

At least 10% of dwellings in a BTR development must be designated as affordable housing. These dwellings must be rented at 74.9% or less of the market rent for similar dwellings. The relevant market rent could potentially be determined by reference to external benchmarks. There will be potential for disagreements about market rent and then whether the rent of the affordable housing component is set at no more than 74.9% of market rent.

The affordable rental dwellings must be representative of the overall dwelling mix in the development. It is not permitted to only designate the smallest or least attractive apartments as affordable housing. At least one dwelling of each type (by floorspace, number of bedrooms, etc.) must be offered at an affordable rent.

Eligibility for affordable rental housing can be subject to tenant income requirements set by the Government to ensure the discounted rentals are targeted to low and moderate income earners.

It is not clear what happens if a tenant who is a low to moderate income earner, receives a salary increase which moves that person out of this bracket. There does not seem to be any concessional period for adjustment so owners may have to build in a buffer of safety.

MIT Withholding Tax Reduction

Under the existing law, passive rental income earned by MITs and attributed to foreign investors is generally subject to a 30% withholding tax. The draft legislation lowers this to a 15% concessional rate for MITs that derive rental income from investing in active BTR developments during the 15-year compliance period.

This concession makes Australian BTR projects more competitive with other international opportunities from the perspective of foreign institutions investing via MIT structures.

The 15% MIT rate applies only while a project maintains active BTR status. If active status ceases within 15 years, the BTR misuse tax applies to claw back the tax benefits obtained.

However, there is no concessional withholding rate on the distribution of any capital gain on disposal.

Administration and Integrity Measures

The draft legislation includes specific reporting and notification obligations for BTR proponents to support administration and integrity of the concessions.

Owners must notify the ATO within 28 days whenever:

  • A development first commences being an active BTR development
  • An active BTR development is expanded with additional dwellings
  • Ownership of an active BTR development changes
  • An active BTR development ceases to be active.

Trustees of MITs are also required to notify the ATO before paying any distributions to foreign investors that include concessional BTR rental income.

The BTR misuse tax is the main integrity measure to deter abuse of the concessions. If a development ceases to be an active BTR development within 15 years, the misuse tax applies to capture:

  • the amount by which the accelerated 4% capital works deductions exceeded the standard 2.5% deductions, grossed up at the owner’s marginal tax rate and subject to an uplift factor
  • 10 times the amount of rental income distributions by MITs that benefited from the 15% concessional withholding tax rate instead of the 30% rate, also subject to an uplift factor.

The misuse tax is roughly calibrated to neutralise the tax benefits obtained, plus an additional amount representing interest on the tax shortfall. The ATO has powers to amend prior year assessments to give effect to the misuse tax if required. No tax deduction is allowed for misuse tax incurred.

Commencement and Transitional Arrangements

The BTR concessions only apply to developments that commence construction after 7:30pm AEST on 9 May 2023, the date the measures were announced. This start date requirement applies even if a development does not meet all the other eligibility criteria to be an active BTR development until a later income year.

The legislation package commences on the first 1 January, 1 April, 1 July or 1 October after it receives Royal Assent. All provisions of the primary Bill are conditional on the separate imposition Bill (which imposes the BTR misuse tax) also commencing.

State Taxes concessions for BTR Developments

Broadly speaking: 

  • In addition to the duty normally payable when a person acquires land, an additional duty surcharge rate (of up to 8%) applies to a foreign acquirer of residential land, unless an exemption applies. An exemption from surcharge duty may apply for residential developers generally or for land that is developed into an eligible BTR. (No foreign surcharge duty applies in ACT or NT.)
  • Land tax is generally payable by an owner of land (except in NT), calculated on the taxable value of land. A concession applies to reduce the taxable value by half for eligible BTR developments (generally during the operational phase and for a specified period only, eg 20 – 30 years).
  • In addition to ordinary land tax, a surcharge land tax of up to 4% applies to land owned by a foreign person (other than in WA, SA and NT). An exemption may apply during the development phase of a BTR project, and in some cases for a specified period during the operational phase.

The requirements to access BTR concessions vary between the States and Territories (see our detailed note here), but at a high level some key features to qualify as an eligible BTR development include:

  • a new development – being a new building or a conversion usually from a non-residential to residential use;
  • a parcel held within a unified ownership structure (but can be co-owned);
  • management of the BTR development must be provided by a single entity (eg management of the leases, common areas, facilities etc), including on-site management access for tenants. Affordable/social housing can be separately operated;
  • a minimum number of self-contained dwellings (eg 50 or more);
  • residential tenancy agreements offered to the public (ie not a subset such as student accommodation), meeting specified requirements including an offer of a fixed term lease of at least 3 years (but tenants may opt for a shorter term);
  • required proportions of affordable/social housing; and
  • required proportions of labour sourced from certain classes of workers.

Although there are broad similarities between the requirements from a state tax perspective with the requirements to access income tax concessions under the draft legislation, there remains key points of difference. In particular:

  • it is generally possible to access state tax concessions where the BTR development is owned in a tenancy in common structure, provided that a single management entity is jointly engaged by both co-owners to manage the BTR development. However, this kind of structure would appear to be inconsistent with the “single entity” requirement under the draft legislation.
  • for the States which require a fixed proportion of the BTR development be available for affordable housing, the relevant tests looks only to whether numerically there are sufficient dwellings available on an affordable housing basis. There is no additional requirement that each category of dwelling are available on an affordable housing basis.
  • most of the States require that the first stage of a BTR development deliver at least 40 or 50 dwellings, otherwise the state tax concessions are not available. For example, if a BTR development delivers 35 dwellings (stage 1 occupancy certificate issued) and then subsequently delivers a further 50 dwellings (stage 2 occupancy certificate issued), concessions would only be available for the stage 2 dwellings. If this occurs in the reverse order, concessional status is available for all dwellings. This strict staging concept is not included in the draft legislation (rather concessional status is available once 50 dwellings are offered for rent to the public) so it is important to be aware of the difference for staged developments from a state taxes perspective.

Key contacts

James Pettigrew
James Pettigrew
Partner, Sydney
+61 2 9322 4783
Jinny Chaimungkalanont
Jinny Chaimungkalanont
Partner
+61 2 9322 4403
Ryan Leslie
Ryan Leslie
Partner, Melbourne
+61 418 186 499

Mark Peters
Mark Peters
Solicitor, Sydney
+61 2 9322 4099

Decision Alert: Federal Court finds PepsiCo liable for royalty withholding tax and potential diverted profits tax

By Ryan Leslie, Geraldine Chan and Graeme Cooper

Overview

The Federal Court has ruled in favour of the Commissioner of Taxation (Commissioner) against PepsiCo, Inc (PepsiCo) in PepsiCo, Inc v Commissioner of Taxation [2023] FCA 1490 (30 November 2023). The case concerned PepsiCo’s “royalty-free” agreements with Schweppes Australia Pty Ltd (SAPL).

The Federal Court ruled that PepsiCo was liable for royalty withholding tax (at a 5% rate) in relation to portions of payments made under exclusive botting agreements (EBAs) which were held to be royalties and, in the alternative, diverted profits tax (DPT) would apply at a rate of 40%, i.e. if the payments were not royalties.

This decision was the first time the DPT provisions were considered by a Court. PepsiCo have now appealed the decision. In order to achieve a successful outcome, PepsiCo needs to succeed on both the royalty issue and the DPT issue. If PepsiCo succeeds on the royalty issue but doesn’t also succeed on the DPT issue on appeal, this would increase the tax bill 8-fold.

Key takeaways

  • Scrutiny of “royalty-free” arrangements: the case further emphasises the ATO’s ongoing focus on cross-border intangible arrangements where royalty withholding tax has not been paid, including where licences are granted and no express royalty is payable. Multinational entities operating in Australia under similar arrangements may face increased scrutiny. The ATO has also released a draft taxation ruling TR 2024/D1 Income tax: royalties – character of payments in respect of software and intellectual property rights, which reflects its current draft views on when payments made in respect of software and intellectual property rights will be a royalty. Those views continue to differ from those expressed in the now withdrawn ruling TR 93/12.
  • A broader approach to characterisation of “royalties”?: previous case law in IBM and Task Technology had emphasised that in determining whether payments made are characterised as royalties, Australian courts have interpreted the rights and obligations under the relevant agreement,’ as the agreement will determine whether the payments are for the right or use of, relevantly, software. However, the decision of the Federal Court indicates that in considering whether a payment constitutes a “royalty”, it is necessary to consider the characterisation of the relevant payments and the terms of the relevant agreements in their “business and commercial context”. The Court drew support from section 6(1) of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936) which defined royalty regardless of how the payments are described and that Article 12(4) referred to payments “of any kind”.
  • Payments from an Australian resident entity to another Australian resident entity may give rise to royalty withholding tax: the Federal Court found that the payments made by SAPL were “income derived by” and “paid at the direction of” PepsiCo since the EBA obliged SAPL to buy concentrate from PepsiCo or a subsidiary nominated by PepsiCo. Such a broad reading of the EBA would appear to impose a withholding obligation on SAPL (despite SAPL paying an Australian entity and not being pursued for failure to withhold penalties based on the facts described in the case).
  • DPT: the Federal Court’s decision sheds some light on the application of the DPT provisions. It confirms that the “principal purpose test” within the DPT provisions is a lower bar compared to the “dominant purpose test” within the general anti-avoidance provisions. The Federal Court confirmed that the meaning of “principal purpose” is “a purpose that is a prominent, leading or main purpose”, of which there can be more than one but need not be the dominant purpose.

