Exposure draft legislation and explanatory materials for a diverted profits tax have been released by the Federal Government. Targeted at multinational groups transferring profits to offshore associates, the measures will give the Commissioner of Taxation a power to issue assessments at a punitive rate of tax based on limited knowledge, pursuant to a 'pay now, argue later' approach. Partner Toby Knight and Senior Associate Scott Lang discuss the detail of the exposure draft, the remaining uncertainties and the practical implications for multinational corporate groups.
How does it affect you?
- The diverted profits tax (DPT) will allow the Commissioner of Taxation (Commissioner) to tax certain cross-border transactions between related entities at a penalty rate of 40 per cent from 1 July 2017. Members of multinational corporate groups with annual global income of at least $1 billion and annual Australian turnover of at least $25 million may be subject to the DPT.
- The Commissioner may issue a DPT assessment if there is a scheme carried out for a principal purpose of obtaining an Australian tax benefit or both an Australian tax benefit and the reduction of a foreign tax liability, the scheme involves a foreign resident associate of a taxpayer, the taxpayer obtains a tax benefit from the scheme, the scheme is not subject to sufficient foreign tax and has insufficient economic substance.
- Once issued, a DPT assessment must be paid within 21 days and is subject to review for 12 months. If the Commissioner and the taxpayer fail to agree on how to tax the alleged diverted profits during that time (ie under transfer pricing rules rather than DPT rules), the taxpayer's only recourse will be to lodge an appeal to the Federal Court within 30 days. In those proceedings, the taxpayer will be prevented from adducing evidence that it has not already provided to the Commissioner during the review period unless the Commissioner consents or the court grants leave to do so.
- As such, the DPT is designed to provide an 'extra weapon' for the Commissioner in transfer pricing disputes. It will be a strong incentive for multinational groups to comply with transfer pricing rules and to disclose information to the Commissioner about their cross-border transactions rather than suffer a DPT assessment or, if they do, face evidentiary limitations in challenging it.
- Uncertainty remains on exactly how the DPT will operate in practice because significant features of it have not been included in the exposure draft Bill. Further related draft legislation and administrative guidance on the DPT should be forthcoming.
As part of the 2016-2017 Budget, the Federal Government announced its intention to introduce a DPT for income years commencing on or after 1 July 2017 (modelled on the second limb of the United Kingdom's DPT). On Budget night, the Government released a short consultation paper outlining the broad structure of the DPT.1 On 29 November 2016, the Government published exposure draft legislation and an explanatory memorandum that were developed following the submissions received in relation to the consultation paper.
Consistent with expectations, the DPT provisions will be inserted into, and complement, the general anti-avoidance rules contained in Part IVA of the Income Tax Assessment Act 1936 (Cth) (1936 Act).2 This is aimed at precluding taxpayers from claiming any relief from DPT on the basis of double tax treaties entered into between Australia and other countries and given effect in Australian law by the International Tax Agreements Act 1953 (Cth).3 It also means that existing jurisprudence on Part IVA will be relevant when interpreting and applying the DPT.
