The Australian Government significantly expands ATO powers to fight multinational tax avoidance: Legislation introduced for 40 per cent Diverted Profits Tax (DPT)

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Introduction and overview

The Australian Government introduced legislation (DPT legislation) into Parliament on 9 February 2017 to implement a further component (second limb) of the United Kingdom–style diverted profits tax (DPT), with effect from 1 July 2017. The Exposure Draft for the legislation, which was released in November 2016, has remained largely intact, however with important additions, including the concept of "DPT tax benefit", specific exceptions (e.g. Managed Investment Trusts, foreign sovereign wealth funds and foreign pension funds), and modifications for thin capitalisation and controlled foreign companies.  Further, significant additions - including 16 examples - have been made to the guidance provided in the accompanying Explanatory Memorandum.

The DPT is targeted at a broad range of structuring arrangements including intellectual property transfers and related royalty arrangements, marketing/distribution/procurement hubs, offshoring services, captive insurance/reinsurance, certain leasing arrangements and financing/hybrid instruments.
  

As stated in s 177H of the Income Tax Assessment Act 1936 (ITAA 1936), the objects of the DPT rules are:

  • to ensure that the Australian tax payable by significant global entities (i.e. broadly multinationals with global revenue of AU$1 billion or more) properly reflects the economic substance of the activities that those entities carry on in Australia;
  • to prevent those entities from reducing the amount of Australian tax they pay by diverting profits offshore through contrived arrangements between related parties; and
  • to encourage those entities to provide sufficient information to the Commissioner of Taxation to allow for the timely resolution of disputes about Australian tax.

The DPT significantly bolsters and complements Australia’s general anti-avoidance and transfer pricing rules as a means to encourage multinationals to have a dialogue with the Australian Taxation Office (ATO) to negotiate their transfer pricing outcomes. Like the recently introduced Multinational Anti-Avoidance Law (MAAL), the DPT is intended to promote greater compliance by multinationals with Australian tax obligations and greater openness and transparency with respect to their global businesses.

The DPT is designed to achieve greater compliance and transparency by applying a punitive 40 per cent tax rate on diverted profits and by requiring this tax to be paid upfront once the Australian Commissioner of Taxation (Commissioner) reasonably concludes that the DPT applies. A review period of 12 months then follows where the taxpayer may provide information to the Commissioner to justify its arrangements, and which may result in a reduction to the DPT liability (including to nil).

The DPT legislation empowers the ATO with a wide-ranging armoury to pursue large multinationals it suspects of engaging in international profit shifting.  It provides revolutionary changes to the tax assessment, payment, review and appeals processes largely never seen before in Australia.

The Government estimates there are approximately 1,600 taxpayers within the scope of the DPT and expects to collect AU$100 million per year from its application.

In addition to the DPT, the DPT legislation also proposes amendments, which if enacted, will increase the administrative penalties imposed on significant global entities who fail to adhere to tax disclosure and related obligations. The proposed amendments are intended to apply from 1 July 2017 and will (a) increase the maximum penalty to AU$525,000 for multinational companies which fail to meet their reporting obligations and (b) double the penalties relating to making false and misleading statements to the ATO with a view to discourage multinational companies from being reckless or careless in their tax affairs.

Further, the DPT Bill also contains amendments to update Australia's transfer pricing rules in Division 815 of the Income Tax Assessment Act 1997 (ITAA 1997) to include the OECD Base Erosion and Profit Shifting (BEPS) amendments to the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations that were approved by the OECD Council on 23 May 2016.

When does the DPT apply?

The DPT will apply to a taxpayer where:

  • the taxpayer is a significant global entity;
  • taxpayer obtained a DPT tax benefit;
  • it is reasonable to conclude that the taxpayer entered into a scheme with a principal purpose of obtaining a tax benefit, or both to obtain a tax benefit and reduce a foreign tax liability;
  • a foreign entity that is an associate (as per s 318 of the ITAA 1936) of the taxpayer is one of the persons who entered into, carried out or is otherwise connected with the scheme; and
  • the taxpayer is not a type of entity that is excluded from the DPT. Managed investment trusts, foreign collective investment vehicles with a wide membership, investment entities wholly owned by foreign governments, complying superannuation entities and foreign pension funds are expressly excluded from the DPT.

There are specific exclusions which may exempt the taxpayer from the application of the DPT. These are discussed in further detail below.