Background

PepsiCo and Stokely-Van Camp, Inc (SVC), had EBAs with an independent Australian bottling company, Schweppes Australia Pty Ltd (SAPL). Under this agreement, PepsiCo or SVC agreed to sell, or cause a related entity to sell, beverage concentrate to SAPL for bottling and sale, and granted SAPL the right to use the Pepsi and Mountain Dew trademarks. However, no royalties were paid under the agreement, and therefore, no withholding tax was paid in Australia. The only relevant payments made were for the purchase of concentrate. During the 2017-18 and 2018-19 years (the Relevant Years):

  • Concentrate Manufacturing (Singapore) Pte Ltd (CMSPL), a Singaporean entity and a member of the PepsiCo Group, produced concentrate according to a recipe or formula provided by PepsiCo and SVC;
  • CMSPL supplied the concentrate to PepsiCo Beverage Singapore Pty Ltd (PBS), an Australian entity also a member of the PepsiCo Group;
  • PBS supplied concentrate to SAPL and invoiced SAPL for the concentrate that had been supplied and SAPL paid PBS for the concentrate; and
  • PBS transferred the money received from SAPL to CMSPL (we assume as a concentrate purchase price – the ATO did not seem to assert that any portion of this payment was a royalty), retaining only a small margin.

It is interesting to note that the terms of the EBAs were changed in 2020, and the payment and pricing terms were removed from the EBAs and instead moved to a separate Concentrate Sale Agreement. Such a change may have led to a different tax outcome for Pepsico and SVC, however this was not considered by the Federal Court as the change to the terms of the EBAs occurred after the Relevant Years.

The Commissioner issued royalty withholding tax notices under section 128B of the ITAA 1936 to PepsiCo and SVC requiring both entities to pay approximately $3.6 million in royalty withholding tax on money paid by SAPL to PBS.

In the alternative, the Commissioner issued DPT assessments pursuant to Part IVA of the ITAA 1936 imposing a tax liability of $28.9 million on PepsiCo and SVC.

Decision

Royalty withholding tax

The Federal Court held that royalty withholding tax was payable because:

  • a portion of the payments made by SAPL to PBS were “consideration for” the use of, or the right to use, the relevant trademarks and other intellectual property which were provided under the EBAs, in the circumstances of this case. As such, the payments satisfied the definition of “royalty” in Article 12(1) of the US DTA and section 6(1) of the ITAA 1936. Although PBS was not a party to the EBAs, the Federal Court held that payments made by SAPL and PBS were linked to the license of PepsiCo’s trademarks and intellectual property (that is, without PepsiCo’s trademarks and IP: (a) SAPL would not have been able to package and sell the beverages under PepsiCo’s and SVC’s brands and if so, it could be inferred that SAPL may not have agreed to make the payments, and (b) a failure by SAPL to perform its payment obligations could result in a termination of the agreement and therefore the licence). The Federal Court’s consideration of the treaty was on a ‘textual’ basis and did not consider extrinsic materials that may have assisted in interpreting it;
  • the circumstances in which a royalty will be found to be payable extend beyond the terms of the agreement, and may include the business and commercial context in which the agreement was struck. In the circumstances, his Honour considered that it was appropriate to look beyond the description of the payments in the agreement between the parties. His Honour concluded that “the licence of the trademarks and other intellectual property was fundamental to the agreement” and that “the payments…were linked with the licence of the trademarks and other intellectual property”;
  • the relevant portions of the payments were income derived by PepsiCo or SVC for the purposes of section 128B(2B)(a) of the ITAA 1936 and amounts to which they were beneficially entitled for the purposes of Article 12 of the US DTA. As PBS was nominated as the seller of the concentrate under the EBAs, the Federal Court held that this constituted a direction to pay PBS rather than PepsiCo/SVC. The payments therefore “came home” to PepsiCo/SVC by being applied as they directed; and
  • for the same reasons above, the relevant portions of the payments were therefore deemed to have been paid by SAPL to PepsiCo or SVC by virtue of section 128A(2) of the ITAA 1936. The payments were “dealt with on behalf of PepsiCo/SVC” or dealt with “as PepsiCo/SVC directs” as the Federal Court concluded that PepsiCo and SVC were entitled to receive the payments made by SAPL under the EBAs and had nominated PBS as the seller of the concentrate under the EBAs, and thereby directed SAPL to pay PBS.

The conclusion that the payments were “income derived by” entities other than the entities which sold the concentrate seems to rely on a very broad interpretation of the relevant concepts.

DPT

The Federal Court held that if the royalty withholding tax provisions did not apply, the DPT provisions would apply.

The alleged scheme was entry into the EBAs on terms whereby no royalty was paid for the use of intellectual property. In determining that each of PepsiCo and SVC obtained a “tax benefit”, The Federal Court accepted the Commissioner’s counterfactual that absent the scheme, the EBAs might reasonably have been expected to express the payments to SAPL to be for all of the property provided by PepsiCo rather than for concentrate only. Consequently, PepsiCo/SVC might reasonably be expected to have been liable to pay royalty withholding tax on a portion of the payments.

The Federal Court ruled that:

  • each of PepsiCo and SVC obtained a tax benefit in connection with the relevant scheme; and
  • having regard to the matters in section 177J(2) of the ITAA 1936, it would be concluded that PepsiCo and SVC in entering into or carrying out the relevant scheme had a principal purpose to obtain a tax benefit (not being liable to pay Australian royalty withholding tax) and to reduce foreign tax (US tax on their income). Relevantly, the Federal Court considered that one of the factors indicating the presence of the requisite principal purpose was the disconnect between the form and substance of the EBAs. In form, the payments to be made by SAPL were for the concentrate alone and not for the licence of the trademarks and other intellectual property. However, in substance, the payments to be made by SAPL were for both the concentrate and the licence of the trademarks and other intellectual property.

Although PepsiCo was unsuccessful in arguing that the royalty withholding tax provisions did not apply to the arrangement, the tax liability for PepsiCo and SVC would have been significantly higher if the royalty withholding tax provisions did not apply and the DPT applied instead (5% of the royalty amount under the royalty withholding tax provisions compared to 40% of the royalty amount under the DPT provisions).

In view of PepsiCo’s decision to appeal the decision, we expect that a superior court’s view on the issues will be instructive on both the royalty and DPT issues, though it of course remains possible a settlement is reached before an appeal is heard given the downside risk if the royalty withholding tax aspects of the appeal succeed and the DPT aspects do not.

Key contacts

Ryan Leslie
Ryan Leslie
Partner, Melbourne
+61 418 186 499
Geraldine Chan
Geraldine Chan
Solicitor, Melbourne
+61 3 9277 2706

Graeme Cooper
Graeme Cooper
Consultant, Sydney
+61 2 9322 4081

Tax Insight – Senate Report on Thin Capitalisation Provisions

On 22 September 2023, the Economics Legislation Committee handed down the final report of its inquiry into the provisions of the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share-Integrity and Transparency) Bill 2023. The Report is deeply disappointing and does not augur well for other important consultations. This Tax Insight focuses on the parts of the Bill and Report dealing with the thin capitalisation provisions.

1.  Background

The background to this Bill starts with the proposal announced by the ALP in April 2022 as part of its tax policies for the 2022 election to change the thin capitalisation test to one based on the ratio of interest expense to earnings, rather than the ratio of debt to asset values. (The ALP’s election policies with respect to tax are available here.)

After the election, in August 2022, Treasury released a Consultation Paper, Government election commitments: Multinational tax integrity and enhanced tax transparency which laid out some of the likely parameters of the new design. (Our Tax Insight on the Consultation Paper is available here.)

In March 2023, Treasury released an Exposure Draft of provisions to give effect to the policy. The Draft did give effect to the Government’s promise to reconceptualise the thin capitalisation regime, but it also included an unexpected proposal to repeal s. 25-90, denying a deduction for interest incurred to capitalise or buy foreign subsidiaries. While this surprise attracted the most attention, the Exposure Draft contained other problematic provisions. (Our Tax Insight on the Exposure Draft is available here.)

The furore created by the Exposure Draft caused Treasury to modify its position somewhat. When the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share – Integrity and Transparency) Bill 2023 was introduced into the House of Representatives in late June 2023, the contentious proposal to repeal s. 25-90 was removed for further consultation, but it was replaced by another surprise – a so-called “debt deduction creation” regime. Many of the problematic provisions of Exposure Draft had not been resolved. (Our Tax Insight on the Bill is available here and our podcast is available here.)

2.  Senate Committee process and recommendations

The Senate then referred the Bill to the Senate Economics Legislation Committee. The Committee received 53 submissions on the Bill by 21 July and held one day of public hearings on 15 August. Its report was released on 22 September 2023.

Most of the submissions from the tax profession and industry addressed technical shortcomings with the design and the drafting, focussing on issues such as:

  • issues in the current calculation of EBITDA,
  • difficulties in the accessing the external debt test,
  • difficulties meeting the conditions for the conduit financier regime,
  • problems applying the fixed ration and group ratio rules to groups of trusts,
  • transitional rules and commencement dates,
  • substantial issues in relation to the “debt deduction creation” regime and the seemingly broader than anticipated scope of operation,

and so on. Those submissions were consistent and thorough.