Taxpayers to which DPT will apply
The DPT will only apply to taxpayers that are significant global entities.4 A significant global entity is an entity that has annual global income of at least $1 billion (either alone or as part of a consolidated group for accounting purposes).5
Even if an entity is a significant global entity, the DPT will not apply where it is reasonable to conclude that the annual turnover of the entity and all other Australian resident members of the same group is less than $25 million, provided that none of those entities have artificially booked turnover outside of Australia.6 Turnover will be considered to have been artificially booked outside Australia if the turnover reported in Australia for accounting purposes does not reflect the substance of the activities carried on in Australia.7
While the exposure draft Explanatory Memorandum states that only Australian turnover will be taken into account when determining whether the $25 million de minimus threshold is reached, the current drafting of the exposure draft Bill is not necessarily so restrictively defined.8
Situations in which DPT will apply
Broadly speaking, the DPT will apply where the following elements are satisfied:
- There is a scheme entered into by a person or persons.9 This requirement draws upon the existing provisions of Part IVA of the 1936 Act. A scheme is defined broadly to mean any agreement, arrangement, understanding, promise or undertaking (whether express or implied, whether enforceable or not enforceable, or intended to be enforceable by legal proceedings) and any scheme, plan, proposal, action, course of action or course of conduct (whether unilateral or not).10
- It is reasonable to conclude that one of the persons who entered into or carried out the scheme (or any part thereof) did so for a principal purpose of enabling a taxpayer (referred to as the 'relevant taxpayer') either alone or together with other taxpayers to obtain a tax benefit or to both obtain a tax benefit and a reduction in liability to tax under a foreign law in connection with the scheme.11
This principal purpose element raises a number of important points:
- According to the Explanatory Memorandum, the purposes of the persons who entered into or carried out the scheme must be determined objectively by reference only to the information available to the Commissioner at the time of issuing any DPT assessment. That will involve analysis of how the scheme was implemented, the substantive outcomes of the scheme and the nature of any connection between the relevant taxpayer and other parties.12
- The reference to a principal purpose means that 'the relevant principal purpose … must be one of the main purposes, having regard to all the facts and circumstances.'13 This is an easier test for the Commissioner to fulfil than the sole or dominant purpose test that applies to the rest of Part IVA (other than the recently enacted MAAL, which has the same lower threshold).14
- The inclusion of the dual purpose of obtaining a tax benefit, as well as a reduction of liability to tax under a foreign law, means that DPT will apply even if the persons that enter into or carry out the scheme had a principal purpose of reducing foreign tax liabilities.15 This means that a purpose of minimising foreign tax will not preclude the provision applying where there is simultaneously a purpose of obtaining an Australian tax benefit.
- In addition to the standard Part IVA considerations, in determining whether the principal purpose element is satisfied, regard must be had to the amount of the tax benefit, the result in relation to the operation of any foreign tax law that would be achieved by the scheme and the extent to which non-tax financial benefits that are quantifiable will or may reasonably be expected to result from the scheme.16 In relation to that last consideration, if the amount of quantifiable non-tax financial benefits exceeds the amount of the tax benefit, this may suggest that the principal purpose of the scheme is not to obtain the tax benefit.17
Despite the differences between the principal purpose test for DPT (and MAAL) and the dominant purpose test in the general rule in Part IVA, the inclusion of the DPT in Part IVA and the fact that DPT still requires the purpose of a person who entered into or carried out the scheme to be identified means that general principles distilled from previous Part IVA jurisprudence will remain relevant.18 One of the fundamental principles in this regard was identified by the High Court in Commissioner of Taxation v Spotless Services Ltd. In that case, the court held that differentiating between rational commercial decisions and seeking to obtain a tax benefit in this context is to accept a false dichotomy.19 Their Honours emphasised that '[a] particular course of action may be … both "tax driven" and bear the character of a rational commercial decision. The presence of the latter characteristic does not determine the answer to the question whether … [there is a] "dominant purpose" of enabling the taxpayer to obtain a "tax benefit".'20 The same logic should apply in determining the principal purpose of a diverted profits scheme.
