Insights and observations 8 min read
As foreshadowed in a Discussion Paper in August 2022, Treasury has produced draft rules adding to Division 26 of the Income Tax Assessment Act 1997 (Cth). These additions seek to deny significant global entities deductions for intragroup payments made in relation to the exploitation of intangibles connected with low corporate tax jurisdictions.
These measures complement, but are blunter than, the OECD's Pillar Two reforms that are designed to impose top-up taxes to the extent to which the effective tax rate in a jurisdiction is less than 15%. These rules may act as a significant disincentive for multinational groups to structure their intragroup payments in a way that results in intangible-related income being derived in low corporate tax jurisdictions. These rules may apply even if all such payments are priced at arm's length and there is sufficient economic substance in the jurisdiction that is the ultimate owner of the relevant intangible assets.
- The Federal Government is proposing to deny the ability of significant global entities to deduct payments relating to intangible assets connected with low corporate tax jurisdictions.
- Unlike the OECD's Pillar Two reforms, which focus on the effective tax rate in a particular jurisdiction, this measure seeks to deny deductions where in-scope payments are made into countries where the relevant income is taxed at less than 15%. In most cases, this is the national headline corporate tax rate, with any sub-national corporate tax rates disregarded.
- The regime is expected to apply broadly, to any intragroup payment that directly or indirectly relates to an intangible asset potentially subject to scrutiny. Although the measure is not expected to disrupt genuine supply and distribution arrangements, the Commissioner may seek to unbundle a perceived intangibles component of an intragroup transaction and to trace this through to the ultimate economic owner of the intangible asset.
- This anti-avoidance measure will sit alongside existing regimes that may also be relevant, including the transfer pricing, diverted profits tax and royalty withholding tax provisions. As a result, it is possible for a taxpayer paying an arm's length royalty (on which withholding tax is paid) to an associate with sufficient economic substance in a low corporate tax jurisdiction to be denied a deduction in Australia. Moreover, unlike other anti-avoidance measures, this measure does not impose any 'purpose' test.
- Multinational taxpayers, particularly those with income referable to intangible assets being derived in jurisdictions with headline corporate tax rates of less than 15%, should review their current arrangements against the proposed measure. It is expected to apply from 1 July 2023.
Following a Discussion Paper in August 2022 and an announcement in the October 2022-23 Budget, the Federal Government has proposed a new anti-avoidance measure to deny multinational groups the ability to claim tax deductions for payments made to related parties in relation to intangibles held in low- or no-tax jurisdictions. On 31 March 2023, Treasury released an Exposure Draft and associated Explanatory Materials. This measure is part of a wider package of domestic anti-avoidance and tax integrity measures, including thin capitalisation reform (see our Insight), disclosure of subsidiary information and public country-by-country reporting. With an intended effective start date of 1 July 2023, this measure is separate from, but complementary to, the OECD Pillar Two Rules that are expected to be implemented by Australia in the near future.
This measure will be added to Division 26 of the Income Tax Assessment Act 1997 (Cth) (ITAA97), which contains a wide variety of items that, even if prima facie deductible under ordinary deductibility principles, are denied deductibility. These include penalties (s 26-5), political contributions and gifts (s 26-22), bribes (ss 26-52, 26-53) and expenditure relating to illegal activities (s 26-54).
The stated object of this measure is to deter large multinational groups from structuring their arrangements so that income from exploiting intangible assets is derived in low corporate tax jurisdictions. The Federal Government's concern is that valuable intangible assets, which generally are not tied to particular physical locations, are highly mobile. This may allow multinational groups to centralise intangible assets in jurisdictions with either a low headline corporate income tax rate or a regime that preferentially taxes income from intellectual property. Australian taxpayers may be able to claim deductions for payments for the use of these intangible assets, whether directly via royalties or indirectly (eg embedded in product purchases or service fees).
This measure will sit alongside a variety of existing regimes, including Australia's:
- Transfer pricing rules (contained in Division 815 of the ITAA97), which are designed to ensure that payments to related parties are consistent with the arm's length standard.
- Royalty withholding tax regime (contained in Division 11A of the Income Tax Assessment Act 1936 (Cth) (ITAA36)), which is designed to ensure that Australia can tax royalties paid to persons outside of Australia (subject to any modifications agreed via bilateral negotiations with Australia's treaty partners).
- Diverted profits tax (contained in Part IVA of the ITAA36), which is designed to ensure that the Australian tax payable by Australian taxpayers properly reflects the economic substance of the activities carried on in Australia, and to prevent multinational groups from reducing the amount of Australian tax through contrived arrangements between related parties.
- General anti-avoidance rule (contained in Part IVA of the ITAA36), which is designed to counteract schemes entered into or carried out by a person for the sole or dominant purpose of obtaining a tax benefit.
Under the proposed regime, a significant global entity (SGE) will be denied a deduction in relation to payments made by it to an associate, to the extent that the payment results in the associate deriving income associated directly or indirectly with the exploitation of an intangible asset in a country that is a low corporate tax jurisdiction. This regime encapsulates the following key concepts.
