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

2023-24 Budget Update: Key changes to Australian state taxes

By Jinny Chaimungkalanont, Mark Peters, Dan Miles, and Jonathan Wu

After the Northern Territory kicked off the State and Territory budget season on 9 May (see our note below and our original post here), Victoria and Western Australia have now also delivered their 2023-24 budgets.

The Victorian government has today (23 May 2023) announced significant stamp duty changes, which will eventually see industrial and commercial landowners pay an annual property tax instead of lump sum stamp duty. The property tax will be set at 1% of the property’s unimproved land value, and the changes are proposed to take effect from 1 July 2024. The Victorian government also announced a number of other revenue measures, including the abolition of business insurance duty, and the ‘COVID Debt Levy’, which will see additional payroll tax and land tax levied.

Victoria’s proposed transition from stamp duty to a property tax follows the stamp duty reforms announced and enacted by the New South Wales government in 2022, which the Minns government has moved to abolish this week (instead, proposing to lift the residential duty exemption threshold from properties with a dutiable value of $650,000 to $800,000, and to introduce a concession for properties with a dutiable value of up to $1 million). The New South Wales government has today (23 May 2023) introduced the First Home Buyer Legislation Amendment Bill 2023 into Parliament.

Additionally, in the week following the budget, the Western Australian government introduced the long awaited Land Tax Assessment Amendment (Build-to-Rent) Bill 2023 (WA) into Parliament. The proposed concession bears strong similarities to the existing build to rent land tax concession in Victoria.

Victoria

Annual property tax to replace stamp duty on commercial and industrial properties

Significant Victorian stamp duty changes were announced as part of the Victorian Budget for 2023-24. Under the proposed changes, when commercial and industrial properties are first sold on or after 1 July 2024, that ‘first purchaser’ will be able to choose to:

  • pay the property’s final duty liability as an upfront lump sum; or
  • pay fixed duty instalments over 10 years (plus interest).

The new annual property tax (set at 1% of the property’s unimproved land value) will become payable on a property after a 10 year transitional period, which begins on the date of the first disposal of the property on or after 1 July 2024 (meaning that the earliest date on which the new tax could become payable is 1 July 2034).

Once a property has transitioned to the new system, duty will no longer be payable on a sale of that property.

The changes will not apply to owners of industrial or commercial property who acquire their interest before 1 July 2024.

The Bill that will implement the annual property tax has not yet been released. The budget papers indicate that further announcements are to be made by the end of 2023. We will provide a further update when the Bill is released.

There are many unanswered questions:

  • It is not clear what the ‘trigger event’ will include, to bring relevant property into the property tax regime: for example, where properties are transferred after 1 July 2024 under a corporate reconstruction or a change of trustee concession, become subject to an economic entitlement arrangement, or where a landholder duty acquisition occurs.
  • Query the position of the first purchaser after 1 July 2024, who will effectively pay duty as well as the annual property tax after a 10 year transitional period.
  • The treatment of commercial residential properties will also need to be considered.
  • The extent to which landholder duty will continue to apply to acquisitions in landholding companies and unit trust schemes which hold landholdings which are either wholly or partly subject to the new annual property tax.
  • Finally, whether the new annual property tax will ultimately be expanded to include residential property remains to be seen. Given that duty revenues are forecast to rise by 8.4% per year over the forward estimates,[1] and the government’s focus on reducing debt incurred during the height of the COVID pandemic by 2033, it may be some time before we see changes to residential duty.