- The relevant taxpayer will obtain a tax benefit in connection with the scheme.21 This requirement also draws upon the existing provisions of Part IVA of the 1936 Act. Generally speaking, a taxpayer will obtain a tax benefit if an amount is not included in its assessable income or a deduction is allowable to it that would not otherwise have been included or allowable in the absence of the scheme.22
- There is a foreign entity (ie an entity that is not resident of Australia for tax purposes) that is an associate (within the meaning of section 318 of the 1936 Act) of the relevant taxpayer who entered into, carried out or is otherwise connected with the scheme or any part of the scheme.23 The definition of associate in section 318 is complex and can associate persons that are not conventionally considered to be related. Importantly, this requirement means that DPT will not apply to a scheme in which only Australian resident entities are involved.24
Apart from the $25 million turnover exception, DPT will also not apply where it is reasonable to conclude that either the sufficient foreign tax test or the sufficient economic substance test are satisfied.25
Sufficient foreign tax test
The sufficient foreign tax test will be satisfied where the total increases in foreign tax that will or may reasonably be expected to result from the scheme during the relevant tax period equals or exceeds 80 per cent of the amount of the corresponding reduction in Australian tax.26 Importantly, only foreign taxes that are equivalent to income tax are considered; foreign Value Added Taxes are irrelevant.27
From a practical perspective, this requirement initially collapses into a comparison of the company tax rates of Australia and the relevant foreign state. Even assuming that a payment from an Australian resident to a foreign resident is fully taxable in the foreign resident's state, if that state's company tax rate is less than 24 per cent (ie 80 per cent of the Australian company tax rate of 30 per cent), then the sufficient foreign tax test cannot be satisfied.
Given Australia's relatively high company tax rate, transactions involving foreign residents will often fail to satisfy the sufficient foreign tax test. Indeed, statistics from the OECD show that 16 of its 34 other member states have company tax rates of 24 per cent or lower.28 This means that arm's length transactions with related parties in states not traditionally considered as low tax jurisdictions (eg the United Kingdom, Sweden, Finland, Iceland and Denmark) may still fail the sufficient foreign tax test.
However, the sufficient foreign tax test may also fail to be satisfied in other cases where the foreign state provides specific tax relief in relation to the scheme.29 Consequently, this test will only provide an effective exception to DPT in limited cases.
Sufficient economic substance test
The sufficient economic substance test will be satisfied where the income derived from the scheme by each entity that entered into, carried out or was otherwise connected with the scheme (or part of it) reasonably reflects the economic substance of the entity's activities in connection with the scheme.30 Here the focus is on active (not passive) activities of the entity.31
In applying the test, the exposure draft Explanatory Memorandum states that the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations and the OECD's Base Erosion and Profit Shifting Project Actions 8-10 final report Aligning Transfer Pricing Outcomes with Value Creation should be taken into account to the extent that they are relevant.32 In turn, these reports state that the following considerations will be relevant:33
- contractual terms of the transaction and surrounding circumstances;
- functions performed, assets used and risks assumed by the parties;
- how functions performed relate to the wider generation of value by the group;
- characteristics of property transferred or services provided;
- economic circumstances of the parties and the markets in which they operate; and
- business strategies pursued by the parties and industry practices.
However, the provisions of the exposure draft Bill dealing with the sufficient economic substance test do not make any reference to these OECD materials or transfer pricing materials more generally. Consequently, it is not certain that the courts would automatically refer to them.
Calculation and consequences of DPT
Where DPT does apply, it will be calculated according to the following formula:
DPT liability amount
Diverted profit amount
where the diverted profit amount is generally either the amount of decrease in assessable income or capital gain, the amount of increase in an allowable deduction or capital loss (or the amount of any tax offset or exploration credit divided by the 30% company tax rate).35
The consultation paper stated that an offset would be allowed for any Australian taxes paid on the diverted profits (eg withholding taxes or income tax on income attributed under the CFC rules) but not for any foreign taxes paid on the diverted profits.36 However, the exposure draft Explanatory Memorandum is silent on the first issue, merely reasserting that DPT will not be reduced by the amount of any foreign tax paid on the diverted profits.37
Interest will be payable on the amount of DPT from the date any amount would have been payable on the relevant income tax assessment to which the diverted profits are referrable until the date on which the DPT assessment is issued.38 However, the general penalty regime that applies to Part IVA schemes will not apply to diverted profits schemes given the penalty rate of DPT (ie 40 per cent rather than the general company tax rate of 30 per cent).39
Similarly, the Commissioner will not be able to issue a determination under the general provisions of Part IVA to cancel the tax benefit involved in a diverted profits scheme merely because the scheme is liable to DPT.40
The DPT assessment and review process is abbreviated. In summary it involves:
- Informal discussions between Commissioner and taxpayer (including notice of intention to issue a DPT assessment).