Purpose test

The primary condition for the application of the DPT is that it is reasonable to conclude that the taxpayer had the requisite purpose for the DPT to apply. Like the MAAL, when determining whether a requisite purpose to obtain a tax benefit is met, the DPT utilises the “principal purpose test”, which is a lower threshold than the “sole or dominant purpose test” that forms a part of Australia’s general anti-avoidance regime.

The “principal purpose test” applies where it is reasonable to conclude that a scheme was carried out for “one or more of the principal purposes” of:

  • enabling the taxpayer to obtain a tax benefit, or both to obtain a tax benefit and to reduce its foreign tax liabilities; or
  • enabling the taxpayer and another taxpayer to each obtain a tax benefit, or both to obtain a tax benefit and to reduce one or more of their foreign tax liabilities.

When coming to a reasonable conclusion in respect of a taxpayer’s purpose, the Commissioner is not prevented by a lack of, or incomplete, information provided by the taxpayer. The duty and onus are therefore on the taxpayer to provide as clear and complete a picture as possible to the ATO if it does not want to be caught under the DPT.

Critically, there are a range of factors included in the final legislation that the Commissioner must have regard to when determining whether the taxpayer has the requisite principal purpose. These are:

  • the eight specific factors listed in s 177D(2) of the ITAA 1936, pertaining in particular to the form and substance, timing and effects of the scheme;
  • the extent to which the non-tax financial benefits (that are quantifiable) exceed the amount of tax benefits brought about by the scheme;
  • the result, in relation to the operation of any foreign tax law achieved by the scheme; and
  • the tax benefit that arises from the scheme.

As with many determinations under Pt IVA of the ITAA 1936, should the commercial benefits of the arrangement exceed the perceived tax benefits this would provide a reasonably strong indication there is no tax avoidance purpose.

Common non-tax financial benefits that are quantifiable for these purposes may include things such as economic value generated by the scheme as well as costs saved (including non-income tax costs e.g. tariffs, payroll tax, stamp duty) from centralising functions such as marketing, manufacturing or research and development.

Significant global entity

The DPT, like the MAAL, only applies to “significant global entities”. A significant global entity for the purposes of Australian tax legislation is an entity that:

  • has an annual global income (as shown in the financial statements) of AU$1 billion or more; or
  • is a member of an accounting consolidated group where the global parent’s annual global income is AU$1 billion or more.

As meeting the definition of a significant global entity is based on yearly financial reports, an entity may fall in and out of this category from year to year. This means that some entities may be subject to the DPT in one year, but not in the next.

A foreign entity must be an associate and involved in the scheme

The DPT will only apply where the taxpayer affected has an associate that is a foreign entity that entered into, carried out or is otherwise connected with the scheme or any part of it.

Transactions that are not cross-border will therefore not be captured by the DPT.

Tax benefit

For the DPT to apply, the taxpayer must obtain a “DPT tax benefit” as defined in s 177A, s 177C and s 177J(1) of the ITAA 1936. A DPT tax benefit will often take the form of an understatement of assessable income or withholding tax, or an overstatement of deductions.

DPT does not limit other anti-avoidance provisions

Importantly, where the DPT applies, the other provisions of the anti-avoidance measures contained in Part IVA are not limited by such application. Thus, in practice there may be instances where both the DPT and MAAL apply to a taxpayer (perhaps different taxpayers) as a result of the same transaction/arrangement.

Exclusions to the DPT

There are three discrete circumstances in which the DPT will not apply to a taxpayer. This ensures that taxpayers that are considered low-risk are not subject to the punitive tax rates of the DPT, and will instead need to comply with their ordinary transfer pricing obligations.

These exclusions, discussed below, can be critical in the context of taxpayers having their DPT assessment reduced to nil in the assessment period.

If a taxpayer intends to rely on one of the exclusions to the DPT, it must provide sufficient information to the Commissioner to confirm that the exclusion applies.

There are also special modifications, discussed below, addressing areas of overlap between the DPT and two other tax integrity measures, being Australia’s thin capitalisation rules and controlled foreign company (CFC) rules.

AU$25 million turnover test

Some technical and substantive amendments have been made to this test in the final legislation.

Under this test, the DPT will not apply where the total combined Australian assessable income, the exempt income, the non-assessable non-exempt income of the taxpayer and the other members of its global corporate group is less than AU$25 million. This protects taxpayers with relatively small Australian operations.