Other changes

The government also announced the following state revenue measures:

  • Doubling of land tax absentee owner surcharge rate: From 1 January 2024, the land tax absentee owner surcharge will be increased. The surcharge rate will increase from 2% to 4%, and the tax-free threshold for non-trust absentee owners will decrease from $300,000 to $50,000. This will align Victorian and New South Wales rates.
  • Land tax: As part of the COVID Debt Levy, from 1 January 2024, the tax-free threshold for general land tax rates will decrease from $300,000 to $50,000. A temporary fixed charge of $500 will be levied on taxpayers with landholdings with taxable values of $50,000 to $100,000, and a temporary fixed charge of $975 will apply to taxpayers with landholdings with taxable values of $100,000 to $300,000. For general taxpayers with property holdings with taxable values of above $300,000 (and trust taxpayers with property holdings with taxable values of above $250,000), land tax rates will temporarily increase by $975 plus 0.1% of the taxable value of their landholdings above $300,000. This applies until 30 June 2033.
  • Payroll tax: From 1 July 2024, the payroll tax free threshold will be lifted from $700,000 to $900,000, and from 1 July 2025, the tax-free threshold will be lifted to $1 million.
  • As part of the COVID Debt Levy, from 1 July 2023, employers with national payrolls above $10 million per year will pay additional payroll tax. A rate of 0.5% will apply for employers with national payrolls above $10 million, and employers with national payrolls above $100 million will pay an additional 0.5%. The additional rates will be paid on the Victorian share of wages above the relevant threshold. This levy will apply until 30 June 2033.
  • In addition, also from 1 July 2024:
    • the tax free threshold will ‘phase out’. This will result in the tax-free amount reducing for each dollar an employer pays in wages over $3 million. Employers with wages over $5 million will not benefit from the tax-free threshold; and
    • approximately 110 non-government schools will lose their payroll tax exemption.
  • Business insurance duty abolished: Business insurance duty (which applies to public and product liability, professional indemnity, employers’ liability, fire and industrial special risks, and marine and aviation insurance) will be abolished. This will occur over a 10 year period. The duty will be abolished by 2033, with the rate of duty, currently 10%, being reduced by 1% each year from 1 July 2024. Victoria has already abolished insurance duty on life insurance.

New South Wales

The New South Wales government has today (23 May 2023) introduced the First Home Buyer Legislation Amendment Bill 2023 into Parliament, ahead of the NSW Budget being handed down (currently proposed to be Tuesday 19 September 2023). The bill proposes to introduce the following key changes:

  • Residency requirement increases to 12 months: Increasing the time required for a person to reside in a home as the person’s principal place of residence to be eligible for a first home duty exemption or concession from 6 months to 12 months.
  • Increase threshold for first home exemptions: Increasing the residential duty exemption threshold from properties having a private dwelling built on them from a dutiable value of $650,000 to $800,000. The threshold for vacant blocks of residential land remains unchanged at $350,000.
  • Increase threshold for first home concessions: Increasing the threshold for a residential duty concession for properties having a private dwelling built on them from a dutiable value of $800,000 to $1 million. The threshold for vacant blocks of residential land remains unchanged at $450,000.
  • Abolition of the opt in property tax for future transfers: amending the Property Tax (First Home Buyer Choice) Act 2022 such that transfers of land on or after 1 July 2023 (except those made pursuant to an agreement entered into before 1 July 2023), are not eligible to opt in to pay property tax.

It will be interesting to see the progress of this Bill, noting the NSW Coalition’s commitment to blocking the repeal of property tax (and by implication, the introduction of the updated thresholds).

Western Australia

The Western Australian Budget for 2023-24 continued to deliver a strong fiscal result with a $3.3b surplus. No significant state tax reform was announced as part of the budget.

In the week following the budget, the Western Australian government introduced the long awaited Land Tax Assessment Amendment (Build-to-Rent) Bill 2023 (WA) into Parliament (this reform was first proposed in last year’s budget – see our note here). The proposed concession bears strong similarities to the existing build to rent land tax concession in Victoria. To qualify for the exemption, which if the bill is passed will be available from the 2023-24 assessment year, a development must:

  • contain at least 40 self-contained dwellings available for residential leases;
  • be owned by the same owner or group of owners, and be managed by the same management entity; and
  • be completed between 12 May 2022 and 1 July 2032.

We will provide a further update on the build to rent land tax concession as the legislation proceeds through the Western Australian parliament.

