2015 FINANCIAL SERVICES TAXATION CONFERENCE

Transcription

1 2015 FINANCIAL SERVICES TAXATION CONFERENCE The ATO s Changing Approach to Resolution of Banking and Finance Industry Issues Session 2 Written by: James Campbell Director Australian Taxation Office Presented by: Judy Morris and James Campbell Australian Taxation Office National Division February 2015 Surfers Paradise Marriott Resort & Spa James Campbell, Australian Taxation Office 2015 Disclaimer: The material and opinions in this paper are those of the author and not those of The Tax Institute. The Tax Institute did not review the contents of this paper and does not have any view as to its accuracy. The material and opinions in the paper should not be used or treated as professional advice and readers should rely on their own enquiries in making any decisions concerning their own interests.

2 James Campbell The ATO s Changing Approach to Resolution of Banking and Finance Industry Issues CONTENTS 1 Overview Attachments Banking and finance income tax strategy Internal derivatives guidelines Administrative solution AUD LIBOR Cap Review of public advice and guidance - overview... 4 James Campbell, Australian Taxation Office

3 James Campbell The ATO s Changing Approach to Resolution of Banking and Finance Industry Issues 1 Overview The overall aim of the presentation is to provide attendees with an understanding of the current approach being used by the ATO as part of its banking and finance industry strategy. It will also inform the various stakeholders (corporates, advisors, others) about how the approach may impact on them and how they can play a role in the process. The presentation focuses on the ATO s changing approach to the resolution of banking and finance industry issues covering some of the specific initiatives with relevant illustrative examples. In terms of resolution in this context, the ATO is focussing on reducing the level of uncertainty from an interpretative perspective so that risk is mitigated to an acceptable level for both the taxpayer and the ATO in a compliance context. The presentation will cover some background in terms of the structure within the ATO from a banking and finance perspective and some historical aspects in terms of the approach that had been utilised to deal with industry issues. It will cover the key principles behind the new approach being adopted including specific initiatives and the key relationships being built with stakeholders. Attendees will be provided with some of the practical means by which the ATO identifies, prioritises and attempts to resolve industry issues and will reference the current focus areas under the 2014/15 industry strategy. Two specific case study examples will be presented to illustrate some recent successes; these include the release of guidance on the recognition of internal derivatives for tax purposes and the development of an administrative solution to deal with Part IIB subsequent to LIBOR not being quoted in AUD. There will be some discussion on the ATO s review of public advice and guidance as the management of the ATO s banking and finance strategy needs to ensure that it is aligned with any outcomes from the review. James Campbell

4 James Campbell The ATO s Changing Approach to Resolution of Banking and Finance Industry Issues 2 Attachments The following documents are referenced during the presentation and provide background context. 2.1 Banking and finance income tax strategy B&F income tax strategy pdf 2.2 Internal derivatives guidelines Internal Derivatives Guidelines Final - October 2014.pdf 2.3 Administrative solution AUD LIBOR Cap Administrative solution - Proxy for AUD LIBOR.pdf 2.4 Review of public advice and guidance - overview Review of Public Advice and Guidance Products Overview.pdf James Campbell