The Committee split along party lines with a majority position endorsed by the 4 members from the ALP and Greens, and a minority position from the 2 Liberal members. The majority recommendation was that, “the bill be passed subject to technical amendments foreshadowed by Treasury.” In other words, the Committee was completely unmoved by any of the submissions other than accepting an undertaking by Treasury to make “minor technical amendments” which Treasury acknowledged in the hearing. These included:

  • making clarifications to the Australian resident requirement so that the third party debt test applies to trusts that may have been ‘inadvertently excluded’ in the drafting of the bill”;
  • a possible “narrowing of the (debt deduction creation) rules” which could involve “excluding the securitisation vehicles and even perhaps the authorised deposit-taking institutions (ADIs) on a similar basis to how they’re excluded from the proposed amendments to the thin capitalisation rules…”; and
  • Including certain exclusions which would clarify the operation of the rules modelled on the former 16G ITAA 1997 (sic) exclusions”

The qualification that Treasury can make the “technical amendments [it] foreshadowed” implies that these changes have been evaluated and endorsed by the Committee, but apparently “this committee has not seen those amendments, despite the request by committee members for Treasury to provide them …” This is particularly disappointing given industry had less than 4 weeks to make submissions but Treasury, having had the benefit of 2 months to review the submissions and 5 weeks from the public hearings, was still not in a position to provide the proposed amendments to the committee for review. So, it seems the majority was content to leave everything to the wisdom of Treasury and inquire no further.

Equally as concerning was the majority’s acceptance of the justification for the debt creation rules. Treasury and the ATO only provided high level reasons, without specific examples of issues that were of concern: “When we drafted the current debt deduction creation law, we drafted it with a view to other guidance and perhaps changes in legislation that have occurred since the original rules were in place” … and  “… we are aware of views in the tax advisor community that the absence of the debt creation laws since 2001 actually allowed for debt creation schemes to take place in a way that we can’t otherwise address without these rules, so there’s evidence of it in the past.”

Similarly, requests by taxpayers and the profession for the debt deduction creation rules to be grandfathered were waved away as being too administratively difficult for taxpayers to track and too complex to draft, despite a grandfathering rule having been introduced when changes were made to the rules governing sovereign immunity. In addition, requests for the start date of the thin capitalisation rules to be deferred were met with a dead bat on the basis that “essentially, the changes commencing from 1 July 2023 would only need to be reported in tax filings for the 2023-24 financial year, which, for ordinary June balances, would not be until later in 2024. So there is also time for entities to make appropriate changes accordingly.”

3.  Next steps

Given tenor of the report, it seems likely that the Government will simply accept the report and adopt its recommendations. Whether or not Treasury will decide to fix any of the technical drafting defects before the Bill is enacted remains to be seen, but given the composition of the committee, it is almost certain that whatever Treasury decides to do will just be rubber-stamped by both Houses of Parliament.

Toby Eggleston
Toby Eggleston
Partner, Melbourne
+61 413 151 183
Nick Heggart
Nick Heggart
Partner, Perth
+61 437 001 229
Ryan Leslie
Ryan Leslie
Partner, Melbourne
+61 418 186 499
James Pettigrew
James Pettigrew
Partner, Sydney
+61 2 9322 4783
Jinny Chaimungkalanont
Jinny Chaimungkalanont
Partner, Sydney
+61 418 479 417

Tax Insight – Debt Creation Regime

It was not a complete surprise when the proposal to repeal s. 25-90 was omitted from the thin capitalisation Bill introduced into Parliament on 22 June – the lobbying against the measure had been extensive. But Treasury’s decision to include a new debt creation regime instead was unexpected. Having considered the new debt creation rules, this may be a case of, be careful what you wish for.

1.     Background

In the lead-up to the May 2022 election, the ALP announced that, if elected, it would replace Australia’s existing asset-based thin capitalisation regime with a model based on the recommendations of the OECD’s Final Report on BEPS Action 4: to cap debt deductions by multinationals at 30% of earnings. The ALP had taken a different policy to the 2019 election, proposing to repeal all but the ‘worldwide gearing ratio’ as the thin capitalisation test for Australian entities.

In August 2022, after the ALP election win, Treasury released a consultation paper, Government election commitments: Multinational tax integrity and enhanced tax transparency posing questions about the implementation of the policy, along with questions about a group-based fixed ratio test (in lieu of the existing worldwide gearing test) and an external debt test (in lieu of the existing arm’s length debt test).

In March 2023, Treasury released an Exposure Draft of the thin capitalisation provisions. The Draft also included a proposal to repeal s. 25-90 (and the parallel s. 230-15(3)(c) in the TOFA provisions). Not surprisingly, this provision in the Exposure Draft drew loud complaints as this proposal had not been mentioned in the campaign for the 2019 election or the 2022 election or in the August 2022 consultation paper.

It was not a big surprise when the proposal to repeal s. 25-90 was omitted from the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share – Integrity and Transparency) Bill 2023 when it was introduced into the House of Representatives on 23 June 2023. But the decision to substitute a debt creation regime was completely unexpected. This regime will be difficult to negotiate and will operate as a serious impediment on corporate restructuring and intra-group debt in many circumstances.

The Bill was referred to the Senate Standing Committee on Economics on 22 June, and submissions closed on 21 July. The Committee received over 40 submissions, with many focussed on the debt creation component. The Committee’s report is due by 31 August.

2.     Debt creation

The Bill attacks debt deductions arising from debt connected with two scenarios:

  • Debt (from related parties or third parties) which is used to fund the acquisition, refinancing or retention of assets (or liabilities) acquired from an associate pair [s. 820-423A(2)]; and
  • Debt (from related parties only) that is used (or helps) to finance a payment or distribution to an associate pair [s. 820-423A(5)].

At first glance, the scope of the regime seems tolerably clear, but many traps and snares lie hidden in the text. A few of the more obvious problems based on the current drafting of the Bill are:

  • even though the debt creation provisions will be located in Div 820, the drafting expressly undoes many of the exceptions from the thin capitalisation rules which currently exist. Consequently, taxpayers who currently enjoy an exception from the rest of the thin capitalisation regime (for example, insolvency remote SPVs or investors with 90% of their assets onshore) may find they are exposed to the debt creation rules;
  • in the same vein, the debt creation rules will operate alongside the thin capitalisation rules. So taxpayers who can pass the interest-to-earnings test or external debt test, are nevertheless still exposed to the debt creation regime;
  • there are no express cross-border elements to the operative rules. Consequently, entirely domestic transactions will be caught if done by an entity within the scope of Div 820 (usually, an associate of the entity with the cross-border operations). So, the rules can apply to resident-to-resident sales, or to borrowing from residents who will be assessable in Australia on the interest;
  • one of the more curious interpretation issues is the application of the rule to “acquiring … a legal obligation” from a “disposer”. Does this mean taking on an obligation (ie, borrowing from an associate “disposer”) or “acquiring” an existing obligation from the obligor (which would be acquiring a CGT asset, a transaction that is already covered)? If the phrase means taking on an obligation, then it would amount to a blanket ban on all related party debt, whether the debt is used to finance the acquisition of an asset, or making a payment, or anything else;
  • the second limb of the test denies a deduction for interest on debt which helps an entity make a “payment.” The term “payment” is not defined, so presumably it would include all payments such as paying the price for goods, land or services, repaying the principal of a loan, returns of capital or share buy-backs, and so on; and
  • the language of the Bill attempts to diminish the importance of a direct linkage between the borrowing and the use of the funds. For example, it will be sufficient if the money is used “predominantly” in one of the prohibited ways so presumably the borrowed funds can be supplemented or depleted for other uses, and the rule will still have partial effect. And, so far as the second rule is concerned, the money does not need to be strictly traceable into a payment or distribution to the associate; it will be sufficient if the borrowed money will “increase the ability of any entity … to make …” a prohibited payment or distribution.

The examples in the Explanatory Memorandum (EM) do not acknowledge any of these problems and the potential unintended breadth of its operation. Instead, the EM justifies these rules using examples where there might be some mischief:

  • “debt deductions arising from debt [which] funded the acquisition of shares in a foreign subsidiary from a foreign associate; or business assets from foreign and domestic associates in an internal reorganisation after a global merger”
  • “debt deductions arising from related party debt created by an entity to fund or increase the ability of the entity to make payments to a foreign associate as part of an entirely internal restructure …”.

The Bill does not acknowledge that the rules can be enlivened in innocuous situations: where no additional debt is being introduced into the group, or where interest which used to flow offshore will now be paid to a resident instead. Rather the EM expressly acknowledges the potentially wide application of the provisions:

The provisions are drafted broadly to help ensure they are capable of applying to debt creation schemes of varying complexity. This approach is necessary given the ability of multinational groups to enter into complex debt creation arrangements.

These rules will need to be very carefully considered for any debt connected with a group restructuring (whether of entities or assets), and for any related party debt.

3.     Anti-avoidance rule

Recommendation 6.2(b) of the final report of the 1999 Ralph Review of Business Tax recommended that Part IVA be used “as the preferred response to … tax avoidance”, and that specific rules should be enacted only if, “they offer a more structured, targeted and cost-effective response”. For some reason, the drafters have ignored this recommendation and decided it will be useful to have a dedicated anti-avoidance rule just to protect the debt creation regime. The anti-avoidance rule will reinstate the operation of the debt creation rules where “the Commissioner is satisfied” a scheme has been put in place for a principal purpose that includes achieving the result that neither sub-section applies.

As with any anti-avoidance rules, there is obviously a great deal of wariness about just how ambitious the ATO will be in exercising its discretion to trigger the rule. For example, would the ATO assert these decisions are amenable to challenge:

  • the decision to raise external debt (rather than internal debt) to fund a payment to an associate, or
  • the decision to buy trading stock direct from a third party manufacturer (instead of via an associate wholesaler), or
  • the policy of acquiring assets from related parties with retained earnings or new equity, and using debt only to acquire assets from unrelated parties, or
  • the policy of using retained earnings to fund dividends, while at the same time borrowing from an associate to meet working capital expenses such as funding payments to staff and suppliers?

