Legislation to implement a diverted profits tax has passed the Federal Parliament. From 1 July 2017, the tax may potentially apply to the diversion of profits offshore through arrangements between related parties. Targeted at large multinational groups, the diverted profits tax is a fusion of anti-avoidance and transfer pricing rules. Partner Toby Knight and Senior Associate Scott Lang discuss the final form of the legislation and the steps multinational groups should take to prepare for its implementation.
How does it affect you?
- The diverted profits tax (DPT) will allow the Commissioner of Taxation (Commissioner) to impose tax at a penalty rate of 40 per cent on certain significant global entities for schemes 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) involving a foreign resident associate of a taxpayer where the taxpayer obtains a tax benefit from the scheme and the scheme is not subject to sufficient foreign tax and has insufficient economic substance.
- Multinational groups should determine whether they might be within the scope of the DPT and, if so, review their current and future cross border transactions to assess the risk of DPT being applied and consider restructuring options if appropriate. They should ensure that they have prepared transfer pricing documentation that complies with the requirements of Australian taxation laws and materials published by the OECD.
- Multinational groups already involved in transfer pricing audits or disputes in relation to transactions continuing past 1 July 2017 should familiarise themselves with the detail of the final legislation and the implications it will have for their engagement with the Australian Taxation Office (ATO). As one of the fundamental purposes of the DPT is to encourage taxpayers to disclose more information to the Commissioner, taxpayers need to understand the implications of the DPT for the nature of information that might be disclosed to the ATO and the timing of that disclosure so as to minimise the risk of receiving a DPT assessment and/or best preserve the taxpayer's prospects of challenging any such assessment should it issue.
- While most aspects of the DPT have been finalised by the passage of the legislation, the procedures that the ATO will adopt prior to issuing DPT assessments remain to be outlined. Taxpayers should monitor the release of administrative guidance by the ATO in relation to these procedures.
It has been less than a year since the DPT was originally announced in the 2016-2017 Budget and the Federal Government began consulting with relevant stakeholders.1 This preliminary consultation was followed by the release in November 2016 of exposure draft legislation and an explanatory memorandum.2 For more background on the exposure draft materials, refer to our earlier Focus: Diverted Profits Tax Exposure Draft Bill and Explanatory Memorandum Released. The current legislation was introduced into the Parliament in February.
Despite the relatively short period between policy announcement and finalised legislation, there have been some significant changes to the detail of the DPT. However, one feature of the DPT that has remained constant throughout the process and is reflected in the final legislation is the fact that it will be inserted into Part IVA of the Income Tax Assessment Act 1936 (Cth) (1936 Act). This will ensure that DPT overrides any relief available under double tax treaties entered into between Australia and other countries and given effect in Australian law.3
DPT will only apply to significant global entities (ie an entity that has annual global income of at least $1 billion or that is part of a consolidated group for accounting purposes that does).4
In a change from the exposure draft, DPT will not apply to the following categories of taxpayer on the basis that, because they are sovereign owned or widely held and predominantly carry on passive activities, they present a low integrity risk and should not face an unnecessary compliance burden:
- Managed investment trusts
- Foreign collective investment vehicles with wide membership
- Foreign (investment) entities owned by a foreign government
- Complying superannuation entities
- Foreign pension funds
DPT will only apply where it is reasonable for the Commissioner to conclude that the assessable, exempt and non-assessable non-exempt income of the significant global entity (ignoring any decrease to assessable income due to the diversion of profits) plus the assessable income of any of its associates that are members of the same group exceeds $25 million.5 In effect, this constitutes a de minimus group-wide Australian income test as the assessable income of foreign residents generally only includes Australian-sourced income.6 This is to ensure that DPT does not apply where the Australian operations of a group are relatively small.7
The Federal Government estimates that only 1600 taxpayers will potentially fall within the scope of the DPT.8
In essence, the DPT will apply where the following elements are satisfied:9
- there is a scheme (a term already defined in Part IVA);
- the relevant taxpayer has obtained, or would but for the operation of the general anti-avoidance rule in Part IVA obtain, a tax benefit in connection with the scheme (also a term already defined in Part IVA);10
- having regard to certain specified matters, it would be (objectively) concluded that one of the persons who entered into or carried out the scheme or any part of it did so for a principal purpose, or for more than one principal purpose that includes a purpose, of enabling the relevant taxpayer (either alone or with others) to obtain an Australian tax benefit or to both obtain an Australian tax benefit and reduce one or more foreign tax liabilities. The Explanatory Memorandum emphasises that this principal purpose test reflects the language of the OECD's BEPS Action 7 Final Report: Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, which should be relevant to the interpretation of the test.11 The matters specified as relevant to this principal purpose test include the amount of any quantifiable non-tax financial benefits relative to the amount of the tax benefit. The Explanatory Memorandum lists a number of quantifiable non-tax financial benefits including: productivity gains, cost savings, value additions, synergies, location specific benefits, reduction of non-income tax costs and provision of government incentives;12
- a foreign entity that is an associate (within the meaning of section 318 of the 1936 Act) of the relevant taxpayer entered into, carried out or is otherwise connected with the scheme or any part of it; and
- it is reasonable to conclude that the sufficient foreign tax or sufficient economic substance tests (described below) do not apply.