Northern Territory

Coinciding with the Federal Budget, the Northern Territory was the first of the States and Territories to deliver its FY2023-24 budget. The NT budget brings significant red tape reduction to businesses with a connection to the Territory, with the abolition of stamp duty on the conveyance of non-land property, except for chattels conveyed with an interest in land. NT stamp duty will also be abolished on chattels conveyed with a lease that has nil or nominal dutiable value.

The Stamp Duty Amendment Bill 2023 (NT) was introduced to the NT Parliament this morning and will bring significant changes to the imposition of stamp duty in the Territory. The key changes include:

  • Business Sale Duty: Largely abolishing stamp duty on business sale agreements by removing from the definition of dutiable property:
    • goodwill;
    • business names, trading names, and trade marks;
    • rights to use things, systems and processes in the Territory that are the subject of a patent, a registered design, or copyright;
    • information and technical knowledge connected with a business undertaking in the Territory;
    • patents, registered designs, and copyright;
    • Commonwealth or Territory statutory licenses or permissions (noting that mining tenements and petroleum interests remain subject to duty as part of the extended definition of land).

These changes will result in a significant red tap reduction as it is quite common in the case of large scale business transactions for there to be a limited connection to the Territory which could give rise to a lodgement obligations. It will also mean that certain IP and trade mark transactions (e.g. the grant or transfer of an IP licence in respect of a NT business) will not be chargeable with duty.

It is clear that the administrative burden both on the Territory Revenue Office and on taxpayers far exceeded the revenue derived with the anticipated budgetary impact of this change to result in revenue forgone of $3 million per annum from 2023-24.

The changes also extend to abolishing duty on franchising arrangements.

  • Exemptions for Chattels Only Transactions: Introducing a new exemption from stamp duty so that the transfer of chattels in the Territory will not be subject to duty if the only other dutiable property the subject of the same transaction is a conveyance or grant of a lease, or an interest in a lease, for nil or only nominal dutiable value.

The inclusion of this exemption will ensure that duty is only imposed on the transfer of chattels in the Territory if a substantive interest in land / an option to purchase land is also conveyed / granted.

Duty should not be payable on the usual acquisition of a business, where the only land interest is a lease on usual commercial terms and the lease has nil or nominal dutiable value.

  • Grant of Resource Interests: Clarifying the exemption from duty on the grant of a “resource interest” (being, a mining tenement or a petroleum interest (both further defined terms)) so that duty is not payable where the grant of a resource interest occurs unless, in the opinion of the Commissioner, the grant forms part of a wider transaction amounting in effect to a transfer of the resource interest.
  • Surrenders of Property: Confirming that certain surrenders of property will continue to be subject to duty. For example, the surrender of an easement in order to allow the same easement, or a substantially similar easement, to be granted to a third person will continue to be subject to duty.

If ultimately passed, the changes will be deemed to take effect from 9 May 2023.

These changes bring the NT in line with most other jurisdictions which have abolished duty on non-land business assets. Such duty remains payable only in Queensland and Western Australia.

More to come

The budgets for the remaining States and Territories are expected over the coming months with Queensland and South Australia expected in the week commencing Monday, 12 June and Tasmania expected on Thursday this week.

[1] Noting that duty revenues are estimated to have accounted for 26.5% of the government’s total taxation receipts for 2022-2023.

 

Jinny Chaimungkalanont
Jinny Chaimungkalanont
Partner, Sydney
+61 418 479 417
Nick Heggart
Nick Heggart
Partner, Perth
+61 437 001 229
Tristan Boyd
Tristan Boyd
Special Counsel, Perth
+61 409 349 598
Louise Van Wyk
Louise Van Wyk
Senior Associate, Perth
+61 409 349 598
Mark Peters
Mark Peters
Solicitor, Sydney
+61 431 484 057

Dan Miles
Dan Miles
Solicitor, Melbourne
+61 402 247 919

Jonathan Wu
Jonathan Wu
Solicitor, Sydney
+61 2 9225 5190

Tax Insight – Another public tax reporting obligation

Treasury has released for consultation an Exposure Draft of new rules which will require multinational groups with an Australian presence to publish information about their tax and financial position for all the jurisdictions in which the group operates. Submissions on the Exposure Draft are due by 28 April 2023.