4.     Commencement and transition

The commencement rule in the Bill says the debt creation rules will apply to debt deductions incurred after 1 July 2023 regardless of (say) when the financed assets were acquired.

No express grandfathering or transition rule is provided, a situation which perhaps makes some sense for the general thin capitalisation provisions (debt on foot as at 1 July 2023 was already being measured against an assets-to-debt test, and will now be measured against an interest-to-earnings test instead). But the decision to apply the new regime to debt associated with corporate restructures which may have happened decades ago is more than a little surprising, especially given that the decision to defer the repeal of s. 25-90 was influenced in no small part by the retrospective impact of the change. Repealing s. 25-90 required unscrambling 20 years’ worth of eggs; applying the debt creation rules to debt associated with historic restructures will be just as hard.

Hopefully a suitable transitional rule will be added as a result of the Senate committee’s work. When a similar regime was introduced in 1987, the regime applied to interest incurred after 1 July 1987 but not if the acquisition of the financed asset had happened prior to that date, so there is a precedent for applying this kind of rule only to interest associated with a post-commencement restructuring.

5.     Debt creation, alongside the repeal of s. 25-90

Even though the Explanatory Memorandum says the debt creation regime is being advanced while the proposed repeal of s. 25-90 is subject to further consultation, it seems highly likely that the debt creation regime will survive the repeal of s. 25-90.

The table below shows there would still be scope for:

  • the debt creation rules to operate after the repeal of s. 25-90 (eg, the repeal of s. 25-90 has an impact if the borrowed money is connected to a dividend receipt while the debt creation rules apply if the borrowed money funds a dividend payment), and
  • for the consequences of the repeal of s. 25-90 to have an impact even in the presence of the debt creation regime (eg, the repeal of s. 25-90 has an impact if the borrowed money is used to acquire a 10% shareholding from an unrelated entity while the debt creation rules would not apply unless both the borrowed money is used to acquire a larger stake and from a related party).
Section 25-90 Section 820-423A(2) Section 820-423A(5)
Lender is … Debt deductions on money borrowed from anyone Debt deductions on money borrowed from anyone Debt deductions on money borrowed from an associate pair
Funds used for … Borrowed funds are used to acquire shares (which pay NANE dividends) – ie, typically a 10% stake Borrowed funds are used to acquire (refinance or retain) any CGT asset or a liability Borrowed funds are used to fund a payment or distribution to an associate pair
Asset acquired from … Assets (shares) are acquired from anyone or issued by subsidiary Asset or liability is acquired from (or created by) an associate pair N/A

 

6.     What next?

As mentioned above, the Bill is currently being considered by the Senate Standing Committee on Economics, which is due to table its report by 31 August 2023. Assuming it recommends some changes to the Bill, it will then be up to the Government to decide whether or not to accept those recommendations. The Government has sufficient members on the Committee to suspect the report will not simply be ignored, but the taxation of multinational businesses is an area where the Government seems reluctant to modify announced views.

Toby Eggleston
Toby Eggleston
Partner, Melbourne
+61 413 151 183
Nick Heggart
Nick Heggart
Partner, Perth
+61 437 001 229
Ryan Leslie
Ryan Leslie
Partner, Melbourne
+61 418 186 499
James Pettigrew
James Pettigrew
Partner, Sydney
+61 2 9322 4783
Graeme Cooper
Graeme Cooper
Consultant, Sydney
+61 2 9322 4081
Jinny Chaimungkalanont
Jinny Chaimungkalanont
Partner, Sydney
+61 418 479 417

Tax Insight: Signs of BEPS Life

The Inclusive Framework of the OECD/G20 has released an “Outcome Statement” on developments in the long-running BEPS project. The Statement is evidence of life for the BEPS project. It focuses on work done but not yet public, rather than announcing significant progress on achieving milestones, new developments or major departures from what was already in the public domain. But, importantly, it also hints at problems in finalising the BEPS project.

1.     Some of the lead up

July 2021. After some false starts in earlier documents, the principal design features of the “Two Pillar” BEPS plan had been largely settled by mid-2021.

The Statement on a Two-Pillar Solution to Address the Tax Challenges Arising from the Digitalisation of the Economy (1 July 2021) laid out the key design features of the 2-pillar BEPS plan:

  • Pillar One would comprise of two elements:
    • Amount A: a portion (between 20-30%) of the surplus profits (profitability above 10% of revenue) of MNEs with global turnover above € 20 bn would be taxable in each market jurisdiction where the MNE earns at least €1 m in revenue (or €250,000 for smaller countries) based on the amount of revenue earned in the jurisdiction;
    • Amount B: calculating the profit from baseline marketing and distribution activities occurring in a country would be simplified and streamlined;
    • Digital Services Taxes: part of the package for developed countries agreeing to Amount A is that countries would agree remove all Digital Service Taxes and similar taxes;
  • Pillar 2 would involve three elements:
    • Income Inclusion Rule: a parent entity would be required to pay top-up tax on the profits of low-taxed members of the group (effective tax rate <15%);
    • Undertaxed Payment Rule: other members of the group would be denied deductions sufficient to collect the top-up tax on the low-taxed income of other group members if the IIR had not been enlivened;
    • Subject to Tax Rule: a treaty-override rule allowing source jurisdictions to impose additional tax (between 7.5% and 9%) on certain classes of payments being made to related low-taxed entities.

The original timetable envisioned Amount A of Pillar One and Pillar Two would both become operative during 2023.

October 2021. The subsequent Statement on a Two-Pillar Solution to Address the Tax Challenges Arising from the Digitalisation of the Economy (8 October 2021) did not fundamentally change that design although it did flesh out some details and tweak a few others:

  • the share of revenue available to market jurisdictions under Amount A of Pillar One was fixed at 25% of residual profit;
  • the amount of low-taxed income immune from being taxed under the IIR and UTPR was increased;
  • a de minimis exemption from the UTPR would operate for the first 5 years for MNEs that have modest tangible assets abroad and operate in fewer than 5 other jurisdictions;
  • source jurisdictions would be allowed to collect up to 9% on payments caught by the Subject to Tax Rule;
  • as well the existing commitment to repeal existing DSTs, countries also agreed not to enforce any new DSTs enacted after 8 October until 31 December 2023 (or the coming into force of the expected Multilateral Convention). This latter commitment would become important in 2023.

December 2021 to March 2022. It was not until December 2022 that a major change to the design emerged with the release of three technical documents on Pillar Two: the Model Rules (20 December 2021), the Commentary (14 March 2022) and Illustrative Examples (14 March 2022).

The Model Rules contained provisions recognising a “Qualified Domestic Minimum Top-up Tax”: a domestic tax on the low-taxed profits of members of a MNE group, collecting any additional tax for the benefit of the source country rather than the country of the parent (under the IIR) or other countries in which the MNE group operates (under the UTPR). This was a significant development, effectively supplanting the IIR and UTPR as the main means of ensuring the global minimum 15% tax rate.

Australian developments. In Australia, the Government has been working toward implementing the basic design:

  • the ALP announced its policy for the May 2022 election which included a promise to implement “a global 15 per cent minimum tax [Pillar Two], and ensuring some of the profits of the largest multinationals – particularly digital firms – are taxed where the products or services are sold [Pillar One]” (22 April 2022);
  • Treasury released a consultation paper, Global agreement on corporate taxation: Addressing the tax challenges arising from the digitalisation of the economy (4 October 2022) seeking submissions on implementation issues; and
  • in the 2023 Budget (9 May 2023), the Government announced the timetable for implementing Pillar Two in Australian law:
    • the Income Inclusion Rule would apply for income years starting on or after 1 January 2024;
    • the Undertaxed Profits Rule would apply for income years starting on or after 1 January 2025; and
    • the 15% domestic minimum top-up tax would apply for income years starting on or after 1 January 2024.

2.     The Outcome Statement

The Inclusive Framework has released its Outcome Statement on the Two-Pillar Solution to Address the Tax Challenges Arising from the Digitalisation of the Economy (11 July 2023) reporting signs of BEPS life in anticipation of the meeting of G20 Finance Ministers and Central Bank Governors’ meeting in India later this month. The Statement was agreed to by 138 members of the Inclusive Framework. There are currently 143 members; Canada was a notable absentee for reasons discussed below. Yes, Canada!

The Outcome Statement is largely a progress report:

  • Pillar One Amount A: the Multilateral Convention allowing countries to claim in domestic law tax on a portion of the residual profits of in-scope MNEs has been prepared for signature: the Statement says “the Inclusive Framework has delivered a text of a Multilateral Convention …” But the Multilateral Convention has not been signed, nor even opened for signing because “a few jurisdictions have expressed concerns with some specific items in the Multilateral Convention. Efforts to resolve these issues are underway with a view to prepare the Multilateral Convention for signature expeditiously.” Just what the text says remains secret as it has not been publicly released (although a small extract, dealing with removal of digital services taxes, was released in December 2022). The new timetable is that the convention should be open for signature in the second half of 2023 “with the objective of enabling the Multilateral Convention to enter into force in 2025”;
  • Pillar One Amount B: the Outcome Statement reports no new developments saying, “further work will be undertaken” on various aspects of the proposal “to be completed by year end” leading to new “content … which will be incorporated into the OECD Transfer Pricing Guidelines by January 2024”;
  • Pillar One Digital Services Taxes: the stand-still agreement on enforcing Digital Services Taxes introduced after October 2021 was conditionally extended from 31 December 2023 to 31 December 2024 (and possibly 31 December 2025). Interestingly, the agreement to delay implementation is conditional on “at least 30 jurisdictions accounting for at least 60 percent of the Ultimate Parent Entities … of in-scope MNEs signing the MLC before the end of 2023”; and
  • Pillar Two Subject to Tax Rule: the drafters have apparently decided that a two-pronged attack is needed:
    • they have “completed and delivered” a model provision (and commentary) to add the STTR to existing bilateral treaties; and
    • they have also prepared a Multilateral Instrument and Explanatory Statement (presumably along the lines of the 2018 Multilateral Instrument) allowing signatories to amend existing bilateral tax treaties in bulk. The new Multilateral Instrument will be open for signature from 2 October 2023.

