Changes to Australia's tax rules announced in the 2013/14 Federal Budget

Articles Written by Jane Trethewey

Introduction

In the Federal Budget handed down on 14 May 2013, the Government announced that it would accept a series of Treasury recommendations to protect the corporate tax base from 'erosion' and close 'unfair business tax loopholes' that have been 'aggressively exploited' by some multinational and other large companies to obtain an 'unfair advantage' over their competitors.

This article discusses the announced changes to the following international tax rules:

  • the thin capitalisation (TC) rules;
  • the exemption for foreign non-portfolio dividends received by a company;
  • deductions for interest incurred in deriving exempt foreign dividends; and
  • the capital gains tax (CGT) rules for foreign residents.

Executive summary

Changes to TC and foreign dividend rules from 1 July 2014

  • TC Rules - The safe harbour and worldwide gearing limits will be reduced. On the other hand, the worldwide gearing test will be extended to inbound investors and the TC de minimis threshold will be increased. The 'arm's length gearing test' is to be retained but has been referred to the Board of Taxation.
  • Non-portfolio foreign dividend exemption - This will be amended so that it does not apply to interests that are in substance debt or where it is effectively a portfolio (i.e. less than 10%) interest. The exemption will, however, be extended to receipt of non-portfolio foreign dividends by a company through an interposed partnership or trust.
  • Interest deductions - Deductions for interest incurred in deriving exempt foreign dividends will be disallowed.

These changes are part of the Australian Government's efforts to address 'base erosion and profit shifting' by multinational enterprises (MNEs). A Proposals Paper (Paper)1 for public consultation was released on 14 May 2013 and submissions were due on 12 July 2013.

Changes to non-resident CGT rules from 1 July 2016

  • Mining information, goodwill and other intangible assets of a mining or quarrying business will be treated as 'taxable Australian real property' (TARP) for the purpose of the 'principal asset test'for determining whether shares are 'indirect Australian real property interests' (on which foreign residents are subject to CGT). Inter-company dealings in a tax consolidated group will also be ignored for the purpose of that test.
  • These changes are presumably intended to overcome the recent decision of the Federal Court of Australia in Resource Capital Fund III, L.P. v Commissioner of Taxation [2013] FCA 363 (RCF).2
  • A new withholding regime will be implemented for disposals of Australian real property assets by foreign residents, requiring purchasers to withhold 10% of the purchase price.

A discussion paper on this measure will be released by the end of 2013.

Base erosion and profit shifting

Base erosion and profit shifting

The Assistant Treasurer's Press Release of 14 May 2013 says the proposed changes to the TC and exempt foreign dividend rules are 'designed to protect the corporate tax base by preventing multinationals from shifting profits out of Australia' and prevent 'multinationals that use aggressive tax practices' from getting 'a competitive advantage over other businesses that pay their fair share'.

Along with changes to the transfer pricing rules and the general anti-avoidance rule (GAAR)3,these changes are intended to address 'base erosion and profit shifting' (BEPS) by MNEs, a matter which is causing considerable concern to G20 Finance Ministers and Leaders and is currently the subject of review by the Organisation for Economic Cooperation Development (OECD).

The OECD released its initial report on 12 February 20134, setting out data on the magnitude of BEPS and identifying 6 key 'pressure areas' in relation to the taxation of cross-border activities and the BEPS opportunities they create. These 'pressure areas' included 'hybrid mismatch arrangements and arbitrage', transfer pricing (particularly in relation to intangibles and the 'digital economy') and the effectiveness of domestic anti-avoidance measures such as GAARs, TC rules and 'controlled foreign company' (CFC) regimes. The report focussed on 'international double non-taxation' noting that:

'the tax practices of some [MNEs] have become more aggressive over time, raising serious compliance and fairness issues' and that 'current international tax standards may not have kept pace with changes in global business practices'.

The OECD concluded that, as well as increased transparency on effective tax rates of MNEs5, improved tax compliance and determined action and co-operation by tax administrations, more fundamentally, a 'holistic approach' was needed to address BEPS.

The OECD will release an 'action plan' for future work in this area in July 2013.

Thin capitalisation rules

Overview of current TC rules

The TC rules in Division 820 of the 1997 Act are intended to prevent MNEs from allocating an excessive amount of debt to their Australian operations. The provisions reduce 'debt deductions' (i.e. deductions for interest and certain other expenses in relation to a 'debt interest' issued by the entity) where the maximum allowed debt limit is exceeded.