Income that is booked offshore in a manner that breaches the DPT, and would therefore otherwise be excluded from tax in Australia, is counted towards the AU$25 million threshold.

Sufficient foreign tax test

Under the sufficient foreign tax test, the DPT will not apply if it is reasonable to conclude that, in relation to a scheme, the increase in the foreign income tax liability is at least 80 per cent of the corresponding reduction in the Australian tax liability. This ensures that the DPT does not apply where the foreign tax benefit that arises is insignificant. This calculation is based on foreign taxes that are taxes on income only. Per s 770-15 of the ITAA 1997, foreign income tax includes tax on income, tax on profits or gains whether of an income or capital nature, or any other tax covered by a double taxation agreement. It is not simply the headline rate of tax but rather the income tax actually paid.

In addition to some technical amendments, the final legislation allows for regulations to be made in future to provide a method for calculating the increase to the foreign income tax liability.

For example, this test would in principle be satisfied if a scheme diverts income to a related foreign party that pays foreign income tax at a rate of at least 24 per cent (being 80 per cent of the current Australian company tax rate of 30 per cent). Many jurisdictions have headline income tax rates that are lower than 24 per cent and therefore would be unlikely to pass this test. It is also important to note that if US President Donald Trump’s proposed tax cuts are passed, arrangements with group members that are residents of the United States may become subject to DPT. Countries that have a headline corporate tax rate of lower than 24 per cent include:

Country

Tax rate (2016)

Singapore

17 per cent

United Kingdom

20 per cent

Hong Kong

16.5 per cent

Ireland

12.5 per cent


Sufficient economic substance test

The sufficient economic substance test will be the critical test for many taxpayers to demonstrate that the DPT does not apply to their arrangements. Under this test, the DPT will not apply if, in relation to the DPT tax benefit, the profit made as a result of the scheme by the taxpayer (and its associates that carried out or are otherwise connected with the scheme in a capacity that is more than minor or ancillary) reasonably reflects the “economic substance” of the entity’s activities in connection with the scheme.

In this context, economic substance is focused on the “active activities” (as opposed to passive activities) of the entity in light of OECD guidance (Aligning Transfer Pricing Outcomes with Value Creation, Actions 8-10 – 2015 Final Reports) that emphasises factors including:

  • the contractual terms of the transaction;
  • the functions, assets and risks of the parties and their relative contribution to the generation of value;
  • industry practices/business strategies pursued by the parties;
  • characteristics of property transferred or services provided; and
  • the economic circumstances of the parties and the markets in which the parties operate.

The requirement for cross-border related party transactions to have economic substance is not new and multinationals should already have extensive transfer pricing documentation that address the factors above.

These factors are consistent with the transfer pricing “comparability factors” outlined in s 815-125(3) of the ITAA 1997. However, the changes to the processes for transfer pricing disputes bring a much greater focus on economic substance and the evidence needed to demonstrate it. For example, in the absence of the taxpayer providing sufficient information to demonstrate the economic substance of its arrangements, it is open to the Commissioner to determine that this test is not satisfied (even if it would have been satisfied had the information been provided).

A key change to the Exposure Draft is the reference to the “profit” made as a result of the scheme, rather than the “income” derived by the taxpayer. In determining whether the profit made as a result of the scheme by each entity reasonably reflects the economic substance of the entity’s activities in connection with the scheme, it will be necessary to consider:

  • the components of the profit, being the income itself and the related expenses;
  • the functions, assets and risks (rather than contractual activities) not only of the relevant Australian taxpayer, but also other Australian and offshore associates connected to the scheme; and
  • the entity’s role and activities within the overall scheme, rather than the overall economic substance of the entity itself.

In addition, self-cancelling, offsetting or circular transactions, and back to back arrangements where the entity reassigns its role to another entity (rather than delivering on its contractual obligations), indicate that it is another entity that is in fact carrying out the economically significant functions and assuming the associated risks.

A further change to the Exposure Draft is the exclusion of entities whose role in the scheme is minor or ancillary. Generally, an entity will be considered to have a minor or ancillary role if it has no material bearing on the effectiveness or operation of the scheme and it receives minimal income from the scheme.

It will be for each multinational to determine its ability to rely on the economic substance test. The Explanatory Memorandum states that the application of the sufficient economic substance test is “not intended to impose a significantly larger compliance or evidentiary burden” over existing requirements for transfer pricing documentation. Accordingly, multinationals that have confidence in the robustness of their transfer pricing positions and documentation may decide to rely on this test with minimal or no further action required in response to the DPT. Others may decide the preferred response is to engage with the ATO to negotiate an outcome that both sides agree reflects sufficient economic substance.