Neither text was released for scrutiny.

3.     Some observations

It is notable that the Outcome Statement focuses on the BEPS topics of most concern to developing countries, notably Amounts A and B of Pillar One and the Subject to Tax Rule element of Pillar Two: the Statement refers to special provisions which will be in the MLC “designed to address the unique circumstances of developing Inclusive Framework members”, how advancing Amount B “is a critical component of the broader agreement on Pillar One” and how “the STTR is an integral part of achieving consensus on Pillar Two for developing Inclusive Framework members.”

But the Statement hints at problems in finalising several key components of the BEPS project, especially with regard to Pillar One.

The first sign of trouble is with the 2021 compromise – to defer implementing new DSTs until 31 December 2023, in the expectation that the Multilateral Convention would be in place. The hold-outs with regard to the Multilateral Convention (the “few jurisdictions [which] have expressed concerns with some specific items in the MLC…”) are prolonging delivery of the Multilateral Convention. The majority of the members of the Inclusive Framework were willing to prolong the negotiations and extend the moratorium on implementing new DSTs for a further year, but this was too much for Canada. Its DST is scheduled to start on 1 January 2024 in accordance with the original timetable. The Finance Minister was unwilling to accept further delays noting there was still no “firm and binding multilateral timeline to implement Pillar One” and without that, “Canada [was] at a disadvantage relative to countries which have continued collecting revenue under their pre-existing DSTs”. (It is not clear whether the hold-outs are developing countries, who were expecting Amount A to deliver more revenue to them, or the developed countries since their companies are the most affected).

No doubt, Canada is right to be skeptical, but there must be a high chance that the extension of the moratorium will not actually happen because of the conditions attached to the extension. The extension is conditional on “at least 30 jurisdictions … signing the MLC before the end of 2023 …” and those 30 jurisdictions must represent “at least 60 percent of the Ultimate Parent Entities (UPEs) of in-scope MNEs …” Some researchers have concluded this second condition means the US must sign the Multilateral Convention. Their estimate is that more than 40% of the groups likely to be affected by Amount A of Pillar One are US-based, making the US indispensable. The prospects of the US Senate consenting to the Multilateral Convention are by no means assured.

The second sign of trouble is evident the decision to conduct yet more consultation on Amount B of Pillar One. Amount B has been relatively neglected in the prior BEPS work and this omission now seems to be causing delays, hindering the finalising of the work.

And in the same vein, the two-pronged approach to the STTR hints at disagreement. The invitation to developed countries to implement the STTR through amending bilateral treaties, rather than wait for the Multilateral Instrument, points to some doubts about the prospects for landing the Multilateral Instrument.

The Outcome Statement adds no new details or changes to the other components of Pillar Two: the domestic minimum top-up tax, the income inclusion rule or the under-taxed profits rule. These happen to be of most concern to the developed world and are apparently on track for implementation: the Statement notes, the “global minimum tax framework under Pillar Two is already a reality, with over 50 jurisdictions taking steps towards implementation.”

Toby Eggleston
Toby Eggleston
Partner, Melbourne
+61 413 151 183
Nick Heggart
Nick Heggart
Partner, Perth
+61 437 001 229
Ryan Leslie
Ryan Leslie
Partner, Melbourne
+61 418 186 499
Graeme Cooper
Graeme Cooper
Consultant, Sydney
+61 2 9322 4081
Jinny Chaimungkalanont
Jinny Chaimungkalanont
Partner, Sydney
+61 418 479 417

Tax Insight: Revised rules for non-deductible royalties

Treasury has released a revised version of draft provisions which will deny large Australian businesses deductions for payments connected with intangibles made to associates in low tax jurisdictions. The revisions were made in light of submissions on the March version of the rules, and according to the announcement, will “better achieve the policy intent.” This Tax Insight looks at some of the things that have – and haven’t – changed. Our Tax Insight on the March version of the rules is available here.

Some key changes

Interaction with royalty withholding tax and CFC rules

These provisions are directed at multiple targets – protecting royalty withholding tax where royalty-like payments do not meet the definition of “royalty,” stopping inappropriate access to the reduced rates of royalty withholding tax provided in our tax treaties, and stopping the leakage of income into tax havens. In theory, therefore, they should not be enlivened if:

  • the payment was actually a “royalty” as defined and so attracted royalty withholding tax on the way out of Australia, or
  • Australia already negates the benefit of the low tax rate enjoyed in the tax haven under our CFC rules – that is, the payment is attributable income of an Australian resident shareholder of a CFC, or
  • the rest of the world negated the low tax rate enjoyed in the tax haven through the imposition of Pillar Two measures. (Under the proposed law, one part of the definition of a “low corporate tax jurisdiction” is where a country’s corporate tax rate is below 15%, which is the rate that countries which enliven Pillar Two rules will be visiting upon income earned in the haven.)

None of these exceptions existed in the March version of the rules.

A new provision has been added in the June version to address the first point: the amount of deduction being denied will be reduced to the extent of any royalty withholding tax remitted to the ATO on the payment. The mechanics of the reduction converts the amount of royalty withholding tax paid back into the amount of a deduction. So, for example, remitting $30 of royalty withholding tax on a $100 royalty payment, will immunise the entire $100 from being made non-deductible.

But the calculation subverts the benefits of Australia’s treaties, whether or not there is any “abuse” of the treaty involved: if the payer remits only $10 of royalty withholding tax on a $100 royalty payment, only $33 is immunised and the remaining $67 is still non-deductible. (Indeed, it is hard to see why the regime needs to apply at all to payments which have survived scrutiny under the multiple tests protecting our treaties from abuse: the purpose test in the royalties article, the principal purpose test and limitation on benefits clauses.)

And it is worth noting, the provision does not take into account the impact of any royalty withholding tax levied by an intermediary country through which the payment might flow prior to reaching the “low corporate tax jurisdiction” destination.

With regard to the second point, the revised draft now addresses the scenario where Australia negates the benefit of the low rate enjoyed in the tax haven under our CFC rules. The income will not be regarded as derived in a “low corporate tax jurisdiction” to the extent that the amount is included in the assessable income of the Australian resident shareholder under our CFC rules.

Interaction with Pillar Two

But the Government has not yet been willing to address the third point: the significance of the Pillar Two measures on this rule. Under both versions of the rules, whether or not a country is a “low corporate tax jurisdiction” depends on “the rate of corporate income tax under the laws of that foreign country.” So even if the rest of the world applied Pillar Two measures to impose an effective 15% rate and negate the low tax rate enjoyed in the tax haven, that tax will not count (although a domestic minimum tax levied in the tax haven might count, depending on how it is implemented).

The announcement accompanying the revised draft rules said only, “the Government is further considering interactions of the intangibles measure with global minimum taxes and domestic minimum taxes.”

Earned in a “low corporate tax jurisdiction”

One of the key requirements for triggering the new rule is that an associate of the payer derives the relevant income (income from exploiting an intangible asset) “in a low corporate tax jurisdiction …” Our previous Tax Insight highlighted the confusion in the definition of “low corporate tax jurisdiction”: at some places, the drafting refers to the headline corporate tax rate, at other places it refers to the rate of tax imposed on a particular class of income, and at other places it refers to matters which go to the effective rate being paid by a particular taxpayer. The revised Exposure Draft makes two changes aimed at clarifying the confusion about when this test is met.

(a)   A “low corporate tax jurisdiction …”

First, the revised Draft and the Explanatory Memorandum try to be more explicit that the test of whether a country is a “low corporate tax jurisdiction” is determined by looking at the headline rate: it is the top headline rate of corporate tax, applicable to the largest taxpayers, in respect of income derived in the ordinary course of carrying on business, and disregarding any concessional rates applicable to particular industries [eg, oil and gas] or income or taxpayers, and disregarding the effect of their personal circumstances [the impact of deductions, tax credits, tax losses, and so on].

These changes should mean that a country will not be a “low corporate tax jurisdiction” just because there is no income tax on a particular class of income or if there are concessions for particular industries. But the matter is not clear because the drafting is still inconsistent: on the one hand, the legislation says to, “disregard the effect of … exemptions for particular types of income …”; on the other, it insists that only the lowest rate is considered if, “there are different rates of income tax for different types of income …”  Taken literally, this would lead to the absurd outcome, that if (say) income from oil and gas is exempt, the national headline rate applies, but if there is a low rate on oil and gas, it applies instead of the headline rate.

Two examples in the Explanatory Memorandum which go some way to clarifying the confusion, though one must always treat EMs with caution:

  • the first example says a country is a “low corporate tax jurisdiction” if the headline rate on business income is 10%, even if passive income [ie, the payment leaving Australia] might be taxed at 22%;
  • the second example says a country is not a “low corporate tax jurisdiction” if the headline rate is 20%, even if (say) manufacturing income is taxable at 10% and capital gains are not taxed.