1. Background

The Exposure Draft just released is the latest development in the campaign being waged in Australia and around the world to deploy publicity as a tool to discourage tax avoidance by MNEs.

Australia already has legislative regimes which encourage or require entities to report information about their tax affairs to the public:

  • in February 2013, the Assistant Treasurer announced that the Government would legislate “to improve the transparency of Australia’s business tax system,” an announcement which led eventually to the annual ATO Report of Entity Tax Information; and
  • in May 2015, the Treasurer commissioned the Board of Taxation to develop a Voluntary Tax Transparency Code to encourage large multinationals to disclose tax information.

While these measures were being legislated, many large taxpayers decided to act unilaterally and began publishing a report on taxes paid around the world as part of their suite of annual reports.

Meanwhile, the OECD was working on item 13 of the BEPS Action Plan. The Final Report on Action 13, released in October 2015, required large groups to prepare a country-by-country report with aggregate data on income, profit, taxes paid and economic activity in each of the jurisdictions in which the group operates. This data would be shared with the tax administrations of various jurisdictions on a confidential basis. These requirements were legislated in Australia with effect from 2016.

But apparently, these measures were seen as insufficient:

  • the ATO Tax Information Reports and reports under the Voluntary Tax Transparency Code are publicly accessible but they focus on Australian tax;
  • a taxpayer’s own tax and financial reports are not mandatory, and reported data is selected by the group, making comparisons between groups difficult;
  • country-by-country reports are more granular and uniform, but they are only shared between revenue authorities and (by design) are not publicly available.

Consequently, in the lead up to the 2019 election the ALP promised, “to introduce public reporting of country-by-country reports, ensuring the release of high-level tax information about where and how much tax was paid by large corporations …” This proposal was repeated for the 2022 election with a promise to introduce, “transparency measures including reporting requirements on tax information, beneficial ownership [and] tax haven exposure …”

In August 2022, Treasury released a Consultation Paper, Government election commitments: Multinational tax integrity and enhanced tax transparency seeking submissions on several transparency measures including:

  • mandatory reporting of material tax risk to shareholders of Australian public companies (an Exposure Draft of amendments to the Corporations Act to give effect to this measure was released in mid-March); and
  • public reporting of information drawn from country-by-country reports (which is the focus of this Exposure Draft).

This Exposure Draft is the next step in this process. It is meant to lead to standardised tax and financial information, being collected by the ATO and then made freely available to the public worldwide, detailing a group’s worldwide operations disaggregated for each jurisdiction.

2. The new requirements

Who is affected

The obligation to report information to the ATO is imposed on the parent entity of a country-by-country reporting group required to prepare a country-by-country report, provided the parent is an Australian resident, some member of the group is a resident, or a member of the group has a PE in Australia. The references to the country-by-country reporting rules will link the measure to definitions already set out in the transfer pricing rules and will limit the measure to large multinational groups.

Foreign parent companies will have to report to the ATO if they have subsidiaries or branches in Australia.

The obligation extends to parent entities which are trusts if they have a corporate trustee and to partnership if all the members are corporations.

An exception is available for government-related entities, and the ATO has the power to exclude individual entities and classes of entities.

What to report

An affected entity is obliged to report the itemised information, “in respect of each jurisdiction in which the country-by-country reporting group operates.” The data is thus aggregated for all entities operating in the same jurisdiction to mirror the reporting requirements of the country-by-country report.

While the Exposure Draft alludes to the existing country-by-country reporting regimes, the information which must be reported is more extensive than country-by-country reports require and so cannot be drawn directly from a group’s report. Rather, the legislation lists particular pieces of information which must be reported, and says the information, “must be based on amounts as shown in the audited consolidated financial statements [of the parent entity] …”

The required information includes:

  • a description of group’s main business activities in each jurisdiction;
  • the number of people employed in the jurisdiction as at the end of the income year;
  • the book value of tangible and intangible assets at the end of the income year, other than cash;
  • the gross revenue from transactions with unrelated parties, as well as the revenue and expenses from transactions with related parties (if they are not resident in the same jurisdiction);
  • the profit or loss before income tax, the income tax actually paid and any income tax expense accrued for the current year;
  • a calculation of the effective tax rate and an explanation of the difference (if any) between the tax expense accrued and the tax that would payable if profit before tax was liable to “income tax [at the] rate applicable in the jurisdiction”; and
  • the currency used in the report.

