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:
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.
A discussion paper on this measure will be released by the end of 2013.
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.
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:
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:
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
The safe harbour limits will be changed (for both inward and outbound investors) as follows:
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
This test will be changed as follows:
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.
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.
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.
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:
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).
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.
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:
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.
These measures are also proposed to apply in income years commencing on or after 1 July 2014.
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'.
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:
The following changes are proposed to the principal asset test:
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:
In relation to the valuation of goodwill, his Honour made the following points:
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.
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.
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.
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