- Within seven years of the relevant income tax assessment, issue of a DPT assessment followed by two concurrent periods:
- 21-day period within which the taxpayer must pay; and
- 12-month period within which to review the assessment.
- After the expiry of the 12-month review period, a 30-day period within which the taxpayer may appeal against the DPT assessment to the Federal Court.
Before any DPT assessment is issued, the Commissioner will engage with relevant taxpayers in order to agree on the correct amount of income tax that should be paid on their cross-border transactions. If agreement is not reached through this informal process, the Commissioner will provide the relevant taxpayer with (informal) notice of intention to issue a DPT assessment.41 As a matter of practice, the Commissioner will then give the taxpayer a further 60-day period within which to make submissions.42 If the matter is still not resolved, the Commissioner will issue a DPT assessment. This may be done at any time within seven years after the issuing of the income tax assessment for the relevant income year in which the transactions occurred.43 This assessment will be final rather than provisional for a period of 60 days as had been suggested by the consultation paper.44 Importantly, there is no statutory requirement that the Commissioner provide a taxpayer with notice or an opportunity to make submissions before issuing a DPT assessment.
With the issuing of a DPT assessment, two time periods begin to run concurrently. Firstly, the taxpayer will have 21 days within which to pay its DPT liability.45 Payment of DPT will result in a franking credit arising in the taxpayer's franking account albeit at the company tax rate of 30 per cent, not the DPT rate of 40 per cent.46 Secondly, there is a 12-month review period.47 During this time, the Commissioner must review the assessment and the taxpayer may provide the Commissioner with additional information or documents. The Commissioner may amend both the taxpayer's relevant income tax assessments and DPT assessments (including to reduce DPT payable to nil).48 This review period may be shortened or extended by agreement between the Commissioner and taxpayer.49 The review period may also be extended by order of the Federal Court on application of the Commissioner.50 Changes to the length of the review period will be made depending upon the amount of additional information the taxpayer has provided to the Commissioner.
Only once the 12-month review period has expired is the taxpayer entitled to object to the DPT assessment. That objection must be made within 30 days after the end of the period of review by way of an appeal to the Federal Court.51 Importantly, in any appeal to the Federal Court information or documents that the taxpayer or its associates had in their custody or control at any time before, during or after the period of review will not be admissible without the Commissioner's consent or the court's leave unless they were provided to the Commissioner at any time during the period of review.52 Such evidence will be admissible if the Commissioner consents or the court orders that its admission is necessary in the interests of justice. In both cases, regard must be had to whether the remaining evidence is likely to be misleading and whether it was reasonable for the taxpayer or its associate to give the evidence to the Commissioner.
The purpose of the DPT is to incentivise disclosure by taxpayers of particular cross-border arrangements and compliance with income tax laws rather than raising substantial revenue of itself. The DPT will provide the Commissioner with a power to issue assessments at a punitive rate of tax based on limited knowledge pursuant to a highly truncated procedure. While there is no express link between the DPT provisions and the transfer pricing provisions contained in subdivision 815-B of the 1997 Act, the structure of the DPT shows that it is clearly intended to provide the Commissioner with an 'extra weapon' in transfer pricing cases.
Importantly, the ability of the Commissioner to proceed on limited information, the obligation on the taxpayer to 'pay now, argue later' and the restriction on the admissibility of evidence in any appeal will place increased emphasis on multinational corporate groups undertaking analysis and evidence gathering at an earlier stage in transfer pricing disputes in order to avoid prejudicing their position. Each of these factors provides an incentive for taxpayers to consider early the information and documents relevant to their transfer pricing that should be disclosed to the Commissioner to dissuade him from issuing a DPT assessment or, once a DPT assessment is issued, to ensure that the taxpayer can adduce all relevant evidence in any Federal Court proceedings contesting the DPT assessment.