The rules apply in relation to the Australian operations of:

  • inward (i.e. inbound) investors- foreign entities that carry on business through a permanent establishment (PE) in Australiaor foreign-controlled Australian entities; and
  • outward (i.e. outbound) investors- Australian entities that carry on business through a PE overseas or are a controller of an Australian-controlled foreign entity.

The rules apply in relation to all relevant interest-bearing debt and not just to related party debt (as was the case under the pre-2001 TC rules).

Under the current rules, both inward and outward investors can choose to apply either:

  • the safe harbour debt (or capital, in the case of banks) limit; or
  • the arm's length debt (or capital) limit.

Outward investors also have a third choice available, i.e. the worldwide gearing ratio (or capital) limit, based on the debt to equity ratio of the worldwide group.

The TC rules do not apply to purely Australian domestic firms or where the debt deductions in respect of the Australian operations are below the de minimis threshold (currently $250,000).

It should be noted that, regardless of whether the thin capitalisation rules are satisfied, the transfer pricing rules can still apply to interest and other costs in respect of debt provided on a non-arm's length basis, enabling the Commissioner to determine the arm's length price.6

Proposed changes to TC rules

Safe harbour limit

The safe harbour limits will be changed (for both inward and outbound investors) as follows:

  • for general entities - the safe harbour debt ratio will be reduced from 3:1 to 1.5:1 on a debt to equity basis (or 75% to 60% on a debt to total asset basis);
  • for non-bank financial entities - the safe harbour debt ratio will be reduced from 20:1 to 15:1 (or 94.24% to 93.75% on a debt to total asset basis);
  • for banks - the safe harbour capital limit will be increased from 4% to 6% of risk weighted assets (under APRA regulations) of their Australian operations.

The Paper notes that the current safe harbour ratio, which it says was already 'generous' when introduced in 2001, is now much higher than the actual gearing level of normal corporates with 'truly independent arrangements' and is therefore 'ineffective in stopping MNEs from artificially loading debt in their Australian operations'.7

Worldwide gearing test

This test will be changed as follows:

  • the worldwide gearing ratio will be reduced from 120% to 100% of the worldwide group's gearing level (with an equivalent change to the worldwide capital ratio for banks);
  • the test (currently only available to outbound investors) will be extended to inbound investors.

Arm's length gearing test

Despite earlier suggestions that it may be dropped, the 'arm's length gearing test' (which allows gearing levels above the safe harbour and worldwide gearing limits where the debt level is comparable to independent commercial arrangements) will be retained. It has, however, been referred to the Board of Taxation to consider ways to improve its operation.8 The Board is due to report by December 2014.

Threshold

The de minimis threshold for the TC rules to apply will be increased from $250,000 to $2M of debt deductions in relation to Australian operations. This is intended to reduce compliance costs.

Commencement date

The TC measures are proposed to apply to income years commencing on or after 1 July 2014. It is understood there will be no grandfathering but there may be a transitional period to enable entities to restructure their arrangements.

Non-portfolio dividend exemption and removal of interest deductions

Non-portfolio dividend exemption and removal of interest deductions

Non-portfolio dividend exemption

It is proposed to limit the foreign non-portfolio dividend exemption, currently in s 23AJ 1936 Act, to returns on 'substantial equity holdings' such that it will not apply to returns on interests that are, in substance, debt (e.g. redeemable preference shares) or portfolio (less than 10%) investments. This proposal will implement the reforms announced in the 2009-10 Budget to:

  • remove the exemption for dividends in respect of shares that are 'debt interests' under the debt-equity rules;9 and
  • prevent a taxpayer from accessing the exemption by deriving foreign portfolio dividends through an interposed 'controlled foreign company' (CFC).10

It is also proposed to extend the exemption (which currently applies only to foreign non-portfolio dividends received directly by an Australian company) to dividends received by an Australian company through an interposed partnership or trust.

An initial draft of the proposed provision was included in the CFC exposure draft legislation released on 17 February 2011 (see further below).

Removal of interest deductions against exempt foreign dividends

It is proposed to remove deductions for interest expenses incurred in deriving foreign dividends that are exempt under s 23AI, s 23AJ or s 23AK.11 This is proposed to be done by repealing s 25-90 of the 1997 Act, which enables deductions for interest and similar costs in relation to 'debt interests' that are incurred in deriving exempt foreign dividend income as described above. Section 25-90 was introduced at the same time as the current TC rules in 2001 and was intended to reduce compliance costs.