Aside from the exceptions for particular taxpayers, DPT will also not apply where it is reasonable to conclude (based on the information available to the Commissioner at the time)13 that neither the sufficient foreign tax test nor the sufficient economic substance test applies to the relevant taxpayer in relation to the tax benefit. While these exceptions have been a consistent feature of the proposed DPT, their precise detail has changed significantly in the final form of the legislation.
Sufficient foreign tax test
The sufficient foreign tax test will be satisfied where the total increases in foreign income tax that will result (or may reasonably be expected to result) from the scheme for a foreign entity (either the taxpayer or an associate) that is one of the persons who has entered into, carried out or is connected with the scheme, equals or exceeds 80 per cent of the reduction in the amount of Australian tax payable due to the tax benefit (reduced by any amount the relevant taxpayer must withhold as a result of withholding tax applicable to the tax benefit).14
The focus of this test is on the foreign income tax treatment of the specific scheme, including any generally applicable or scheme-specific foreign income tax relief (eg foreign tax losses, foreign tax credits or other foreign tax attributes). Consequently, it is the actual net foreign tax liability that results from the scheme which is relevant. In cases where there is little or no foreign tax liability due to the application of foreign tax losses, foreign tax credits or other foreign tax attributes, taxpayers will be unable to satisfy the sufficient foreign tax test.15
Sufficient economic substance test
The sufficient economic substance test will be satisfied if the profit made as a result of the scheme by each entity that entered into, carried out or is otherwise connected with the scheme or part of it reasonably reflects the economic substance of its activities in connection with the scheme (provided its role is not merely minor or ancillary).16
In making that determination, regard must be had to any relevant matters including:
- the functions performed, assets used and risks assumed by the relevant entity in connection with the scheme; and
- the OECD's Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations and BEPS Actions 8-10 Final Reports: Aligning Transfer Pricing Outcomes with Value Creation (which provide a methodology for conducting an analysis of functions, assets and risks).
This test is essentially a transfer pricing rule having regard to the OECD standards. It ensures that DPT will not be payable if there is a commercial transfer of economic activity and functions to another jurisdiction.17 The sufficient economic substance test requires that transfer pricing analysis be applied from both Australian and overseas perspectives. This potentially creates a higher compliance burden to ensure that there is documentation justifying the profits made by each entity involved in any cross-border transaction.
Where DPT does apply, it will be calculated according to the following formula:
DPT = DPT base amount(s) x 40 per cent
where the DPT base amount for each tax benefit is either:
- the amount of decrease in assessable income or an amount subject to withholding tax;
- 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 per cent company tax rate.
Shortfall interest charge will also be payable on the DPT base amount.18
While taxpayers can generally claim an offset for amounts of foreign income tax paid on assessable income for income tax purposes, no such foreign income tax offset will be available to decrease any DPT amount.19
Whereas taxpayers will be unable to claim an income tax deduction for amounts of DPT for which they are liable, payment of DPT will result in franking entities receiving a franking credit for the payment, albeit at the standard corporate tax rate of 30 per cent rather than the penalty DPT rate of 40 per cent.20
The lack of a tax offset in conjunction with the 40 per cent penalty rate of DPT may provide a strong incentive for taxpayers to adopt conservative positions so that their transactions are subject to income tax rather than DPT.
