Focus: Diverted Profits Tax
13 May 2016
In brief: Among other measures designed to combat multinational tax avoidance contained in the 2016-17 Budget, is the intended introduction of an Australian Diverted Profits Tax (DPT). This will broadly replicate the second limb of the existing United Kingdom DPT. It will address profit shifting by Australian entities (or foreign residents with Australian permanent establishments) through transactions with related parties in lower tax jurisdictions where the arrangements lack economic substance. The proposed measure is designed to encourage multinationals to earlier resolve transfer pricing audits (and to be more responsive to ATO information or document requests) or face a 40 per cent penalty rate of tax based on a 'best estimates' DPT assessment. Partner Toby Knight (view CV) and Senior Associate Igor Golshtein explore the implications for Australian taxpayers.
How does it affect you?
- The measure is the subject of a Consultation Paper released by Treasury on Budget night1.
- The paper proposes that the measure apply to income years commencing on or after 1 July 2017, but may apply even though the relevant arrangements commenced, or contracts were entered into, before that date.
- Unlike the UK DPT, the Australian DPT will not require upfront disclosure and will not be self-assessed. It will be imposed only when the ATO issues a DPT assessment.
- Potentially affected taxpayers should monitor the consultation process and consider the form of the Exposure Draft Legislation once released. The 1 July 2017 commencement date is intended to allow legislation and administrative guidance to be in place prior to the measure's commencement. The closing date for submissions in response to the Consultation Paper is 17 June 2016.
- Broadly, the measure applies a 40 per cent penalty rate of tax to the 'diverted profits' of Australian entities that are members of large multinational groups that enter into transactions lacking sufficient economic substance with related parties in lower tax jurisdictions, where the tax liability of the offshore related party as a result of the transaction is increased by less than 80 per cent of the corresponding reduction in the Australian entity's tax liability.
- Examples provided in the Consultation Paper of the types of arrangements that may be affected include:
- payments by an Australian company to a foreign company in a lower tax jurisdiction for marketing and administrative services;
- the leasing of assets to an Australian entity by a related entity in a lower tax jurisdiction (as opposed to the Australian entity holding the assets directly); 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 for the right to use the IP;
but the potential breadth of the proposed provisions (if they were to reflect the UK measure) is extremely wide.
- Existing marketing hub, procurement hub, cross-border intellectual property licensing or asset leasing arrangements and even commodity sale and purchase agreements may be potentially affected in post-commencement years. Financing transactions are excluded from the UK second limb, but the Consultation Paper impliedly suggests they may be included in the Australian measure. This may be an area of ATO focus in light of its recent concerns expressed about certain cross-border financing arrangements, which the ATO claims may result in contrived transfer pricing outcomes.
- The tax mismatch condition may prima facie apply to many cross border transactions, given that many jurisdictions have a tax rate that is less than 24 per cent (which is 80 per cent of Australia's corporate tax rate of 30 per cent).
- Potentially affected Australian companies will need to review cross border transactions to, firstly, ascertain whether they involve an effective tax mismatch of the type described (see below). If they do, companies will need to ascertain whether they are able to prove that the transactions have sufficient economic substance in the sense that the non-tax financial benefits of the arrangement exceed the financial benefit of the implied tax reduction of the Australian company. A further step will involve quantifying any diverted profits amount. This may involve comparing the actual transaction to a relevant counterfactual, with reference to the arrangement that would have been undertaken if tax was not a motivation.
- Accordingly, the ATO may be able to 'reconstruct' the transaction for tax purposes and tax a different, hypothetical transaction than that actually entered into. If the DPT is enacted, potentially affected taxpayers may need to consider three different sets of provisions, each of which may involve the consideration of a hypothetical under different statutory tests: Part IVA (general anti-avoidance)2, Subdivision 815-B (transfer pricing)3 and the DPT.
- The measure, if enacted, will likely enable the ATO to put pressure on taxpayers subject to transfer pricing audits, to provide further information or to make concessions, by issuing or threatening to issue DPT assessments.
- Once a DPT assessment is issued, the taxpayer will be put under pressure during the 12-month 'review' period to make transfer pricing adjustments increasing its taxable income – to take amounts outside the Diverted Profits Amount so that they are instead subject to the corporate rate of tax (currently 30 per cent) rather than the 40 per cent DPT penalty rate.