Example - 'debt dumping' structure

The Paper provides the following example of 'an aggressive tax planning scheme' that it says exploits the 'overly generous' TC rules, the 'loophole' in the s 23AJ exemption that allows it to apply to shares that are 'debt interests' and the 'compliance saver' provision in s 25-90, with the combined effect of 'wiping out' Australian taxable income:

  • Parent Co (resident in foreign country 1), which has a wholly owned Australian subsidiary (Aus Co) with annual taxable income of $100M, purchases Target Co (resident in foreign country 2) for $1 billion;
  • Parent Co lends Aus Co $1 billion (presumably within the relevant TC limit) at interest of 7% ($70M) p.a., which Aus Co uses to invest in RP shares in Target Co paying a preference dividend of 5% ($50M) p.a.;
  • The $50M annual dividend from Target Co is exempt to Aus Co under s 23AJ and the $70M annual interest expense to Parent Co (on which withholding tax of 10% is paid) is deductible to Aus Co under s 25-90 - this reduces Target Co's taxable income from $100M to $30M and the total Australian tax liability from $30M to $17M (i.e. company tax of $10M + withholding tax of $7M), with 'no significant change in economic activity undertaken in Australia'.

Arguably, the general anti-avoidance provision in Part IVA of the 1936 Act (which as noted above is also in the process of being amended) should be sufficient to deal with such a scheme, enabling the Commissioner to cancel the excess deduction if the requisite conclusion of a dominant purpose can be reached.

Commencement date

These measures are also proposed to apply in income years commencing on or after 1 July 2014.

CFC and other foreign source income rules

CFC and other foreign source income rules

The 2009-10 Budget had also announced changes to the foreign source income (FSI) attribution rules,12 intended to improve the competitiveness of Australian companies with offshore operations and Australia's attractiveness for regional headquarters of foreign groups.

The foreign investment fund (FIF) rules and the deemed present entitlement rules for foreign trusts were repealed with effect from the 2010-11 income year.

The other changes proposed were a 'rewrite and modernisation' of the CFC rules and the introduction of new 'foreign accumulation fund' (FAF) rules to replace the FIF rules. Exposure draft legislation (was released on 17 February 2011.

The Assistant Treasurer said the remaining reforms to the FSI rules announced in the 2009-2010 Budget will be 'reconsidered' after the OECD BEPS analysis is completed, noting that its report of 13 February 2013 recognised CFC rules as a 'key pressure area'.

Foreign resident CGT rules

Since 2006, Australia's capital gains tax (CGT) rules have applied to foreign residents only in respect of 'taxable Australian property' (TAP). TAP includes 'taxable Australian real property' (TARP), such as land and mining rights, as well as 'indirect Australian real property interests', i.e. non-portfolio (greater than 10%) interests (e.g. shares or units, including rights to acquire shares or units) in entities (the 'non-portfolio interest test') where the total market value of the entity's TARP assets exceeds the total market value of its non-TARP assets (the 'principal asset test').

The following changes in relation to these rules were announced:

  • changes to the 'principal asset test' for indirect Australian real property interests; and
  • introduction of a non-final withholding regime for the collection of tax under the foreign resident CGT regime.

Proposed changes to the 'principal asset test'

The following changes are proposed to the principal asset test:

  • Intangible assets connected to the mining, quarrying or prospecting rights (notably mining, quarrying or prospecting information and goodwill) will be treated as part of the rights to which they relate - and therefore as TARP - for the purpose of the test. It is not clear to what other intangible assets this will apply. It would not, presumably, extend to plant and equipment (which would not be TARP unless it is affixed to land owned by the company)13;
  • Intercompany dealings between entities in the same tax consolidated group will be ignored for the purpose of the calculations, to ensure that assets cannot effectively be counted multiple times, diluting the true asset value (presumably meaning the TARP asset percentage) of the group.

RCF case

The proposed change in 1 above is presumably intended to overcome the recent decision of the Federal Court of Australia in RCF. That case concerned the application of the CGT rules to a foreign private equity fund in relation to the sale of its shareholding (of more than 10%) in an ASX-listed gold mining company. While Edmonds J held in favour of the taxpayer on the basis that the Commissioner was not entitled to tax the Fund (a limited partnership deemed to be a company for Australian tax purposes) by virtue of the double tax agreement between Australia and the United States (US)14, his Honour also considered application of the principal asset test and held that it was not satisfied.

Edmonds J held that mining information and goodwill (as well as the mining plant and equipment) were separate, non-TARP assets of the company for the purpose of the principal asset test.