In addition to the granular information, the Exposure Draft requires the parent to provide, “a description of the … group’s approach to tax.” This concept already appears in the voluntary Tax Transparency Code, and reports usually say things like, “we are committed to complying with all relevant tax legislation; we will not adopt tax positions that are considered aggressive; we will work co-operatively and openly with relevant tax authorities …” and so on. Reports under the new regime will likely say much the same thing.

An entity must notify the ATO of corrections if it becomes aware of errors in the original report.

How to report

The Exposure Draft goes through a curious charade. The obligation is imposed on an affected entity to “publish” the information required by the amendment, but an entity can publish the information only by giving, “a document containing the [required] information to the Commissioner in the approved form.” The Commissioner then makes “the information in the document available on an Australian government website.”

When to report

An entity affected by the measures has up to 12 months after the end of the income year to give the required information to the ATO, although there is a power for the ATO to vary this time limit, presumably for groups with later country-by-country reporting deadlines.

Corrections must be notified to the ATO “as soon as practicable” after the entity becomes aware that its original document contains an error.

Penalties

The Exposure Draft proposes amending the Taxation Administration Act 1953 to add a new strict liability offence where an affected entity fails to comply with its obligation to give the information to the ATO in the required manner. Just how this penalty would be enforced against a non-resident parent is not obvious, but the issue is unlikely to arise.

3. Comment

The result of the process looks very much like the ATO is collecting information about the worldwide operations of MNEs from country-by-country reports, and then publishing it to the world. The Final Report on BEPS Action 13 insists:

Tax administrations should take all reasonable steps to ensure that there is no public disclosure of confidential information … and other commercially sensitive information contained in the [country-by-country documents and] should also assure taxpayers that the information presented in transfer pricing documentation will remain confidential.

The Exposure Draft acknowledges that the information in the country-by-country report is subject to strict confidentiality and cannot be publicly disclosed.

So the Government attempts to sidestep this obligation by simply requiring companies to provide the information in a “separate public reporting obligation”. No doubt this two-step charade [the entity publishes its own information; the ATO just helps out], and the statement that the information uses amounts shown in the audited consolidated financial statements, is meant to convince other governments that the ATO is not simply publishing the contents of country-by-country reports, in breach of the secrecy obligations. One suspects, other governments may see things differently.

4. Dates

Submissions on the Exposure Draft are due by 28 April 2023.

If enacted in its current form, the measure would require taxpayers to report to the ATO information about income years starting from 1 July 2023.

Toby Eggleston
Toby Eggleston
Partner
+61 3 9288 1454

Nick Heggart
Nick Heggart
Partner
+61 8 9211 7593

Ryan Leslie
Ryan Leslie
Partner
+61 3 9288 1441

Hugh Paynter
Hugh Paynter
Partner
+61 2 9225 5121

Jinny Chaimungkalanont
Jinny Chaimungkalanont
Partner
+61 2 9322 4403

Graeme Cooper
Graeme Cooper
Consultant
+61 2 9322 4081

 

Tax Insight – New Limits on Deducting Payments Involving Intangibles

Treasury has released for consultation an Exposure Draft of new provisions which will, in some cases, deny large Australian businesses a deduction for amounts connected with intangibles if paid to associates. If enacted in their current form, the new rules would apply from 1 July 2023. Submissions on the Exposure Draft are due by 28 April 2023.

1. Background

One of the tax policies which the ALP announced in its unsuccessful campaign for the 2019 election was a proposal to, “stop multinationals from getting a tax deduction when they unfairly funnel royalty payments to arms of their own company that pose a multinational tax risk.” The announcement listed the sources of “tax risk” as treaty shopping, funnelling income into tax havens, holding patents in countries with patent box regimes and negotiating “a sweetheart deal” with another country.