This will be particularly important as the ATO will soon be armed with country-by-country reports, which will provide a wealth of information about where multinationals hold their assets, employ staff, book income and pay tax (among other matters).

Special modifications

Unlike the Exposure Draft, the legislation includes two special modifications to the DPT to address Australia’s thin capitalisation and CFC rules.

The thin capitalisation modification is intended to preserve the role of the thin capitalisation rules where a taxpayer that is subject to the thin capitalisation rules obtains a DPT tax benefit that is at least in part a “debt deduction”, such as overstated interest expenses paid to an offshore associate under a loan. This is achieved by requiring that the amount of the DPT tax benefit is calculated by applying the rate (such as the extent to which an interest rate is above market on a related party loan) to the amount of the debt interest actually issued (rather than to the amount of the debt interest that would have existed if the scheme had not been entered into or carried out).  Thus, the DPT should only potentially impact on the interest rate and preserves the thin capitalisation rules to deal with the acceptable amount of debt.

The CFC modification provides that the DPT tax benefit is disregarded to the extent that it arises from attributable income of the foreign entity in respect of the taxpayer and its associates (e.g. services income, reinsurance arrangements).

What happens if the DPT applies?

If the DPT applies to a taxpayer, the Commissioner may issue a DPT assessment to the relevant taxpayer.

The DPT assessment will include the “DPT base amount” and the applicable shortfall interest charge (SIC). Administrative penalties will not apply when a DPT assessment is made because the 40 per cent DPT rate is taken to incorporate a penalty component.

The “DPT base amount” will be, in most cases, the diverted profits amount or the "DPT tax benefit". Tax is payable on the DPT base amount at the rate of 40 per cent. 

SIC will be applied to the DPT base amount for the period between when the income tax of the entity's original notice of assessment for the relevant income year was due and when the notice of DPT assessment is issued by the Commissioner.

If an amount of DPT or SIC remains unpaid after the due date, the entity will be liable to pay GIC on the unpaid amount.

It should be noted that the payment of a DPT liability by an Australian resident taxpayer will give rise to franking credits in that taxpayer’s franking account. However, the franking credits generated will be at the ordinary company tax rate, as opposed to the 40 per cent DPT rate. Similarly, when an Australian resident taxpayer receives a refund of DPT, a franking debit will arise in the taxpayer's franking account equal to the amount that would arise if the DPT rate was equal to the corporate tax rate.

What is the process of issuing and reviewing the DPT assessment?

Unlike in the United Kingdom, the DPT is not a self-assessment regime. That is, taxpayers are not required to disclose upfront that they may have transactions that could be subject to the DPT and that liability will only arise where the Commissioner issues an assessment (and the Commissioner may make a DPT assessment within 7 years of first serving a notice of assessment on the taxpayer for an income year).

Unlike in the Exposure Draft explanatory memorandum, the Explanatory Memorandum to the DPT legislation indicates that the DPT will only apply in "very limited circumstances" and accordingly, the ATO will only issue a DPT assessment after undertaking a "rigorous" internal review. Such rigorous internal framework will include "several levels of oversight, senior executive sign-off and additional safeguards" around the DPT assessment process. Further, the Commissioner will establish a Panel relating to DPT that will include at least one external member and that the Commissioner (except in very limited circumstances) will seek endorsement from the Panel to make a DPT assessment. Whilst the Explanatory Memorandum does not go further in describing what the additional safeguards are or the criteria of the selection of an external member on the Panel, it is expected that such information on the ATO's administrative processes will be revealed in guidance that is yet to be published by the Commissioner.

Previously, the Exposure Draft explanatory memorandum envisaged a process before the 12-month review period, whereby prior to issuing a DPT assessment, the Commissioner would notify the taxpayer if it is considered that they may be subject to the DPT, and that the taxpayer is afforded the opportunity (within 60 days) to make representations to the Commissioner with respect to the factual matters that are the subject of the DPT. However, the DPT legislation (and the accompanying Explanatory Memorandum) appears to no longer provide the taxpayer with such an opportunity. It is uncertain, however we would expect the Commissioner will engage in appropriate detailed dialogue (information collection) with the taxpayer during the "rigorous" internal review prior to issuing a DPT assessment.