But the problem for the drafters is obvious: deciding whether a country is, as a whole, satisfactory or not, must start with the tax rate, but it can’t really stop there if the tax base is thoroughly riddled with exempt items of income.

(b)   “Subject to foreign income tax”

The second change is a new provision added just for the purposes of the royalties measure. It says, income will not be regarded as derived in a low corporate tax jurisdiction to the extent that, “the income is, or will be, subject to foreign income tax at a rate of 15% or more …”  This provision picks up the definition of “subject to foreign income tax” from the anti-hybrid rules: the amount is “subject to foreign income tax” if it is included in the tax base of a foreign country.

It is tempting to see this provision as intended to counter the first example: even though a country as a whole is a “low corporate tax jurisdiction” because its headline rate is 10%, the impact of the new rule would be switched off if this income is “subject to foreign income tax” at a rate of 22%. Unfortunately, there is no indication in the Explanatory Memorandum about just what this core part of the new provision achieves.

Instead, the Explanatory Memorandum focuses on another part of the new provision: what happens when some elements of the definition of “subject to foreign income tax” are removed when the definition is employed in the royalties measure. In the anti-hybrid rules, an amount is not viewed as “subject to foreign tax” if some third country’s anti-hybrid rules are triggered, or if the amount is subject to a foreign State or municipal tax. These exclusions are switched off for the royalties measure and so amounts taxed under anti-hybrid rules or by State and municipal taxes will be viewed as “subject to foreign income tax.”

Penalties

Another change introduced in the June version is to double the penalties that are triggered if a tax shortfall arises (because of a failure to take reasonable care, recklessness or intentional disregard of the provisions) with respect to the application of these provisions. The separate penalty for making a false and misleading statement, even where no shortfall arises, is also doubled. The doubling of these penalties is in addition to the automatic doubling of penalties that already applies for a significant global entity.

Some things haven’t changed

Some key terms used in the original draft have not been changed. In particular, the revised draft does not change some of the key imponderables:

  • when a payment is “attributable to” a right to exploit an intangible asset;
  • how to apportion a single payment if it is both “genuinely made as consideration for other things …” as well as for “a right to exploit an intangible asset …”;
  • when does the transaction involve “a right to exploit an intangible asset” that turns out to be “a right in respect of, or an interest in, a tangible asset” or land or equity interests or a financial arrangement;
  • when an acquisition happens under “an arrangement” between the taxpayer and its associate, or under a “related arrangement”;
  • when an arrangement produces the “result” that income is being derived in a low corporate tax jurisdiction.

Nor has the Government accepted submissions that these rules should explicitly state they are enlivened only where there is evidence of a purpose of avoiding tax. The Explanatory Memorandum refers to the measure as “an anti-avoidance rule designed to deter SGEs from avoiding income tax …” but the rules do not depend on any finding about purpose or intention. The only comfort comes from passages in the Explanatory Memorandum which say the rules don’t apply to transactions and structures which are “genuine” though it is hard to see how that comes about.

Further consultation and start date

While Treasury has revised its Exposure Draft, there is no indication in the announcement about a process for further consultation – the period for consultation on the March version closed in April and there is no public evidence of any extension or restart. Releasing the document as an Exposure Draft suggests Treasury may be willing to receive feedback on this text, but the absence of an explicit process suggests otherwise.

Even though the legislative process hasn’t even started – the Government has yet to introduce a Bill into Parliament – the Government has decided not to delay the commencement of the new provisions. Consequently, these rules – whatever they may end up saying – will apply to any payments made after 1 July 2023, if they are enacted as currently written.

Key contacts

Hugh Paynter
Hugh Paynter
Partner
+61 2 9225 5121
Toby Eggleston
Toby Eggleston
Partner, Melbourne
+61 413 151 183
Ryan Leslie
Ryan Leslie
Partner, Melbourne
+61 418 186 499
Nick Heggart
Nick Heggart
Partner, Perth
+61 437 001 229
Graeme Cooper
Graeme Cooper
Consultant, Sydney
+61 2 9322 4081
Jinny Chaimungkalanont
Jinny Chaimungkalanont
Partner, Sydney
+61 418 479 417

Tax Insight: Thin Capitalisation Bill – In More Detail

This Tax Insight gives a fuller analysis of the changes to the thin capitalisation measures contained in the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share – Integrity and Transparency) Bill 2023 introduced into Parliament last week. The Bill departs from the Exposure Draft, which was released for consultation in March 2023, in important respects. This Tax Insight focuses on five key rules and concepts that have changed since March.

Calculating the Fixed Ratio

The new thin capitalisation test will cap the “net debt deductions” of a general class taxpayer in any year at 30% of the taxpayer’s “tax EBITDA” (unless it qualifies for, and elects to use, one of the other tests).

The Exposure Draft defined these terms and the Bill has adjusted the definitions slightly:

  • the amount of “net debt deductions” put in jeopardy by the new rules has been reduced slightly: that is, more amounts will now potentially reduce the deductions at risk of being denied;
  • the amount of “tax EBITDA” has been amended so the 30% test is now measured against a different number. For example:
    • depreciation deductions allowed under any Subdivision of Div 40 will be added back (increasing the “D” component of EBITDA). The March Bill had limited the add-back just to amounts claimed under Subdivision 40-B, but the expansion in the Bill will mean deductions like project pool amounts and black hole expenses will now increase the size of tax EBITDA;
    • however, amounts which are immediately deductible under Division 40 will not be added back. This would mean some mining expenditure and amounts claimed under instant asset write off provisions will not be added back;
    • similarly, assessable dividends (including from portfolio investments) and franking credits (which would have increased the “E” component of EBITDA) are now excluded. And, for trusts, distributions from other trusts will usually not be included in the “E”, which means head trusts which borrow to capitalise sub trusts will often have difficulty in deriving any earnings under this formula as drafted; and
    • prior year losses are no longer reversed out (so losses will now decrease the “E” component of EBITDA).

In addition, new provisions have been added in the Bill to accommodate the calculation of “net income” which is the concept applicable to trusts and partnerships.

Carry forward of debt deductions denied under the FRT

The Exposure Draft contained provisions which allowed a taxpayer to carry forward deductions denied under the Fixed Ratio Test (but not the other tests) for up to 15 years. This was particularly important for entities with little cash flow in the early years of their operations or where earnings are highly volatile.

However, the Exposure Draft, proposed that the ability to carry forward deductions would be lost if either:

  • the taxpayer switched from using the Fixed Ratio Test to either the External third-party debt test or the Group ratio test at some point, or
  • there was a change to the majority ownership of a company (although no equivalent loss had been proposed for trusts).

As a result of the consultations, the Bill has adjusted these rules. Carry forward deductions will now be available if the business continuity test has been met for companies and the trust loss rules have been passed for trusts.

External Debt Test

The Exposure Draft revealed that the existing arm’s length debt test would be repealed for general class investors, which was something of a surprise given the ALP’s election commitment to, “maintaining the arm’s length test.” Instead, the new external debt test would permit the deduction of all interest expense provided it was being paid to third parties.

A taxpayer who makes this election can deduct their interest expense up to the amount of interest incurred on external debt. If the taxpayer has only external debt, this means the taxpayer can deduct all its interest expense. If the taxpayer has a modest amount of related party debt, it might still want to make this election, knowing that the election comes at the cost of abandoning the deduction for interest on the related party debt. But the Bill has improved that calculus somewhat by specifically adding amounts incurred on hedging with non-associates in the total that can be deducted.

The version in the Exposure Draft imposed a number of restrictive conditions, some of which have been tweaked in the Bill. Debt will not qualify as “third party” debt if:

  • borrower: the issuer is a non-resident;
  • lender: the debt interest was issued to an associate of the entity, or the debt interest is held by associate of the entity at any time during the income year;
  • recourse: the holder of the debt interest has recourse to assets beyond the Australian assets of the entity; or
  • use of funds: the debt is used to fund the entity’s Australian operations, and is not –
    • used to fund a foreign PE, or
    • lent to an associate, or injected as debt or equity into a controlled foreign entity.

The revisions made in the Bill have focussed mostly on cross-border aspects of the test:

  • the requirement that only residents can elect to use the external debt test is new;
  • the requirement that residents must be using the debt to fund “commercial activities [being conducted] in Australia” is new; the previous version allowed a taxpayer to fund any “assets [held] for the purposes of producing assessable income …” which would have extended to offshore operations if they did not amount to a branch;
  •  the holder must not be able to access the borrower’s rights under a guarantee or other form of credit support (most likely given by a related parent entity). Presumably this acts as an indirect constraint on the amount of debt unrelated lenders are willing to advance; and
  • the debt cannot generally be secured although there are exceptions. The interaction between various rules seems to produce these outcomes:
    •  the debt can be secured if the security is over the borrower’s own assets in Australia (whether land or not);
    • the debt can also be secured by a resident associate of the borrower, provided the security is only over land in Australia; but
    • a non-resident associate cannot give security even if it is only enforceable against the non-resident’s Australian land (and definitely not if it is enforceable against the non-resident’s foreign assets).

But even with these adjustments, the requirements may lead to odd outcomes. For example, the prohibitions on parental guarantees and credit support are doubtful. The Explanatory Memorandum says these requirements exist to –

ensure that multinational enterprises do not have an unfettered ability to fund their Australian operations with third party debt. Given Australia’s relatively high corporate tax rate, multinational enterprises may seek to fund their Australian operations with high levels of debt relative to their operations in other jurisdictions.