The DPT only apply in respect to income years commencing on or after 1 July 2017. However, the DPT will apply to the operation of schemes after that date even if those schemes were entered into or came into existence prior to that date.53
The Federal Government has invited submissions on the exposure draft Bill and Explanatory Memorandum, which are due to be provided to the Treasury by Friday, 23 December 2016.
When preparing submissions, it will be important to note that the Government still has to provide a number of further draft documents before the operation of the DPT can be fully understood. In particular, no draft legislation dealing with the imposition of DPT has been released and the exposure draft Bill does not include a number of provisions that are integral to the proposed operation of the DPT (eg that DPT is not reduced by foreign tax payments, that the general Part IVA penalty regime does not apply to diverted profits, that interest is payable on the DPT amount, that DPT is payable within 21 days of the issuing of an assessment and that a franking credit will arise on payment of DPT). Furthermore, there are issues in the consultation paper on which the exposure draft materials are silent (eg that DPT will be offset by any relevant Australian withholding tax or income tax attributable to Controlled Foreign Company rules).
Finally, the consultation paper also stated that draft administrative guidance 'will be developed in consultation with stakeholders and released at the time of introduction of the Bill into Parliament.'54 At the time of writing, no draft of such guidance has been publicly released.
Treasury, Implementing a Diverted Profits Tax (3 May 2016). For more information on the consultation paper, please see our earlier Diverted Profits Tax.
- This is also consistent with the adoption of the Multinational Anti-Avoidance Law (MAAL) contained in s177DA of 1936 Act.
- 1936 Act s177B(1)(b).
- Exposure Draft Treasury Laws Amendment (Combating Multinational Tax Avoidance) Bill 2017 (Cth) (Exposure Draft Bill) sch 1 item 5 s177H(1)(b).
- Income Tax Assessment Act 1997 (Cth) s960-555 (1997 Act).
- Exposure Draft Bill sch 1 item 5 ss177H(1)(e)(i), 177J.
- Exposure Draft Explanatory Memorandum to Tax Laws Amendment (Combating Multinational Tax Avoidance) Bill 2016 (Cth) (Exposure Draft Explanatory Memorandum) 14.
- Ibid 14; cf Exposure Draft Bill sch 1 item 5 s177J.
- Exposure Draft Bill sch 1 item 5 s177H(1).
- 1936 Act ss177A(1)(definition of 'scheme'), 177A(3).
- Exposure Draft Bill sch 1 item 5 s177H(1)(a).
- Exposure Draft Explanatory Memorandum 11. This is a summary of the principles from existing Part IVA jurisprudence including Commissioner of Taxation v Spotless Services Ltd (1996) 186 CLR 404, 423 and Orica Ltd v Commissioner of Taxation  FCA 1399 (7 December 2015) 17-19.
- Ibid 11 (emphasis added).
- See 1936 Act ss177A(5), 177D(1); cf s177DA(1)(b).
- Exposure Draft Explanatory Memorandum 10.
- Exposure Draft Bill sch 1 item 5 s177H(2). The eight standard matters to which regard must be hand when determining purpose under the general anti-avoidance provisions of Part IVA are listed in s177D(2): the manner in which the scheme was entered into or carried out; the form and substance of the scheme; the time at which the scheme was entered into and the length of the period during which the scheme was carried out; the result in relation to the operation of this Act that would be achieved by the scheme; any change in the financial position of the relevant taxpayer that has resulted, will result, or may reasonably be expected to result, from the scheme; any change in the financial position of any person who has, or has had, any connection (whether of a business, family or other nature) with the relevant taxpayer, being a change that has resulted, will result or may reasonably be expected to result, from the scheme; any other consequence for the relevant taxpayer, or for any person with any connection to the relevant taxpayer, of the scheme having been entered into or carried out; and the nature of any connection (whether of a business, family or other nature) between the relevant taxpayer and any person.
- Exposure Draft Explanatory Memorandum 11-12.