The DPT assessment and review process has been slightly modified from the procedures outlined in the exposure draft materials.
In relation to the internal procedures that the ATO will adopt prior to the issuing of a DPT assessment, the Explanatory Memorandum foreshadows the development of an oversight framework and the establishment of a DPT panel:21
The Australian Taxation Office (ATO) will ensure a rigorous framework is introduced for the DPT that encompasses several levels of oversight, senior executive sign-off and additional safeguards so as to provide assurance around the DPT process. This is to ensure that the DPT will only be applied in very limited circumstances and is focused on tax avoidance arrangements by related parties to divert profits offshore. The Commissioner will establish a Panel (similar to the existing General Anti-avoidance Rule Panel) related to DPT that will include at least one external member. Except in very limited circumstances, the Commissioner will seek endorsement from the Panel to make a DPT assessment. The Commissioner will outline the ATO's administrative processes through guidance.
The ATO internal procedures ultimately decided upon will be important given there is no statutory requirement for the Commissioner to provide a taxpayer with advance notice of his intention to issue a DPT assessment or an opportunity to make submissions before issuing such an assessment. Interestingly, the proposed preliminary steps prior to the issuing of DPT assessments have changed markedly from the consultation paper (which provided that the Commissioner would first issue a provisional assessment and after 60 days, during which time the taxpayer could make submissions, would issue a final assessment), to the exposure draft material (which anticipated that the Commissioner would provide taxpayers with (informal) notice of his intention to issue a DPT assessment followed by a 60-day period within which to make submissions before the Commissioner would issue an assessment) to the final legislation (which contains no pre-assessment procedures other than the development of the internal ATO safeguards as set out in the Explanatory Memorandum as described above).
A DPT assessment must be issued within seven years after the income tax assessment for each relevant income year in which the scheme was carried out.
The issuing of a DPT assessment will trigger two periods:
- a 21-day period within which the taxpayer must pay any DPT and shortfall interest charge (after which time general interest charge will become payable); and
- a 12-month period within which the Commissioner will review the assessment by reference to any further information provided by the taxpayer. This period may be shortened by the taxpayer serving a written notice on the Commissioner (which will cause the review period to end 30 days after such service unless the Federal Court has extended the period in the interim) or extended by agreement or order of the Federal Court.
After the expiry of the review period, the taxpayer will have 60 days within which to appeal against the DPT assessment to the Federal Court.
As did the exposure draft, the final legislation provides that, 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.22 A new section in the final legislation provides that expert evidence will be admissible if it came into existence after the period of review and is based on evidence that the Commissioner had in his custody or control at any time during the period of review.
Restricted DPT evidence (being information or documents not provided to the Commissioner during the review period), however, 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 would have been reasonable for the taxpayer or its associate to give the evidence to the Commissioner. The Commissioner must give consent if a failure to do so would render the DPT an incontestable tax for the purposes of the Constitution. When DPT assessments are eventually appealed to the Federal Court, issues that may well be ventilated in such litigation include whether the admission of restricted DPT evidence is the interests of justice or necessary to ensure the DPT is contestable and thus constitutional.
During their passage through Parliament, the DPT Bills were examined by the Senate Economics Legislation Committee. The Committee's report noted various objections raised by taxpayers as to the wide discretions the DPT affords the Commissioner, including in relation to the lack of any 'provision of last resort' wording, the 'pay now, argue later' approach, the lack of any defined internal ATO procedure prior to assessment and the evidentiary restrictions. However, the Committee rejected those criticisms, stating that the measures were necessary to counter multinational tax avoidance and adding that it 'has confidence that the Commissioner will take a measured approach in exercising these powers' and 'that it is up to the ATO to consider whether establishing a DPT review panel might provide assistance in the application of the DPT.'23
Where the Commissioner has issued a DPT assessment, he will have the power to make a compensating adjustment under section 177F(3) of the 1936 Act to prevent double taxation of the same amount (ie so as to not subject the same amounts to both income tax and DPT). Taxpayers will only be able to lodge a request for the Commissioner to exercise this power after the period of review for the DPT assessment has ended.