In relation to valuation, his Honour held that, for the purpose of the test, each asset was to be valued separately, on a stand-alone basis rather than on a global, going concern basis (although it is necessary to assume the assets would be used for the most advantageous purpose for which they are adapted, sometimes referred to as the 'highest and best use' test). He said the relevant 'valuation hypothesis' is the price that would be paid for the asset by a willing but not anxious buyer to a willing but not anxious seller in an arm's length sale, assuming the highest and best use as noted.

His Honour held the value of mining rights (which are TARP), mining information (which will now be deemed TARP) and mining plant and equipment (which will apparently remain non-TARP) is determined as follows:

  • the value of mining rights is the value which could be extracted from the tenements by mining them, ascertained by reference to the discounted cash flows (DCF) less the time delay and outlay cost of re-creating the mining information and replacing the plant and equipment;
  • the value of mining information is the midpoint in the range between zero and the cost (time delay and outlay) of re-creating the information;
  • the value of mining plant & equipment is the midpoint in the range between the sale for removal price and the cost (time delay and outlay) of re-creating the information.15

In relation to the valuation of goodwill, his Honour made the following points:

  • His Honour said goodwill would rarely have any significant value in a gold mining business such as in this case (although it may in other cases).
  • in dismissing a valuation by one of the ATO's experts that started with the company's market capitalisation and allocated to TARP the extra value under that method above the DCF method, his Honour said he did not think the extra value would represent an asset of the company (presumably as opposed to an asset of the shareholders) and that, in any event, it was not TARP. This will presumably not be the case under the proposed change.

How will the value of goodwill be determined?

Issues are likely to arise in relation to valuing goodwill for the purpose of the proposed change to the principal asset test, including whether it will be valued by reference to market capitalisation. It may well be that any excess of the value based on market capitalisation over the value under the DCF method will be allocated to goodwill or some other intangible asset of the company that is now to be treated as a TARP asset.

New withholding regime

It is proposed that, where a foreign resident disposes of certain taxable Australian property, the purchaser will be required to withhold and remit to the ATO 10% of the sale proceeds.

The proposed regime appears to be limited to real property assets and will not apply to assets connected with an Australian permanent establishment (which are also TAP), presumably because a non-resident carrying on business through an Australian permanent establishment would have more substantial connections with Australia and pose less risk to the Commissioner's ability to collect the tax.

Presumably, however, it is proposed that the regime will apply to indirect real property interests. Purchasers may not, however, always be in a position to know whether the principal asset test and the 'non-portfolio interest test'16 are satisfied. It may be that certain circumstances will be prescribed in which it is to be assumed that withholding is required in respect of a sale of, say, shares in a mining or property company unless it can be shown that the tests are not satisfied. The proposed amendments to the principal asset test will, of course, make it more likely that the test will be satisfied in the case of a mining company and purchasers of mining shares may need to assume that test is satisfied.

The Paper says the regime will equally apply to disposal by foreign residents of Australian real property assets held on revenue account. The regime will not apply in relation to residential property transactions with a value of less than $2.5M.

The measure addresses difficulties faced by the ATO in collecting tax from foreign residents who may have little other connection with Australia and may be able to transfer the proceeds offshore before the Commissioner can take action to collect the tax.

A number of countries, including the US17, Canada, Singapore and Peru, have similar withholding mechanisms and the introduction of such a rule in Australia comes as no real surprise.

A detailed discussion paper on the proposed withholding regime will be released by the end of 2013 and detailed public consultation will be conducted in relation to issues such as when obligations will arise, pre-payment of tax liabilities by the seller, payments through intermediaries and removing the obligation where it can be shown that no taxable gain will arise. This last issue is obviously important, given that the seller may not necessarily even make a capital gain (or a capital gain on which tax of 10% of the gross sale proceeds is payable), as well as the difficulties in relation to indirect real property interests noted above.

Commencement date

The principal asset test measures will apply to CGT events occurring on or after 1 July 2016. The new withholding regime will also apply from that date.


1 Entitled 'Addressing profit shifting through artificial loading of debt in Australiaby multinationals'.

2 This case is discussed in more detail in a separate article by the author.

3 A retrospective, treaty equivalent transfer pricing regime was introduced in 2012 (Subdivision 815-A of the Income Tax Assessment Act 1997 (Cth) (1997 Act)) and proposed new transfer pricing rules (Subdivisions 815-B, 815-C and 815-D of the 1997 Act, replacing the current rules in Division 13 of Part III of the Income Tax Assessment Act 1936 (Cth) (1936 Act)) and amendments to the GAAR in Part IVA of the 1936 Act, contained in the Tax Laws Amendment (Counteracting Tax Avoidance and Multinational Profit Shifting) Act 2013 (Cth) (enacted on 2 July 2013). Refer to article by Prashanth Kainthaje on the new transfer pricing rules and article by the author on the proposed changes to Part IVA.

