ATO boldly sharpens its tools: multinational intangible arrangements in its sights

Articles Written by Kathryn Bertram (Partner), Annemarie Wilmore (Partner), Don Spirason (Special Counsel), Georgia Whiteside (Senior Associate)
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Multinational groups who use intangible assets as part of their operations should be aware of two new guidance documents published by the Australian Taxation Office (ATO).

  • PCG 2024/1 Intangibles migration arrangements which relates to cross-border related party Intangibles Migration Arrangements. It sets out the ATO’s views on tax risks associated with:
    • the migration of intangible assets; and
    • the mischaracterisation and non-recognition of Australian activities connected with intangible assets. 
    • In particular, it provides guidance on when the ATO is likely to apply resources to these types of arrangements to investigate risks including the application of the transfer pricing and anti- avoidance rules.
  •  TR 2024/D1 Income tax: royalties – character of payments in respect of software and intellectual property rights which provides guidance about when the ATO will consider that payments made in respect of software and intellectual property rights will be a royalty. It explains that payments for the use of, or the right to use, intellectual property rights will be considered to be a royalty. The ATO takes an expanded view on when there is a right to use intellectual property.

These guidance materials have been published in the context of the ATO’s current focus on what it considers to be multinational profit shifting. The extensive evidentiary expectations outlined in PCG 2024/1, and aspects of the interpretation approach set out in TR 2024/D1 are broadly consistent with what we are observing in practice.

The PCG 2024/1 reveals that the ATO continues to expect evidence beyond routine transfer pricing documentation in relation to higher risk intangibles arrangements. Multinational groups will need to demonstrate the commercial reasons for the arrangement. Under the PCG, taxpayers will be required to self-assess tax risk against the ATO’s framework as part of annual reporting and tax return obligations. The self-assessment will need to be produced to the ATO, as part of annual compliance obligations and/or in the context of an Advance Pricing Arrangement. Higher risk cases can expect the ATO to review the evidence supporting their risk assessment.

The revised draft software ruling, TR 2024/D1 controversially adopts an interpretation approach that is broadly cast and is pro-revenue authority, with little said about the circumstances which would not be considered to be a royalty. While the detail of the ruling relates to software, it would not be unreasonable to expect the same position to be adopted in relation to any arrangements involving intellectual property, consistent with what we are observing in practice.

PCG 2024/1 Intangibles migration arrangements

Multinational related party arrangements involving an Australian entity and functions concerning the development, enhancement, maintenance, protection and exploitation (DEMPE) of intangible assets will need to be examined, regardless of when those arrangements were entered into.

The ATO will likely want to verify arrangements where the Australian entity has historically owned, managed or controlled the DEMPE activities associated with the intangibles, has assumed risk and received income, and following a change in arrangements there is reduced tax in Australia. Examples of the types of arrangements that will attract scrutiny include:

  1. The centralisation of intangible assets (existing and pre-commercialisation) to an overseas entity) via sale, licence or undocumented use.
  2. The Australian entity sells to a related party located offshore, part of its intangible assets, bifurcating into Australian and offshore intangibles.
  3. Contract R&D service arrangements, where the Australian entity is the provider to an international related party of those services.
  4. Multiple parties within a group, including the Australian entity, share or pool intangible assets and risks and costs of development of intangible assets via a cost contribution arrangement.

The PCG sets out the ATO’s risk assessment framework. The framework allocates points to arrangements with certain attributes. There is a focus on:

  • The effect of the restructure or change;
  • The circumstances and substance of the relevant (overseas) entity and its activities in relation to the intangible assets;
  • The tax outcomes of the intangibles arrangement; and
  • Undocumented or unrecognised dealings.

The ATO’s risk assessment framework contains a long list of pre-populated questions, together with 15 examples.[1] The answers to those questions are allocated points, with the overall points informing which of the four zones the taxpayer’s arrangement falls within.

In a welcome development there is greater clarity and explanation regarding the assessment of risk, this includes an explanation of arrangements which will be excluded from consideration, such as certain distribution and low-value services arrangements.