The taxpayer must pay the amount set out in the DPT assessment within 21 days. The SIC is also payable within 21 days. Further, as outlined above, GIC will accrue on any unpaid DPT or SIC after the due date.

Upon the issue of a DPT assessment, the Commissioner then enters a 12-month review period (which can be shortened in certain circumstances) whereby the taxpayer will be given the opportunity to provide further information to the Commissioner relating to the DPT assessment.

Upon review, the Commissioner can either:

  • consider that the DPT assessment is excessive, or if the taxpayer self-amends its income tax assessment during this review period to reduce the DPT tax benefit, reduce the DPT liability (including to nil) and refund the amount paid (including the SIC paid);
  • reduce the DPT liability but amend an income tax assessment to increase the income tax liability (which will be taxed at the normal corporate tax rate instead of the punitive 40 per cent rate, although other penalties may apply) – the usual four-year amendment period will be waived in this regard; or
  • increase the DPT liability (and SIC will also be payable on the additional amount of DPT).

If the taxpayer is dissatisfied with the outcome of the review period, the taxpayer may object within 60 days of the end of the review period and the objection must be by an appeal to the Australian Federal Court, and not to the Administrative Appeals Tribunal. Any information that the taxpayer does not provide to the Commissioner during the review period will not be admissible in evidence in the proceedings (unless the information is expert evidence that comes into existence after a period of review and is based on evidence that the Commissioner had in custody during the period of review).

Consequential amendments

The DPT legislation also proposes several consequential amendments to the other parts of the tax legislation. For example, in the context of income tax consolidation, whilst a tax consolidated group is taxed as a single entity (including for the purposes of applying the DPT), consequential amendments are made to ensure that the imputation provisions operate appropriately when a refund of DPT is made to a former member of a consolidated group and that a DPT liability is a tax-related liability, so that the joint and several liability rules and the tax sharing agreement rules apply to the DPT liability.

Conclusion and takeaways

  • If passed into law in its current form (as expected), the DPT will apply to income years commencing on or after 1 July 2017.
  • The exclusions from the DPT for specific entity types are a welcome addition to the legislation and reflect that these entities are low risk given their shareholder profile and generally passive activities.
  • The Explanatory Memorandum provides significant additional guidance on the sufficient economic substance test but a number of uncertainties and practical challenges remain. While no formal administrative guidance from the ATO has been issued on the DPT, this is anticipated in the coming weeks and will be critical to how taxpayers address the impending commencement of the DPT. The ATO has previously (10 August 2016) issued a discussion paper on compliance and related aspects of centralised procurement, sales and distribution hubs, which it later (on 16 January 2017) amended and released as a Practical Compliance Guideline, and is expected to issue a Law Companion Guide/s on the new DPT.
  • In this context, the punitive rate of the DPT should be strong motivation for large multinationals to consider entering into an open dialogue with the ATO in respect of their cross-border activities. In effect, the DPT will act like a transfer pricing pre-payment.
  • Many multinationals will be confident in the substance of their arrangements and transfer pricing documentation and determine that no further action is required. For those wanting greater certainty regarding the DPT, possible next steps include enhancing transfer pricing documentation, reviewing transfer pricing methods and outcomes, engaging with the ATO to determine an outcome reflecting sufficient economic substance, undertaking a restructure or entering into an Advance Pricing Agreement.
  • In addition to the MAAL, the DPT provides significant additional armoury  for the Commissioner to tackle multinational tax avoidance. While the MAAL and DPT are intended to be targeted at different practical scenarios, there may be circumstances where both the MAAL and DPT can potentially apply. The DPT legislation does not deal in detail with the potential overlap between MAAL and DPT. However, the DPT legislation does provide that if Part IVA generally or the MAAL applies to the taxpayer to which a DPT assessment is also issued to, the Commissioner can make a compensating adjustment to prevent double taxation arising from the DPT assessment.
  • The rationale for the sole recourse of a taxpayer’s objection to a DPT assessment being to appeal to the Federal Court is to encourage taxpayers to provide the Commissioner with complete and accurate information during the period of DPT review. Further, taxpayers are restricted in seeking administrative law remedies (e.g. Judicial Review) during the DPT assessment review period.
  • Multinationals should use the time before the DPT comes into effect to critically review their cross-border transactions and transfer pricing documentation to determine the risk of the DPT applying to their arrangements and any potential exposure.