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. However, the Commissioner will be able to issue such a determination in addition to a DPT assessment if the requirements of the general provisions or of the Multinational Anti-Avoidance Law are also satisfied. Nevertheless, the intention is to ensure that no double taxation arises in respect of the same scheme by the application of both the general provisions and the DPT.24
The Explanatory Memorandum states that the penalties that apply to schemes subject to the general provisions of Part IVA provided for in subdivision 284-C of Schedule 1 to the Taxation Administration Act 1953 (Cth) (Administration Act) will not apply when a DPT assessment is made, given the 40 per cent DPT rate is taken to incorporate a penalty component.25
The DPT will only apply to income years commencing on or after 1 July 2017. However, it 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.26 Accordingly, multinational groups should begin preparing for its operation now.
Given the broad anti-avoidance concepts upon which the DPT is based, it could potentially apply to a wide range of transactions. Particular examples given in the Explanatory Memorandum of transactions that might be subject to DPT include:
- interest payments by an Australian company on a back-to-back loan from its foreign parent using a special purpose intermediary company in a lower tax jurisdiction;
- payments by an Australian company to a related foreign company in a lower tax jurisdiction for marketing, distribution, technical services support or administrative services;
- insurance premiums paid by an Australian insurance company to a foreign reinsurance company and which elects to be taxed separately from the reinsurance company;
- arrangements under which intellectual property of an Australian company is licenced to a foreign subsidiary but the Australian company continues to perform the sales and support functions; and
- the transfer by an Australian entity of intellectual property to a related entity in a lower tax jurisdiction, which entity then receives royalties from another related party.
While the broad structure of the DPT has now been finalised, how the ATO will actually use it in practice remains to be seen. The Explanatory Memorandum states that while the DPT is designed to bolster and complement transfer pricing and anti-avoidance rules and is 'not a provision of last resort', it is nevertheless expected that 'DPT will be applied only in limited circumstances' after the ATO has considered whether the operation of ordinary income tax provisions is sufficient.27 As already mentioned, a DPT Panel will be established and its endorsement will generally be required before the Commissioner can proceed to issue a DPT assessment. The circumstances in which this endorsement will not be required and the procedures of the DPT Panel will be the subject of further administrative guidance to be issued by the ATO.
With all of this in mind, all multinational groups should:
- Determine whether the group contains entities that could be subject to DPT.
- Review current and future cross border transactions to see if they fall within the scope of the DPT, assess the risk of DPT being applied to those transactions and consider restructuring options if appropriate.
- Ensure they have prepared transfer pricing documentation that complies with the requirements of subdivision 284-E of the Administration Act and relevant materials published by the OECD, as this will assist in satisfying the sufficient economic substance test exception.
- Monitor the release of administrative guidance by the ATO in relation to the procedures it will adopt prior to issuing DPT assessments.
For multinational groups already involved in transfer pricing audits or disputes, it will also be important to:
- Undertake analysis and evidence gathering at an earlier stage in order to avoid prejudicing their position under the restricted DPT evidence provisions.
- Consider at the earliest possible stage what information and documents relevant to their transactions should be disclosed to the Commissioner (and when) 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. For instance, the Explanatory Memorandum suggests that evidence of non-tax financial benefits might include representations made to management or boards or evidence of non-tax financial benefits that have actually accrued to date.28
- Ensure they understand the provisions in the Administration Act governing the shortening and/or extension of the period of review and the implications those provisions will have on the review of a DPT assessment. For example, if a taxpayer provides documents to the Commissioner at the very end of the review period (or earlier and then immediately seeks to shorten the review period), this may enliven the provisions of the Administration Act that permit the Commissioner to apply to the Federal Court for an order extending the review period if he has been unable to complete his examination of the taxpayer's affairs due to any action of, or failure to take reasonable action by, the taxpayer.29 The Explanatory Memorandum expressly states that this ensures taxpayers cannot terminate the review period prematurely after providing a large amount of material to the Commissioner or after refusing to provide particular information after a reasonable request.30
The legislation expressly acknowledges that the purpose of the DPT is to ensure that the Australian tax payable by significant global entities properly reflects the economic substance of their activities, to prevent the diversion of profits offshore through contrived arrangements between related parties and to encourage significant global entities to provide sufficient information to the Commissioner to allow for the timely resolution of tax disputes.31 These purposes will influence how the Commissioner applies the DPT and also how the Federal Court will interpret the DPT legislation. It remains to be seen whether the DPT will be a 'game-changer', but its provisions certainly give the Commissioner a powerful new tool in relation to transfer pricing disputes.