In April 2022, in the campaign for the 2022 election, the ALP announced a similar proposal to limit, “the ability for multinationals to abuse Australia’s tax treaties when holding intellectual property in tax havens.”

In August 2022, Treasury released a Discussion Paper outlining the design of, “a new rule limiting MNEs’ ability to claim tax deductions for payments relating to intangibles and royalties that lead to insufficient tax paid.” (This Paper is examined in more detail in our Tax Insight available here.)

Treasury has now released an Exposure Draft of provisions to give effect to the policy. The detail has evolved significantly in the last 4 years. The Exposure Draft is available here.

2. Key Elements

The new rule will deny a deduction to an Australian entity for a payment (or crediting an amount or incurring a liability to make a payment) where 5 key conditions are met:

  1. the payer is a significant global entity;
  2. it is making the payment to an associate, whether directly or indirectly;
  3. the payment is, “attributable to a right to exploit an intangible asset”;
  4. as a result of some arrangement, income from the exploitation of an intangible is derived by the recipient or another associate; and
  5. that income is derived in a low corporate tax jurisdiction.

3. Some of the pitfalls

At first glance, the intended scope of the section seems easy grasp, but the apparent simplicity of the drafting hides many traps. Most of the complexity arises from:

  • asserting that a transaction can be re-characterised to reveal a payment for a right to use an intangible; and
  • asserting that the Australian taxpayer is to be denied a deduction because another transaction, to which the taxpayer is not a party, occurs between other entities in the same corporate group, which shifts income into a low tax jurisdiction.

Royalties versus deductible “payments”

While the focus of the 2019 announcement was on limiting the deductibility of “royalty payments” made by MNEs, by 2022, Treasury’s Discussion Paper revealed the policy had expanded to include payments which were not technically “royalties” and did not trigger royalty withholding tax. The Paper gave as examples, payments for goods, payments for services or payment of management fees.

The Exposure Draft adopts this broader scope. The Explanatory Memorandum says the drafting is meant to extend to, “a payment … made for other things, such as services or tangible goods …” Hence, an Australian SGE may find deductions are being denied for the cost of trading stock or management fees or payments for services.

However, it seems the drafting is not enlivened for payments which are not deductible, but rather form part of the cost of depreciating assets or the cost base of CGT assets.

Embedded royalties: payments “attributable to” a right to exploit an intangible asset

In order for a deductible payment to be in jeopardy, it is necessary that “the [deductible] payment is attributable to a right to exploit an intangible asset …”

Obvious examples would include payments for the right to use a copyright, patent or registered design in the Australian entity’s operations, payments for the right to display trademarks and logos in marketing activities, payments for rights to broadcast radio and TV content, and so on. The drafting extends the definition to include payment for rights to exploit things which aren’t property at law, such as gaining access to confidential information. The phrase “attributable to” is probably meant to capture payments for supporting services in connection with the licensing of IP or revealing information. In all these cases, the Australian entity acquires rights in connection with an intangible which is owned (and remains owned) by another. The Explanatory Memorandum says the word “exploit” is meant to be broader than “use,” but the essence of the test still requires that the Australian entity gets a limited right to exploit something owned by another.

Which is why the attempt to capture embedded royalties is so fraught. In what circumstances can a payment for trading stock or management services be re-labelled as “attributable to” a right to exploit an intangible? The Explanatory Memorandum offers no explicit guidance about how and when a payment is “attributable to” a right to exploit an intangible. The example in the Explanatory Memorandum involves a taxpayer who distributes products under a distribution agreement. It pays for management and other services it acquires under the agreement; it is allowed (at no cost) to display logos etc when marketing the goods. The Example asserts, without explanation, that a portion of the management fee paid to the other party is attributable to exploiting the IP. The Example is equally reticent about how to quantify the non-deductible portion of the payment saying simply that, “to the extent that the payment of these fees is attributable to the right to exploit the trademark …” it will be non-deductible.