4 Entitled 'Addressing Base erosion and Profit Shifting'.

5 In this regard, the Tax Laws Amendment (2013 Measures No. 2) Act 2013 (enacted on 2 July 2013) contained measures to 'improve the transparency of tax payable by large corporate entities', including a requirement for the Commissioner of Taxation (Commissioner) to publish (among other things) the tax payable of corporate taxpayers with accounting incomes of $100 million or more a year.

6 Refer Taxation Ruling TR 2010/7 on 'The interaction of Division 820 of the 1997 Act and the transfer pricing provisions' and TR 92/11 and TR 97/20 on the Commissioner's views on transfer pricing methods in relation to debt arrangements. This is dealt with expressly in the new transfer pricing rules - see s 815-25 and proposed s 815-140 of the 1997 Act.

7 The Paper says the aggregate gearing ratio (book value debt-to-equity) of unlisted corporates is 54% (according to the Reserve Bank of Australia), while that of 95% of ASX listed companies (other than banks) is 1:5 to 1 (according to Treasury analysis of 2011 financial statements for 2044 companies).

8 The Terms of Reference for this report were released by the Assistant Treasurer on 4 June 2013.

9 The debt-equity rules are in Division 974 of the 1997 Act. The Assistant Treasurer announced on 4 June 2013 that he has referred these rules (which were introduced in 2001) to the Board of Taxation for review and consideration as to whether they need to be improved to address any inconsistencies with other jurisdictions that may give rise to 'tax arbitrage opportunities'.

10 This will be achieved by repealing s 404 of the 1936 Act, which excludes both portfolio and non-portfolio dividends from attributable income in respect of a CFC.

11 Sections 23AI and 23AK of the 1936 Act exempt dividends paid out of attributable income that has previously been assessed to the taxpayer under the CFC rules in Part X of the 1936 Act or the former FIF provisions in Part XI of the 1936 Act, respectively.

12 Following recommendations made by the Board of Taxation.

13 In RCF, Edmonds J held that certain items that the ATO's valuers had treated as TARP on the basis that they were fixtures were not TARP as they were affixed to the land (which was not owned by the company) and not to the mining tenements. It may be, however, that a lessee's right to remove such fixtures would now be deemed to be part of the mining tenements under the proposed change. It is also noted that under the US FIRPTA rules (see below), certain personal property that is associated with the use of the USreal property (such as farming machinery or hotel furniture) is treated as real property.

14 About 97% of the partnership interests were held by UStax residents.

15 The valuation of mining information and plant and equipment is based on the assumption that the hypothetical buyer does not otherwise have or own the information or plant and equipment and it is not otherwise available for purchase and also that the hypothetical buyer and seller have equal bargaining power.

16 It may be difficult for the purchaser to know whether a seller who holds less than 10% of the shares satisfies the 'non-portfolio interest test', given that the test is associate-inclusive and the wide definition of 'associate' (in s 318 of the 1936 Act).

17 Under the Foreign Investment in Real Property Tax Act of 1980(FIRPTA), which imposes income tax on foreign persons disposing of US real property interests (USRPI) and requires buyers of USRPI to withhold 10% of the full sale price if the seller is a foreign person (which it is the buyer's obligation to ascertain),. This is subject to 4 exceptions (including acquisitions of shares in a publicly traded UScorporation or in a non-publicly traded UScorporation where the corporation supplies the required affidavit). The amount of withholding may be reduced below 10% only upon certification by the IRS that a reduced amount applies and only if the seller applies to the IRS for reduced withholding by filing a particular form by the closing date of the sale.

Important Disclaimer: The material contained in this article is comment of a general nature only and is not and nor is it intended to be advice on any specific professional matter. In that the effectiveness or accuracy of any professional advice depends upon the particular circumstances of each case, neither the firm nor any individual author accepts any responsibility whatsoever for any acts or omissions resulting from reliance upon the content of any articles. Before acting on the basis of any material contained in this publication, we recommend that you consult your professional adviser. Liability limited by a scheme approved under Professional Standards Legislation (Australia-wide except in Tasmania).

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