Guarantees may indeed allow more debt to be borrowed, but they also mean any debt should be cheaper. Treasury no doubt believes that without this rule, the Australian operations will carry excessive debt; it may turn out that with this rule, the Australian operations will carry very expensive debt. One cannot predict ex ante which outcome will happen, or which will be better (or worse) for the Australian revenue.

Conduit financing structures and the Third Party Debt Test

The Exposure Draft contained a conduit financing regime to accommodate the common practice of using a “Fin Co” to raise external funds and on-lend to other members of the (non-consolidated) group. The rules allowed the on-lending of externally-raised debt to associates of the borrower by relaxing some of the conditions that would ordinarily prohibit this (the associate test and the recourse test). But even with these adjustments, the conditions which had to be met were very strict, in essence requiring a back-to-back loan arrangement of the borrowed funds (only) and on the same terms.

The Bill has relaxed some of the strictness of the former conditions relating to the “recourse” test and the “same terms” requirements, but a number of issues remain, including for stapled structures.

Associated entities

Multiple provisions (in the current law, the March Exposure Draft and in the Bill) turn on whether the parties involved in a structure or transaction are “associated entities.” For example,

  •  the thin capitalisation provisions in Div 820 are only enlivened if an entity, all its associates, are claiming debt deductions greater than $2 m for the income year;
  • the status of a financial entity or ADI attaches to every associate of the financial entity or ADI;
  •  the debt creation rules (discussed below) are based on a test which uses the concept of an associate;
  •  third party debt cannot be borrowed from, or held by, an associate;
  •  the conduit financing regime requires that every party in the chain is an associate;

and so on.

In the Exposure Draft, the level of ownership which would make an entity an “associated entity” was to be reduced from the standard 50% to 10%. The Bill has relaxed this restriction for some rules to an interest of 20% or more. But the change to a 20% test is not universal – the definition of “associated entity” will need to be carefully monitored in each scenario to see whether the 10%, 20% or 50% threshold applies.

Debt creation regime

The biggest surprise in the Bill was the decision to revive the debt creation rules, a version of which existed as Div 16G ITAA 1936 and operated between 1988 and 2001. The Explanatory Memorandum makes it clear that the “targeted debt creation rules were progressed in … place [of the proposed repeal of s. 25-90, which was deferred.]” The Explanatory Memorandum also relies on the OECD’s Report on BEPS Action 4, “which recognises the need for supplementary rules to prevent debt deduction creation.” These measures were not included in the March Exposure Draft and so were not the subject of consultation.

The new provisions will disallow debt deductions to the extent that they are incurred in relation to “debt deduction creation.”  At its simplest, the Bill contemplates two transactions:

  •  an entity acquires a CGT asset, or takes on a legal or equitable obligation from another entity which is an associate and the relevant entity incurs debt deductions in relation to the acquisition or holding of the CGT asset or obligation. The Explanatory Memorandum gives as examples,
    • issuing debt to acquire shares in a foreign subsidiary from a foreign associate or
    • issuing debt to acquire business assets from foreign and domestic associates in an internal reorganisation after a global merger;
  • an entity borrows from an associate to fund a payment to that entity, or another associate. The Explanatory Memorandum gives the example of debt issued to allow an entity to make payments to a foreign associate as part of an entirely internal restructure.

The debt creation rules will affect financial entities and to ADIs, both of which were immunised from most of the other changes being made in the Bill.

The substantive rules are also buttressed by a dedicated anti-avoidance rule which allows the Commissioner to issue a determination negating a scheme “for more than one principal purpose that included the purpose of …” ensuring that the debt creation rules were not triggered.

The provisions will operate independently of the rest of the thin capitalisation provisions. Hence, an entity which may have only external third party debt may nevertheless fall foul of these rules. If both rules can apply, there will be an ordering issue, similar to the problem which currently exists between thin capitalisation and transfer pricing or between thin capitalisation and the debt-equity rules.

Because these rules exist inside Div 820, they will be subject to the same $2m de minimis threshold that applies to the rest of Div 820. But, unlike the rest of Div 820, and unlike the former Div 16G, there are no cross-border elements to these rules – once the relevant entity has the cross-border attributes which attract Div 820 (eg, it is owned by a non-resident), the rules can be triggered by entirely domestic transactions and reorganisations.

Finally, while these provisions were added as the price for deferring the repeal of s. 25-90, our crystal ball strongly suggests these provisions are now permanent features of the law and will not be reversed even if s. 25-90 is removed.

What hasn’t changed

The Bill has not addressed two matters in the Exposure Draft which drew detailed submissions:

  • the transfer pricing rules will now require general class investors to demonstrate that the amount of debt they owe is not excessive (ie, even if the fixed ratio test is applied and debt deductions are less than 30% of tax EBITDA); and
  • the new rules will apply for income years commencing on or after 1 July 2023 with no grandfathering of existing debt or transition period to allow for the reorganisation of existing structures.

Key contacts

Toby Eggleston
Toby Eggleston
Partner, Melbourne
+61 413 151 183
Ryan Leslie
Ryan Leslie
Partner, Melbourne
+61 418 186 499
Nick Heggart
Nick Heggart
Partner, Perth
+61 437 001 229
Graeme Cooper
Graeme Cooper
Consultant, Sydney
+61 2 9322 4081
Jinny Chaimungkalanont
Jinny Chaimungkalanont
Partner, Sydney
+61 418 479 417

 

Tax Insight: Government Introduces Thin Capitalisation Changes

The Government has introduced into the House of Representatives the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share – Integrity and Transparency) Bill 2023 to enact its proposed changes to Australia’s thin capitalisation regime. This Tax Insight gives a brief summary of the key points; a fuller analysis will follow.

Thin capitalisation changes

So far as thin capitalisation is concerned, the Bill will enact the key components of the policy which the ALP took to last year’s election and released for consultation earlier this year. See our Tax Insight at https://hsfnotes.com/taxaustralia/2023/03/27/tax-insight-changes-to-thin-capitalisation-rules/

For general investors:

  • The current safe harbour for general investors (the level of debt must not exceed 60% of the value of assets) will be replaced by test which limits debt deductions to no more than 30% of tax EBITDA.
  • Where interest is denied under this test, the deficiency may be carried forward for up to 15 years.
  • The current option which allows gearing of the Australian entity up to the gearing level of the worldwide group will be replaced by a test based on the adjusted earnings ratio of the worldwide group.
  • The arm’s length debt test has been replaced by an external third party debt test.
  • The new tests start from 1 July 2023.

There have been modifications to some of the detail in the Exposure Draft, but the key design elements remain.

Section 25-90 deferred, but …

An Exposure Draft of the Bill released for comment earlier this year had included a proposal to repeal s. 25-90. See our Tax Insight at https://hsfnotes.com/taxaustralia/2023/03/17/tax-insight-new-limits-on-deducting-interest/

This measure has been omitted from the Bill, but it is not dead. The Explanatory Memorandum to the Bill says, “stakeholder concerns regarding section 25-90 were considered by Government, with the proposed amendment deferred, reflected in its removal from the final legislation, to be considered via a separate process to this interest limitation measure.”

And the deferral of s. 25-90 came at a price. The Bill includes new “debt creation” rules (based on the former Div 16G ITAA 1936) which were not released for consultation. The Explanatory Memorandum to the Bill says, the “targeted debt creation rules were progressed in its place.” The measure will disallow debt deductions, “to the extent that they are incurred in relation to debt creation schemes”. The Bill outlines 2 cases:

  • an entity borrows to acquire an asset from an associate, and
  • an entity borrows from an associate to fund a payment it will make to that entity or another associate.

These rules will operate independently of the thin capitalisation regime, as a discrete measure to deny interest deductions. They will require careful and detailed analysis.

Other measures in the Bill

The Bill also contains amendments to the Corporations Act 2001 to require Australian public companies (listed and unlisted) to disclose itemised information about subsidiaries in their annual financial reports. This requirement will apply to financial reports for financial years starting on and after 1 July 2023.

Status update

The Government also took the opportunity to give an update on the work toward meeting some of its election commitments, re-announced in the October 2022 Budget, and previously released for consultation. Consequently, a large part of the Explanatory Memorandum to the Bill has nothing to do with measures in the Bill; it is devoted to explaining what is happening elsewhere. These measures include:

Measure Update
MNEs will be required to publish tax information drawn from country-by-country (CbC) reports which will be made public

[See our Tax Insight at https://hsfnotes.com/taxaustralia/2023/04/18/tax-insight-another-public-tax-reporting-obligation/]

“… four additional data disclosures – related party expenses, the effective tax rate disclosure and the two intangible assets disclosures – [have been] removed from the proposed option

The proposed [measure is] deferred … by 12 months, to apply from 1 July 2024 …

While the disaggregated CbC reporting is intended to support meaningful improvements to tax transparency disclosures, there is a recognition that it does depart from the EU and OECD approaches, and that further consultation with industry may be beneficial on this element of the measure (and the measure more broadly).”

Tenderers for Australian government contracts worth more than $200,000 must disclose their country of tax domicile. “This element does not require legislative amendments and will instead be implemented via administrative changes to the Commonwealth Procurement material”
Denying a deduction for payments made by a SGE to a related party for the exploitation of an intangible asset, where the arrangement leads to income derived in a low or no-tax jurisdiction.