The new rule does not apply to payments connected to every kind of intangible. Rather it is focused on payments for an intangible right over another intangible asset. Hence, the new rule does not apply if the payment is made for a right to use or exploit:

  • a tangible asset (eg, rentals under an equipment lease); or
  • land (eg, payments of rent, or fees for a licence over land).

And the new rule does not apply to rights over every kind of intangible asset: a right to exploit a financial arrangement affected by the TOFA rules is excluded (eg, interest, dividends, gains or losses in relation to some debt or equity interests).

And, one would have thought, the rule should not extend to payments to buy rather than exploit – whether to buy goods, or land or an intangible – though the drafting says it will be a payment to “exploit” an intangible if the payment is being made to allow the entity to sell or license the intangible. So, it is hard to see how a payment to buy branded goods could involve a disguised payment to exploit the brand. TA 2018/2 Mischaracterisation of activities or payments in connection with intangible assets, which foreshadowed these rules, says it does not apply to, “resellers of finished tangible goods where the activity of reselling the goods involves an incidental use of a brand name that appears on the goods and related packaging.” One would hope the final legislation will include a similar limitation in these rules.

But this issue of embedded royalties is clearly a major concern to the ATO which is trying to challenge them under current law. It is understood the ATO is arguing, in its case against Pepsi, that the transactions involved there were amenable to challenge under the diverted profits tax. And the issue was the major focus of TA 2018/2 Mischaracterisation of activities or payments in connection with intangible assets. The TA says the transactions outlined in the TA may contain a “royalty” liable to withholding tax, may trigger transfer pricing rules or might trigger Part IVA. The new provision will add another option to the list.

Payments pursuant to “arrangements”, involving multiple entities

In order for a deductible payment to be in jeopardy, it is necessary that:

  • “the [deductible] payment is attributable to a right to exploit an intangible asset …”; and
  • the taxpayer or an associate acquires the intangible asset, or a right to exploit the intangible asset or actually exploits the intangible asset; and
  • that acquisition happens under
    • the arrangement between the taxpayer and its associate which conferred the right to exploit the intangible asset, or
    • a related arrangement (the parties to which are not itemised).

So the drafting contemplates at least one, and possibly several arrangements:

  • the plain vanilla case is: the taxpayer pays a royalty to an associate in a tax haven for a right to exploit an intangible asset and it gets the right it bargained for;
  • the drafting easily captures back-to-back arrangements: the taxpayer pays a royalty to an associate not in a tax haven for a right to exploit an intangible asset, and associate pays another fee to an associate which is in a tax haven for the rights which it has licensed to the Australian entity. The legislation expressly refers to the Australian entity making the payment “to the recipient directly or through one or more other entities”;
  • a more complex case is: the taxpayer pays a royalty to an associate not in a tax haven for a right to exploit an intangible asset; another associate of the taxpayer which is in a tax haven owns or licenses the same or related intangible under an agreement and derives income from another associated entity. The only requirement for this scenario is that (i) the arrangement between the Australian payer and the recipient and (ii) the arrangement between the other entities are somehow “related.”

Low corporate tax jurisdiction

The final requirement for triggering the rule is that, as a result of the agreement, the recipient or some other associate derives income in a low corporate tax jurisdiction.

A “low corporate tax jurisdiction” is defined to mean:

  • a foreign country where the rate of corporate income tax is less than 15% or is nil; or
  • a foreign country which the Minister has determined offers a preferential patent box regime which does not require sufficient economic substance (a test taken from the OECD’s Final Report on BEPS Action 5).

The drafting does not appear to capture a country which simply does not have a corporate tax.

The 2019 announcement said the new regime would use the “sufficient foreign tax test” from the Diverted Profits Tax, but the test finally settled upon in the Exposure Draft is far more manageable:

  • the test focuses on the headline rate for the corporate tax of the country;
  • if the country applies progressive rates to companies, the relevant rate is the highest headline rate;
  • if the country applies different rates to residents and non-residents, ignore a rate which applies only to non-residents.