The proposed legislation follows the definition of SGE as contained in section 960-555 of the ITAA97. In general, an entity is an SGE if it is a member of a multinational group with annual global income of A$1 billion or more. This application is broadly consistent with certain existing tax integrity and transparency measures in Australia (eg diverted profits tax, country-by-country reporting) and the intended application of the OECD's Pillar Two reforms (which is targeted at multinational groups with turnover exceeding €750 million).
The proposed legislation follows the definition of 'associate' as contained in section 318 of the ITAA36. This definition is focused on the presence of sufficient influence or a majority voting interest. Although this is slightly different from the focus of the Associated Enterprises Article contained in Article 9 of the OECD Model Tax Convention (concerning direct or indirect participation in management, control or capital), it is not readily apparent that there is much practical difference. In most cases, the question of whether an entity is an associate of an SGE is likely to be straightforward.
For the purposes of determining whether there has been a payment to an associate, it does not matter whether the payment is made directly or through one or more entities. For that purpose, it also does not matter where the associate is located.
This proposed regime closely, but not completely, follows the definitions of 'royalty' or 'royalties' in section 6 of the ITAA36. Although 'intangible asset' is not a defined term, the proposed regime is intended to be interpreted broadly, covering intellectual property, copyright, access to customer databases, algorithms, software licences, licences, trademarks, patents, leases, licences and other rights over assets. However, as tangible assets, interests in land and financial arrangements are perceived to be less mobile and/or subject to other regulatory frameworks, they are explicitly excluded from the regime.
In broad terms, a foreign country is a low corporate tax jurisdiction if the corporate tax rate is less than 15% (or nil). In most cases, this will be the headline corporate tax rate. In other cases, this might be the highest possible rate that applies to an amount of income or the lowest possible rate that applies to a type of income. Unlike the OECD Pillar Two reforms, the legislation is unconcerned with the effective tax rate in a jurisdiction. Relatedly, the definition looks to national taxes only, and ignores the impact of sub-national taxes (eg at a state, province, region, canton or local level).1 The Minister may, having regard to any relevant findings, determinations, advice, reports or other publications of the OECD, make a determination that a foreign country is a low corporate tax jurisdiction if the laws of a foreign country provide for a preferential patent box regime without sufficient economic substance.
Risk of multiple taxation
In the event an Australian taxpayer makes a payment involving the exploitation of an intangible asset to an associate in a low corporate tax jurisdiction that is subject to proposed section 26-110, it may also be subject to tax in the low corporate tax jurisdiction and/or be subject to withholding tax in Australia. Specifically:
- A royalty payment made to an associate that is a tax resident in a foreign jurisdiction by an Australian taxpayer is prima facie subject to withholding tax at 30% in Australia. This withholding tax rate may be reduced under the provisions of the Royalties Article in any relevant double tax agreement (DTA).
- As the withholding tax obligation arises merely on the payment of a royalty, it may be of no consequence that the Australian taxpayer may be denied a deduction for such payment as a result of the application of these new provisions to be contained in Division 26.
- In most countries, the receipt of a royalty by a taxpayer from an associate tax resident in a foreign jurisdiction is prima facie subject to corporate income tax. To mitigate or eliminate double taxation from such a transaction, the foreign jurisdiction may exempt the transaction from corporate income tax or provide a foreign tax credit to the extent to which Australian tax was withheld. This may be under the foreign jurisdiction's domestic law or a DTA with Australia. However, in the event the foreign jurisdiction does not have (or exercise) an applicable exemption or credit mechanism, the royalty may be taxed at the foreign jurisdiction's full corporate tax rate.
As a result (but subject to the final form of the legislation), the payment by an Australian taxpayer of a royalty to a low corporate tax jurisdiction that is subject to proposed section 26-110 may give rise to a withholding tax liability while not being deductible in Australia. This is in addition to any corporate income tax in the foreign country.
Potential breadth of the regime
This regime has potentially broad application.
First, the word 'exploit' is defined very broadly. To 'exploit an intangible asset' includes to use, market, sell, license, distribute, supply, receive, forbear in respect of, exploit another intangible asset that is a right in respect of or an interest in, or do anything else in respect of, the intangible asset. The section applies in relation to permission to exploit an intangible asset in the same way as it applies in relation to a right to exploit the intangible asset.
Secondly, the regime extends to payments made by the Australian taxpayer resulting in the recipient or another associate deriving income directly or indirectly from exploiting the intangible asset (or from a related intangible asset) regardless of whether the payments are made by the Australian taxpayer directly or through one or more other entities. As the draft legislation allows for a high degree of 'look-through', neither the character of the intercompany payment nor the tax residence of the immediate recipient is determinative. If the Australian taxpayer makes intercompany payments (howsoever characterised), does anything regarding intangible assets, and another associate derives income from the exploitation of intangible assets in a low corporate tax jurisdiction, the Commissioner may seek to trace these intercompany payments through to the ultimate owner of the relevant intangible assets. Although the Explanatory Materials clarify that the regime 'is not intended … to inappropriately apply to genuine supply and distribution arrangements between associates', multinational group structures with intangible asset holding companies in low corporate tax jurisdictions may be particularly prone to scrutiny.