- It is currently unclear whether for tax treaty reasons the DPT will be enacted as a completely separate tax (unlike the Australian Multinational Anti-avoidance Law (MAAL), which was incorporated into Part IVA, the general anti-avoidance provision), and:
- whether, and if so how, the existing doubled penalties for significant global entities (where there is no reasonably arguable position) will apply to any DPT liability; and
- how it is intended the DPT will interact with Australia's Double Tax Agreements.
- The measure is intended to change the dynamic of transfer pricing dispute negotiations, and its scope will form a back-drop to transfer pricing audits and the ongoing negotiations of some advance pricing arrangements.
In 2015, the United Kingdom introduced a DPT with two limbs.4 The first limb was broadly replicated in Australia by the enactment of the MAAL, which addresses schemes where a foreign entity artificially avoids a taxable presence in Australia. It applies from 1 January 2016. The second limb of the UK DPT addresses cross-border transactions entered into by UK resident entities which lack economic substance and result in a 'tax mismatch' outcome.
The new Budget measure, directed at profit shifting by Australian companies, will be based on this second limb. Legislation and administrative guidance on the new DPT are still to be drafted, and will follow a consultation process. However, in addition to the Consultation Paper, the provisions of the second limb of the already enacted UK DPT, and the UK experience to date, provide some guidance on the key issues likely to be faced by Australian taxpayers.
When it applies
- It will impose a 40 per cent penalty rate of tax on 'diverted profits' of Australian residents, or foreign residents with Australian permanent establishments, where:
- the entity has, or is a member of a group consolidated for accounting purposes that has, annual global revenue of $1 billion or more (ie it is a significant global entity);
- the Australian member of the significant global entity group, does not have Australian turnover of less than $25 million, unless income is artificially booked offshore rather than in Australia (ie a de minimis exception does not apply); and
- the taxpayer has entered into a transaction with a related party that:
- has given rise to an effective tax mismatch; and
- the transaction, or series of transactions, has insufficient economic substance.
- An 'effective tax mismatch' will arise where the Australian entity enters into a transaction with an offshore related party as a result of which its tax liability is reduced and the tax liability of the related party in the other jurisdiction is increased by less than 80 per cent of the corresponding reduction in the Australian entity's tax liability.
- The transaction or series of transactions will have insufficient economic substance where it is reasonable to conclude 'based on the information available at the time to the ATO' that the transaction(s) was 'designed' to secure the tax reduction, unless the non-tax financial benefits of the arrangement exceed the financial benefit of the tax reduction.
- If the transaction gives rise to both an effective tax mismatch and has insufficient economic substance, the ATO may issue a DPT assessment.
What the DPT applies to
- The Diverted Profits Amount to which the 40 per cent penalty rate applies is:
- where the deduction claimed is considered by the ATO to exceed the arm's length amount (called an 'inflated expenditure case'), 30 per cent of the transaction expense; and
- otherwise the ATO's best estimate of the diverted taxable profit that can be reasonably made at the time.
- While an offset against the DPT will be allowed for any Australian tax paid on the diverted profits (for example, on income attributed under the CFC regime), no credit will be allowed for foreign taxes paid on the diverted profit amount.
- The DPT will not be deductible or creditable for Australian income tax purposes, but a franking credit will be allowed for DPT paid, limited to the applicable company tax rate.
DPT administrative processes
- The ATO will initially issue a provisional DPT assessment and detail the reasons why the DPT applies. It must do this within seven years of the relevant tax return being lodged.
- The taxpayer will then have 60 days to make representations about factual matters set out in the provisional DPT assessment, but not about transfer pricing matters.
- If the ATO still considers the DPT applies, it can issue a final DPT assessment, which it must do within 30 days of the end of the representation period.
- The taxpayer must pay the final DPT assessment within 21 days, but has no right of appeal at this stage.
- Following the issue of the final DPT assessment, a 12-month review period commences, in which the taxpayer can provide information to the ATO to seek to get it to amend the DPT assessment including on transfer pricing grounds. However, the ATO can also increase the amount of DPT by issuing a supplementary DPT assessment.
- Once the review period ends, the taxpayer has 30 days to lodge a court appeal.