The drafting refers to “the rate of corporate income tax under the laws of [a] foreign country …” which means the test looks at the rate for the country, not the rate of tax being paid by a particular taxpayer (eg, does the taxpayer have losses or tax credits), nor the rate of tax imposed on a particular class of income (eg, is this kind of income exempt). However, the drafting does become more granular:

  • the impact of deductions, losses and tax credits are excluded;
  • if the income is exempt from tax, we are told the rate of tax on that amount is nil.

In theory, both of these matters should be irrelevant to identifying “the rate of corporate income tax under the laws of [a] foreign country …” but their presence confuses the matter, and indicates the headline rate may not be the end of the story.

Purpose of avoiding tax?

The 2019 announcement was clear that this rule would only be triggered if the taxpayer had a purpose of avoiding Australian tax: “a multinational can still get the tax deduction if the firm can substantiate to the Commissioner of Taxation that the royalty payments are not for the dominant purpose of tax avoidance.”

This test has now been abandoned in favour of a “results” test: it will be sufficient if, “the entering into of the arrangement … results in the recipient or another associate of yours deriving income” in a low corporate tax jurisdiction. So, the focus is now simply on what happened, not why it happened.

The Explanatory Memorandum says, “it is not intended for this anti-avoidance rule to inappropriately apply … where there is no tax avoidance behaviour” but the drafting contains no test of “purpose” or “intention” which might limit the inappropriate operation of the section.

This will be left to the ATO to administer, but how this issue is to be dealt with in practice is left unresolved.

4. Royalty Withholding Tax?

It is worth noting that nothing in the Exposure Draft deals with the interaction between this measure and the tax on payments which are royalties and subject to royalty withholding tax. It is conceivable that both measures will operate. In the case of a royalty paid to a non-treaty country, this might lead to an effective rate of 60%: 30% imposed on the recipient (and collected from the payer) and 30% imposed on the payer through the denied deduction.

The media releases accompanying the Exposure Draft have referred to “levelling the playing field for Australian businesses”. However, by both imposing royalty withholding tax and denying a deduction for the payer it is clear that these measures will tilt the field in favour of Australian enterprises. Whether this level of support is acceptable to our trading partners will be a watching brief. The US Treasury has already indicated its displeasure with the ATO’s expanded view of royalties as expressed in TR 2021/D4.

One would have expected the measure would not apply where the Australian payer has complied with Australian royalty withholding tax rules (including having regard to applicable tax treaties) but that suggestion has not been taken up in the current drafting.

5. Interaction with Pillar 2

Finally, there is no mention of the interaction of this measure with the OECD’s Pillar 2 project of a global minimum tax of 15%. If Pillar 2 is widely adopted (and the income inclusion rule is proposed to start for income years after 1 January 2024), then whatever justification for this measure will fall away given the income for exploiting intangibles will be picked up and taxed at a minimum of 15%.

6. Dates

The new rule will apply to payments made (or liabilities incurred) from 1 July 2023.

Submissions on the Exposure Draft are due by 28 April 2023.

 

Toby Eggleston
Toby Eggleston
Partner
+61 3 9288 1454

Ryan Leslie
Ryan Leslie
Partner
+61 3 9288 1441

Jinny Chaimungkalanont
Jinny Chaimungkalanont
Partner
+61 2 9322 4403

Hugh Paynter
Hugh Paynter
Partner
+61 2 9225 5121

Graeme Cooper
Graeme Cooper
Consultant
+61 2 9322 4081

Toby Eggleston shares his expert advice on the top tax issues in tech deals

By Toby Eggleston

Toby Eggleston joins Malika Chandrasegaran and Mia Harrison-Kelf on the Inside Tech: Done Deal podcast to discuss the tax related issues that arise when negotiating tech deals. They cover what regulators, such as FIRB and the ATO, are thinking about at the moment, issues such as scrip for scrip rollover, earnouts, retention payments and option schemes, and the ways that we are bridging value gaps on tech deals in current markets.

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