Thirdly, although 'intangible asset' is an undefined term, it may extend beyond mere intellectual property.2 In an example included in the text of the Exposure Draft, intangible assets are said to include not only intellectual property, but information or data, including a database of customers, and an algorithm. The Explanatory Materials set out a variety of examples of activities that Treasury believes would be considered to be within the meaning of exploiting an intangible asset, including accessing information contained on a database. This is notwithstanding the fact that the High Court has previously established that there are no proprietary rights in information or data per se.3
Therefore, the Commissioner may take the position that certain intercompany payments that may not be subject to royalty withholding tax on the basis that they are not payments for the use of, or the right to use, or the supply of, specified intellectual property – such as management fees that contain an express or implied right to use a customer database – fall within the scope of proposed section 26-110. As a result, the scope of the definition of 'intangible asset' may be an area of disagreement between taxpayers and the Commissioner.4
Interaction with treaty non-discrimination articles
Australia has given the force of law to non-discrimination articles contained in several of its DTAs. Crucially, the first sentence of Article 24(4) of the OECD Model Tax Convention, which has been replicated in Australia's DTAs with Chile, Finland, Germany, India, Israel, Japan, New Zealand, Norway, South Africa, Switzerland and the UK, provides as follows:
"… interest, royalties and other disbursements paid by an enterprise of [Australia] to a resident of the other Contracting State shall, for the purpose of determining the taxable profits of such enterprise, be deductible under the same conditions as if they had been paid to a resident of [Australia]. …"
This specific provision has not been tested in an Australian court. However, the High Court considered the operation of a related treaty non-discrimination article for the first time in Addy v Commissioner  HCA 34, a 2021 decision that limited the operation of a regime that sought to impose a different personal income tax regime on holders of working holiday visas (colloquially referred to as the 'backpacker tax'). In short, the decision confirms that the prohibitions contained in non-discrimination articles have the effect of disapplying proscribed discriminatory taxation or connected requirements and instead applying the more favourable ones. We considered the ramifications of this case in more detail here.
Although each case will turn on its facts, any attempt by the Commissioner to disallow a deduction arising from payments to associates in low corporate tax jurisdictions where Australia has an Article 24(4) equivalent non-discrimination article in its treaty with such low corporate tax jurisdictions may be challenged by taxpayers. This issue is particularly acute in the case of Switzerland, a country with which Australia has negotiated a relevant non-discrimination provision and, at the time of writing, has a federal corporate income tax rate of less than 15%.
Further complex treaty interpretation issues may arise in so-called triangular cases, such as where the payment is made to intermediate associates:
- In jurisdictions with which Australia has a DTA containing the relevant non-discrimination article (eg the UK) and the income from the exploitation of the intangible assets ultimately accumulates in a low corporate tax jurisdiction with which Australia also has a DTA containing the relevant non-discrimination article (eg Switzerland).
- In jurisdictions with which Australia has a DTA containing the relevant non-discrimination article (eg the UK) but the income from the exploitation of the intangible assets ultimately accumulates in a low corporate tax jurisdiction with which Australia does not have a DTA containing the relevant non-discrimination article (eg Ireland).
- In jurisdictions with which Australia does not have a DTA containing the relevant non-discrimination article (eg Ireland) but the income from the exploitation of the intangible assets ultimately accumulates in a low corporate tax jurisdiction with which Australia also has a DTA containing the relevant non-discrimination article (eg Switzerland).
Multinational taxpayers should consider their intangible asset holding structures and transfer pricing flows. Particular attention should be given to group structures where income from the exploitation of intangible assets ultimately accumulates in one or more low corporate tax jurisdictions. This should be done as soon as possible given the indicative commencement date of 1 July 2023.
Consultation on the proposed measures ends on 28 April 2023.
This appears to be at odds with other domestic tax provisions. For example, certain sub-national taxes, such as Swiss cantonal taxes, are treated by the Commissioner as foreign taxes eligible for credit against Australian corporate income tax (see, eg, IT 2437, IT2507). Moreover, Swiss cantonal taxes are explicitly treated as if they were an additional foreign tax of Switzerland for the purposes of Australia's controlled foreign corporation regime: Income Tax Assessment (1936 Act) Regulation 2015, reg 21.
The draft legislation does not make reference to supplementary materials that may aid in interpreting the scope of 'intangible assets', such as Chapter VI of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022. It is therefore doubtful that OECD commentary on intangible assets is relevant to the exercise. See, in particular, Commissioner v SNF (Australia) Pty Ltd  FCAFC74.
Breen v Williams (1996) 186 CLR 71.
Commissioner v Consolidated Media Holdings Ltd  HCA 55.