- Treasury, Implementing a Diverted Profits Tax (3 May 2016). For more information on the consultation paper, please see our earlier Focus: Diverted Profits Tax.
- Exposure Draft Treasury Laws Amendment (Combating Multinational Tax Avoidance) Bill 2017 (Cth); Exposure Draft Explanatory Memorandum, Tax Laws Amendment (Combating Multinational Tax Avoidance) Bill 2016 (Cth).
- 1936 Act s177B(1)(b); International Tax Agreements Act 1953 (Cth) s4(2).
- 1936 Act s177J(1)(c); Income Tax Assessment Act 1997 (Cth) s960-555 (1997 Act).
- 1936 Act s177K.
- 1997 Act s6-5(3).
- Explanatory Memorandum, Treasury Laws Amendment (Combating Multinational Tax Avoidance) Bill 2017 (Cth) 31 (Explanatory Memorandum).
- Explanatory Memorandum 4.
- 1936 Act s177J.
In determining whether a relevant taxpayer has obtained a tax benefit, there are two new modifications that must be applied to cases involving thin capitalisation and controlled foreign corporations.
Where the thin capitalisation rules apply to a relevant taxpayer and the tax benefit includes a debt deduction, the tax benefit is calculated by:
- firstly, determining the debt interest that would have been issued and the rate that would have applied had the scheme not been entered into; and
- secondly, applying that rate to the actual amount of debt: 1936 Act s177J(5).
This modification preserves the operation of the thin capitalisation rules in relation to the amount of debt: Explanatory Memorandum 18.
Where the foreign associate of the relevant taxpayer is a controlled foreign company (CFC) pursuant to the CFC rules, any tax benefit is reduced by any amount of attributable income of the foreign entity:
- that has been included in the assessable income of the relevant taxpayer or one of its Australian resident associates (that is not a trust or partnership); and
- to the extent that the amount is directly referable to the tax benefit and would not have been attributed to the taxpayer or its associate if the scheme had not been entered into or carried out: 1936 Act s177J(6)-(6A).
This ensures that income already brought to tax under the CFC rules is not also taxed again under the DPT: Explanatory Memorandum 19.
- Explanatory Memorandum 21-2.
- Ibid 24.
- Ibid 30.
- 1936 Act s177L.
- Explanatory Memorandum 32-3.
- 1936 Act s177M.
- Explanatory Memorandum 36, 44.
- Taxation Administration Act 1953 (Cth) sch 1 s280-102C.
- Explanatory Memorandum 50.
- 1997 Act ss 25-5(2), 201-15, 205-30, 208-115, 208-120, 219-15, 219-30.
- Explanatory Memorandum 52.
- Taxation Administration Act 1953 (Cth) sch 1 s145-25.
- Senate Economics Legislation Committee, Parliament of Australia, Treasury Laws Amendment (Combating Multinational Tax Avoidance) Bill 2017 [Provisions] and Diverted Profits Tax Bill 2017 [Provisions] (March 2017) 20.
- Explanatory Memorandum 48.
- Ibid 50. However, no amendments have been made to subdivision 284-C of Schedule 1 to implement this assurance.
- Treasury Laws Amendment (Combating Multinational Tax Avoidance) Bill 2017 (Cth) sch 1 item 52.
- Explanatory Memorandum 4, 7, 13-4.
- Ibid 24.
- Administration Act sch 1 ss145-15, 155-35.
- Explanatory Memorandum 54-5.
- 1936 Act s177H; Explanatory Memorandum 52.