Many of the responses required to the risk assessment framework will be subjective in nature, and so there is the potential for the ATO to form a different view to the taxpayer on the arrangements (similar to what is commonly experienced by taxpayers in transfer pricing disputes in Australia). Extensive and detailed evidence regarding the functions, assets and risks of the entities of the group will be required to meet the ATO expectations for higher risk cases.

TR 2024/D1 Income tax: royalties – character of payments in respect of software and intellectual property rights

This is a further draft of the ATO’s views on the circumstances where the ATO considers an amount paid under a software arrangement to be subject to royalty withholding tax.

TR 2024/D1 sets out the technical interpretation that will be adopted by the ATO. In the eyes of the ATO, a royalty, and hence royalty withholding tax, will need to be recognised where an agreement provides for:

  • the grant of a right to use IP (e.g. ability to reproduce a computer program), regardless of whether that right is exercised;
  • the use of an IP right. The ATO takes an expanded view of when there will be “use” of an IP right (e.g. the ATO view appears to be that authorising access to software is a use of an IP right);
  • the supply of know-how or assistance in relation to IP; and
  • the sale by a distributor of hardware with embedded software, where the distributor is granted or uses rights in the IP.

The ruling, once finalised, will apply retrospectively as well as prospectively.[2]

The analysis adopted by the ATO in this draft draws heavily from concepts in copyright law for the purposes of determining whether a royalty arises for tax purposes. There is significantly more detail compared to the earlier draft ruling regarding the key concepts relevant to royalty analysis. In addition, the draft ruling deals with the interaction between the domestic law definition of royalty and the treaty definition.[3]

Some of the points of interest covered by the draft ruling include:

  • characterisation of a payment will require a detailed consideration of the IP rights granted or used in connection with an arrangement;
  • ‘consideration’ incorporates a wider notion than consideration in a contractual sense;
  • what the payment is ‘for’ is a question of fact. The terms used in an agreement may be relevant to, but not determinative of, the character of a payment as a royalty;
  • an amount may be a royalty even if not described as such. An objective assessment of the whole agreement and the commercial context is required to determine characterisation;
  • where a payment is principally for the grant of IP rights and other rights are ancillary or incidental, the ATO’s starting point is that the consideration is properly characterised as being entirely for the grant of the IP rights. If the software arrangement has no value or substance without the use of the IP rights, then all the payments under the arrangements will be royalties.

Absent from this draft ruling are the examples that featured previously in TR 2021/D4. In its place, two common “scenarios” are discussed:

  • Scenario 1 – where the performance of the contract requires the use of copyright rights;
  • Scenario 2 – where the agreement lacks specificity regarding the parties’ rights and obligations.

The ATO’s view is that under both of these scenarios a royalty will need to be recognised. In relation to Scenario 2, the ATO states that apportionment can be applied if the taxpayer has sufficient evidence that establishes that the distribution rights (or other rights outside of the definition of royalties) had substantial value independent of the right to use copyright and other IP. The ruling does not go on to explain further what evidence would be required.

Taxpayers will need to work through the ATO’s new approach to interpretation as it signals that the ATO may form the view that an obligation to pay RWHT may apply in circumstances where it did not previously.

We note that taxation rulings outline the ATO’s views on the interpretation of certain taxation laws (i.e. they do not have the force of law themselves). There may be alternative arguments to the ATO’s approach.

Next steps

We are aware that the ATO is already conducting reviews into arrangements in a number of sectors including e-commerce, pharmaceutical, health and science and resources sectors, with aggressive positions being adopted in relation to both technical and pricing outcomes.

While the ATO is adopting a strong stance in relation to these matters, there are a number of opportunities for taxpayers to maximise on their inherent advantages regarding these arrangements and look to achieve more reasonable outcomes. Clear objective evidence and independent valuation expertise are essential to displace the ATO’s pro-revenue starting position on pricing outcomes for intangible arrangements.

[1] Previously only 13 examples in PCG 2023/D2.
[2] It replaces the now withdrawn ruling TR 93/12 relating to the use of a local distributor of “simple use” software, and also replaces draft Taxation Ruling TR 2021/D4. 
[3] The ATO notes that there are material differences in the meaning of royalty for domestic and treaty purposes in the US, Mexican and Singaporean tax treaties, although the focus in the draft is on the standard treaty.

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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