- This is implicitly recognised by the Exposure Draft Explanatory Memorandum, which states that where a person acts upon professional advice, it may be appropriate to attribute the objective purpose of the adviser to the person: 12. This is a summary of the principle from Commissioner of Taxation v Consolidated Press Holdings Ltd (2001) 207 CLR 235, 264. See also above n 12.
- (1996) 186 CLR 404, 415 (Brennan CJ, Dawson, Toohey, Gaudron, Gummow and Kirby JJ).
- Ibid 416.
- Exposure Draft Bill sch 1 item 5 s177H(4).
- 1936 Act s177C. Other tax benefits include a capital loss being incurred, a foreign income tax offset being allowable, an innovation tax offset being allowable, an exploration credit being issued, or withholding tax not being payable that would not have been incurred, allowable, issued or not payable respectively in the absence of the scheme.
- Exposure Draft Bill sch 1 item 5 ss177H(1)(c), 177H(1)(d).
- Exposure Draft Explanatory Memorandum 13.
- Exposure Draft Bill sch 1 item 5 ss177H(1)(e)(ii), 177H(1)(e)(iii).
- Ibid sch 1 item 5 s177K.
- Ibid 15-6.
- Organisation for Economic Co-operation and Development, Tax Database: Table II.1 Corporate income tax rate (14 November 2016). The OECD member states with corporate tax rates above 24 per cent are Austria, Belgium, Canada, France, Germany, Greece, Israel, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, New Zealand, Norway, Portugal, Spain and the United States of America.
- Exposure Draft Explanatory Memorandum 15.
- Exposure Draft Bill sch 1 item 5 s177L.
- Exposure Draft Explanatory Memorandum 18.
- Ibid 18.
- The rate of DPT has been set higher than the company tax rate of 30 per cent as a penalty to encourage compliance with Australian income tax laws: Exposure Draft Explanatory Memorandum 22.
- Exposure Draft Bill sch 1 item 5 ss177M(a), 177N. The imposition of DPT and its 40 per cent rate of diverted profits tax are not contained in the Exposure Draft Bill, but will be contained in a separate (as yet unpublished in draft) Bill: Exposure Draft Explanatory Memorandum 30.
- Treasury, above n 1, 6.
- Exposure Draft Explanatory Memorandum 22. Once again, this provision is not included in the Exposure Draft Bill because it is to be included in another (as yet unpublished in draft) Bill: Exposure Draft Explanatory Memorandum 30.
- Ibid. This provision is not included in the Exposure Draft Bill for the same reason.
- Ibid 30. This provision is not included in the Exposure Draft Bill for the same reason.
- Exposure Draft Bill sch 1 item 5 s177M(b).
- Exposure Draft Explanatory Memorandum 23-4.
- Ibid 23.
- Exposure Draft Bill sch 1 item 9 s145-10.
- Treasury, above n 1, 7.
- Exposure Draft Explanatory Memorandum 23-4, 30. Again, this provision is not included in the Exposure Draft Bill because it is to be included in another (as yet unpublished in draft) Bill: Exposure Draft Explanatory Memorandum 30.
- Ibid 31. This provision is not included in the Exposure Draft Bill for the same reason.
- Exposure Draft Bill sch 1 item 9 s145-15.
- Exposure Draft Explanatory Memorandum 5-6, 27. While it is not included in the Exposure Draft Bill, it is contemplated that interest will be payable by the Commissioner on any refunded amount: 27. Again, while it is not included in the Exposure Draft Bill, the period for amending income tax assessments will be extended for this purpose: 27.
- Exposure Draft Bill sch 1 item 9 s145-15; Taxation Administration Act 1953 (Cth) sch 1 s155-35.
- Taxation Administration Act 1953 (Cth) sch 1 s155-35.
- Exposure Draft Bill sch 1 item 9 s145-20. The taxpayer cannot make an application to the Administrative Appeals Tribunal.
- Ibid sch 1 item 9 s145-25.
- Ibid sch 1 item 11.
- Treasury, above n 1, 7.