[See our Tax Insight at https://hsfnotes.com/taxaustralia/2023/04/18/tax-insight-new-limits-on-deducting-payments-involving-intangibles/]

“The option is the preferred option … The option applies to payments made from 1 July 2023.”

 

Toby Eggleston
Toby Eggleston
Partner, Melbourne
+61 413 151 183
Ryan Leslie
Ryan Leslie
Partner, Melbourne
+61 418 186 499
Nick Heggart
Nick Heggart
Partner, Perth
+61 437 001 229
Graeme Cooper
Graeme Cooper
Consultant, Sydney
+61 2 9322 4081
Jinny Chaimungkalanont
Jinny Chaimungkalanont
Partner, Sydney
+61 418 479 417

Tax Insight – Australia’s Second Income Tax

The recent Budget contained only a few surprises but one important announcement was the confirmation of what many had already suspected: Australia will soon have a second income tax. In fact, it will start in just over 6 months.

Australia will enact a so-called “qualified domestic minimum top-up tax” (“QDMTT”) as part of the suite of measures to enact the OECD’s Pillar Two proposals into Australian law, along with the proposed Income Inclusion Rule (“IIR”), Undertaxed Profits Rule (“UTPR”) and possibly a Subject to Tax Rule. Those rules will be enacted to set out Australia’s claim to any low-taxed profits earned by foreign companies in case other countries forget to enact their own QDMTT. But they are almost certainly going to become irrelevant verbiage and very quickly: the main game has already shifted to countries enacting their own QDMTT, allowing them to get in first and switch off other countries’ tax claims. The impetus to do this has only increased with the threat from the Republican members of the US Congress Ways and Means Committee to retaliate against the companies of any country which tries to collect tax on the profits of US companies under the UTPR.

Consequently, speculation has now shifted to just what Australia’s second income tax will look like. The optimists are hoping Treasury will closely follow the design of the IIR and UTPR: the QDMTT will be designed in such a way that it leaves no room for other countries’ IIRs and UTPRs to operate, but nothing more. The pessimists suspect Treasury won’t want to stop there: Treasury will take the opportunity of imposing a brand new tax to design one unpolluted by any of Treasury’s bêtes noires. The optimists reply: a tax that departs from the design of the IIR and UTPR won’t meet the test of a QDMTT so Treasury will be constrained from being too ambitious. The pessimists respond: the new tax will still switch off foreign governments’ claims as long as it is a tax on profits (“a covered tax”); it doesn’t also need to meet the definition of a QDMTT to be effective in blocking foreign governments.

This issue is currently playing out in the debate around the US’ second alternate corporate minimum tax which began operation on 1 January: people are asking whether it is a QDMTT or not. But the answer to that question is not especially important if it is instead either a second covered tax or if it increases the amount of an existing covered tax.

The same question arises for Australia: will Treasury aim for (i) a tax that is a very close approximation of the IIR and UTPR rules, or (ii) a tax that takes the IIR and UTPR as the model but has some important departures, or (iii) a tax that abandons any attempt to be a QDMTT and aims instead to be a second covered tax?

Option (i) would be the least ambitious approach – to have the QDMTT simply mirror the IIR and UTPR design.

But there are reasons to suspect the tax Australia will end up with is option (ii) – a tax which meets the QDMTT definition, but ends up departing from the model and is more ambitious.

First, the OECD is already encouraging countries to be more aggressive when it comes to their QDMTT. For example,

  • the IIR and UTPR are only triggered for very large taxpayers: MNE groups with revenue exceeding €750m. But when it comes to a QDMTT the OECD invites countries to waive this requirement, “… the application of a QDMTT could be extended to groups … that are not within the scope of the [IIR and UTPR] Rules because their revenues are below the EUR 750 million threshold”;
  • in the same vein, the IIR and UTPR are only triggered for groups with cross-border operations: either a subsidiary or PE located in a jurisdiction different from the ultimate parent. The OECD invites countries to waive this requirement as well: “… a QDMTT could also apply to purely domestic groups, i.e. groups with no foreign subsidiaries or branches”. Some countries will take up this invitation. For example, the EU has decided it will apply the Pillar Two measures to groups that only operate domestically and have no foreign subsidiaries or branches;
  • the IIR does not apply if the low-taxed entity in the group is the ultimate parent. The OECD says a QDMTT should apply to the ultimate parent: “… a QDMTT should impose a Top-up Tax on … all domestic Constituent Entities, including the domestic Parent Entity”;
  • the IIR and UTPR have an active income exemption (the “substance-based income exception”) which renders some income immune from top-up tax. The QDMTT does not need to have such an exemption: “a QDMTT is not required to have a substance carve-out”;
  • the IIR and UTPR have a de minimis exemption but a QDMTT is not required to have a de minimis exclusion: “a QDMTT is not required to have a De minimis exclusion … in order to be considered functionally equivalent to the GloBE rules”;
  • the base for the IIR and UTPR is set by the accounting standards used for preparing the consolidated accounts of the ultimate parent entity. The tax base of a QDMTT can be based on local financial accounting standards: “… a jurisdiction may require income or loss for the jurisdiction to be computed using an Authorised Financial Accounting Standard that differs from the one used in the Consolidated Financial Statements”;
  • the base of the IIR and UTPR reverses deductions for fines and penalties above €50,000 if they are deducted in the financial accounts. A QDMTT can reverse a deduction for even smaller fines or penalties: “… a jurisdiction that does not permit deduction of fines and penalties in any amount under its corporate income tax (CIT) can apply the same standard under its QDMTT”;
  • the amount of top-up tax which will have to be paid under the IIR and UTPR requires a decision about which foreign taxes will count toward the minimum. But the OECD is quite happy if a QDMTT does not treat as a covered tax a tax which would be counted toward reducing the IIR or UTPR: “the determination of Adjusted Covered Taxes needs to be the same or more restrictive”;
  • the IIR and UTPR are subject to transitional and permanent safe harbours. The OECD says safe harbours should also exist in a QDMTT but they do not need to be exactly the same: “the Inclusive Framework will undertake further work on the development of a QDMTT Safe Harbour …”
  • the IIR and UTP rules contain many elections which groups may choose in order to mitigate some requirement or other. When it comes to a QDMTT, the OECD says the QDMTT should generally provide a corresponding election, except, “a QDMTT that does not provide for certain elections, for example GloBE Loss Election, may be functionally equivalent.”

We could go on, but these examples are sufficient to show the OECD is trying to sit on 2 horses at the same time. On the one hand, it tells countries, “a minimum tax must follow the architecture of the [IIR and UTPR] rules using mechanisms that are substantially the same as those used to calculate the effective tax rate and top-up tax payable …”

On the other hand, it tells countries that being more ambitious won’t disqualify their tax as a QDMTT: “Some degree of customisation of a QDMTT in each jurisdiction is to be expected [and] variations in outcomes between the minimum tax and [IIR and UTPR] Rules will not prevent that tax from being treated as a QDMTT if those variations systemically produce a greater incremental tax liability …” The message is clear: a QDMTT must not collect less tax than the IIR or UTPR; collecting more is no problem.

A second reason to expect divergence is, there are aspects of IIR and UTPR design which serve no purpose in a QDMTT. For example,

  • the IIR and UTPR rules devote a large amount of legislative effort to rules that determine which country will get the top-up tax if the IIR is enlivened [which entity is the “ultimate parent entity”, an “intermediate parent entity,” or “partly-owned parent entity”], or if the UTPR is enlivened [the allocation key rules]. None of that detail needs to exist in a QDMTT since all of the tax to be paid under the QDMTT is meant to be paid to the Australian government and no-one else;
  • the IIR and UTPR rules devote a large amount of legislative effort to determining who is an MNE group and whose income and losses can be aggregated [netting is prohibited with entities that are investment entities, joint ventures and minority-owned constituent entities]. Treasury won’t be able to use the tax consolidated group definition from the Australian consolidation regime since it is under-inclusive compared to the IIR and UTPR so there will need to be both more entities included and more entities excluded. The simplest solution may simply be to treat all affected entities as stand-alone entities and not allow netting across any entities in the QDMTT.

It is inevitable the QDMTT will not simply mirror the IIR and UTPR design: Australia can be more ambitious in designing a QDMTT to tax Australian companies than it can be when applying the IIR or UTPR to claim tax from foreign companies.

Option (iii) would be the most ambitious approach: Treasury might abandon any effort at meeting the definition of a QDMTT (or simply not care whether its variations have strayed too far from the definition) and rely instead on the new tax meeting the definition of “covered tax”: a tax “recorded in the financial accounts of a Constituent Entity with respect to its income or profits …” The Commentary to the Model Rules already contemplates, and explains how to handle, “a domestic minimum tax that is not a Qualified Domestic Minimum Top-up Tax but that meets the definition of a Covered Tax …” The opportunity to write the corporate tax Treasury always dreamt of might prove irresistible. There is no down-side in enacting radical departures from the IIR and UTPR provided the tax is still a tax on profits.

It seems inevitable that Australia’s second income tax will end up departing from the parameters set in the IIR and UTPR regimes, but we won’t know just how far until the legislation is released, hopefully later this year.

Toby Eggleston
Toby Eggleston
Partner, Melbourne
+61 413 151 183
Ryan Leslie
Ryan Leslie
Partner, Melbourne
+61 418 186 499
Nick Heggart
Nick Heggart
Partner, Perth
+61 437 001 229
Graeme Cooper
Graeme Cooper
Consultant, Sydney
+61 2 9322 4081
Jinny Chaimungkalanont
Jinny Chaimungkalanont
Partner, Sydney
+61 418 479 417