- For the purposes of the 'insufficient economic substance condition', the UK legislation provides that the non-tax financial benefits 'for the first party and the second party (taken together)' and across all relevant accounting periods can be taken into account in assessing whether such benefits exceed the financial benefit of the relevant tax reduction. If this test is adopted in Australia, a quantification of the non-tax benefits for the period of the transaction across the entire value chain may be necessary, with that amount to be compared to the amount of the Australian tax reduction. However, difficult issues may arise as to how widely 'the transactions', in respect of which this quantification is to occur, are to be defined. Similar issues have arisen in relation to the interpretation of the breadth of a 'scheme' for Part IVA purposes.
- If the same or a substantially similar test of economic substance (as exists in the UK regime) is included in the Australian legislation, a company armed with such a quantification may be better placed to dissuade the Commissioner from engulfing it in the procedural quagmire of a DPT assessment than a taxpayer finding difficulty responding to ATO information requests in a timely manner. A DPT assessment would lead to the 12-month review period with delayed appeal rights, where the Commissioner has the taxpayer's money notwithstanding the DPT assessment is necessarily tentative.
- The application of the DPT 40 per cent penalty rate to 30 per cent of the transaction expense in an 'inflated expenses case' necessarily involves the use of an arbitrary percentage (seemingly based on the corporate tax rate) to calculate the diverted profits amount for the purpose of issuing a provisional DPT assessment. This enables the Commissioner to avoid having to more precisely estimate the diverted profits amount in a deduction case prior to the review period.
- It would seem sensible for the Commissioner to agree to administrative safe harbours to reduce the compliance burden on taxpayers. For example, if a taxpayer has contemporaneous documentation that complies with Subdivision 284-E of the Taxation Administration Act 1953 (Cth), it ought not be put to the added cost and effort of performing analysis to address yet further and different statutory tests to demonstrate sufficient economic substance. The ATO could issue guidance to the effect that it would not seek to apply the DPT, other than in exceptional circumstances, where the taxpayer can demonstrate it has made genuine attempts to comply with the transfer pricing contemporaneous documentation requirements.
- The Consultation Paper suggests that the Australian measure will, for the purposes of calculating the Diverted Profit Amount to which the DPT applies, employ the concept of a 'relevant alternative scenario', which would seem akin to the UK notion of 'the relevant alternative provision'. The UK concept sets up a counterfactual being the alternative 'provision' it would be reasonable to assume would have been made or imposed as between the companies instead of the material provision (or actual transaction) had tax not been a relevant consideration for any person at any time. Thus, the quantification of the Diverted Profits Amount may involve the construction of a hypothetical disregarding tax results in a similar fashion to that now required by the recently amended Part IVA.
- The question remains as to how closely the Australian provisions will mirror the UK provisions, or whether they will seek to further enhance the ATO's powers. Parts of the language in the Consultation Paper reinforce the highly political nature of the measure. They echo exchanges between the Commissioner of Taxation and Senators at recent Senate hearings where the Commissioner expressed frustration at his difficulty in obtaining information from some taxpayers. He expressed his desire to respond by issuing assessments on the information then available to him, forcing the taxpayer to provide information to him if it wished to dispute the assessments.
- It will be important that care be taken with the drafting of the new legislation to include sufficient safeguards for taxpayers so that the measure does not amount to an arbitrary exaction rather than a law with respect to taxation, and so be potentially subject to constitutional challenge.
- 'Implementing a Diverted Profits Tax' (3 May 2016), Australian Treasury.
- Income Tax Assessment Act 1936 (Cth).
- Income Tax Assessment Act 1997 (Cth).
- Refer to our earlier Focus: Taxing Diverted Profits, (28 April 2015).
- Toby KnightPartner,
Ph: +61 3 9613 8590
- Martin FryPartner, Practice Leader, Tax,
Ph: +61 3 9613 8610
- Larry MagidConsultant,
Ph: +61 2 9230 4918
- Malcolm StephensPartner,
Ph: +61 2 9230 4828
- Tony KuhnPartner,
Ph: +61 3 9613 8940
- Paul NicolsPartner, Sector Leader, Industrials,
Ph: +61 2 9230 4414
- Igor GolshteinSenior Associate,
Ph: +61 3 9613 8089
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