5 2.1 Banking and finance income tax strategy B A N K I N G A N D F I N A N C E INDUSTRY S T R A T E G Y f o r Key facts about our industry Strategy overview The banking and finance (B&F) industry comprises 11 sub-segments: Major Banks, Regional Banks, Foreign Banks, Investment Banks, Building Societies, Credit Unions, Financial Asset Investors, Brokers, Money Market Dealers, Deposit Taking Financiers, and Services to Finance & Investment. Our compliance approach will focus primarily on assist and resolve (prevention) strategies. We will identify risks early and quickly in order to develop mitigation strategies that include providing guidance to the industry, which will assist taxpayers by increasing certainty. Our focus will be on the prompt actioning and resolution of risks and providing a service to taxpayers that will assist them to comply. There are 2,965 taxpayers, who paid $11.5 billion in tax, and this contributed approximately 23% of the Public Groups and International (PG&I) income tax collections for the 2013 tax year. We will monitor the global legal, economic and regulatory environment and assess potential impacts for the B&F industry on an ongoing basis. We will utilise ATO and industry data and intelligence, as well as other information obtained from our key B&F taxpayers to continually develop our understanding of compliance risks. Financial services taxpayers regarded as authorised deposit-taking institutions (ADIs) are very highly regulated by APRA along with other agencies (e.g. ASIC). This strong regulation, which in many cases has gone beyond the Basel minimum standards (the internationally fully harmonised Tier 1 capital of the Major Banks is between 11.2% % for the FY 2013), has ensured a safe and stable environment which has played a role in the major banks significantly outperforming their international peers. However, some banks argue that recent increases to Tier 1 capital requirements are an unnecessary regulatory burden, as Australian banks are already well capitalised when compared to banks internationally. We will continue to administer the tax law in an appropriate and reasonable manner, using both our technical and industry knowledge as well as our experience. We will continue to work with industry to provide clarification, guidance, or an ATO view to resolve issues early. We will be adaptable and flexible in our compliance approaches. We are committed to working with the industry, Treasury, and other tax jurisdictions to ensure we have a robust and appropriate compliance strategy and contribute to improving the tax system. The demand for seamless global financial institutions, and challenges to the traditional retail banking model, may present issues or risks associated with digitisation e.g. peer-to-peer lending, trading platforms (high frequency trading), electronic payment and investment services, and virtual currencies. Post GFC, Australia s foreign bank landscape has seen the demise/decline of some European banks and the emergence/growth of Asian banks. Our compliance approach With the formation of the ATO s PG&I business line, the B&F population now has a large number of smaller players. One example of this is Financial Asset Investors who, as at 30 June 2014, accounted for 54% of the total number of taxpayer groups/single entities. These taxpayers are in the business of asset investment, diversified or funds management, private equity funds, hedge funds, options trading, investment management (own account) and holding companies. Currently, the Financial System Inquiry ( the Murray review ) has been set up to consider the changes and developments in our financial systems in recent years and to provide recommendations for a more efficient, competitive, and flexible financial system into the future. The ATO is monitoring submissions and will consider the final report and its impact on the ATO and the tax system. We will further refine our ability to identify tax compliance risks through developing a current and in-depth understanding of the B&F industry within Australia and internationally by: Undertaking industry risk analysis from a multi-disciplinary perspective, including accounting, tax, economic, regulatory and legal. Undertaking analysis in order to identify potential compliance risks that may emerge from changes in the economic, legal and regulatory environment. Better understanding the potential impacts to the B&F industry of developments and trends in the way financial services are provided, including the notable shift to e-commerce-type service offerings and non-traditional approaches to services that have previously been part of mainstream banking businesses. These include peer-to-peer lending, mobile electronic payment platforms, the offering of financial investment services by providers via electronic platforms and the use of virtual currencies. We will contribute to, and leverage from, Australia s work in relation to base erosion and profit shifting (BEPS) from a B&F industry perspective, including focusing on relevant aspects of the BEPS action plan e.g. the use of hybrid mismatch arrangements, the work being done on the use of common reporting standards and automatic exchange of information, the implementation of systemic approaches to co-operation and collaboration amongst revenue authorities, and the gathering of empirical evidence and testing of the current law against BEPS tax planning arrangements. We will continue to develop risk assessment processes to improve their effectiveness and reduce the cost of compliance for the industry by: Banking and finance population by foreign and domestic split RDF category based on 2013 process Identifying better ways to obtain and analyse taxpayer and industry data. Working with the industry (i.e. industry bodies, taxpayers and advisors) to further understand potential compliance risks before undertaking formal compliance action across the relevant sectors of the industry. Working with the industry to develop compliance solutions, where appropriate. Developing timely guidance to improve certainty, before lodgment where possible. Tailoring the type of taxpayer engagement based on our risk differentiation framework (RDF) and well developed understanding of industry compliance risks. Specific approaches for higher risk and key taxpayers Key taxpayer 9 taxpayers Higher risk 1 taxpayer Taxpayers categorised as higher risk will be engaged in intensive continuous real time review through pre-lodgment compliance reviews (PCRs) and post-lodgement audit action, where necessary. Taxpayers categorised as key taxpayers will be continually monitored or reviewed on a real-time basis through annual compliance arrangements or PCRs. Specific approaches for medium and lower risk taxpayers TOTAL 65 Domestic 1,639 Foreign 1,326 Medium risk 18 taxpayers Lower risk 37 taxpayers Taxpayers categorised as medium risk will be engaged in a mix of taxpayer specific and project based risk mitigation compliance activity. The emphasis will be on improving our understanding of taxpayers businesses and drivers of tax performance, and to provide assistance to taxpayers to comply. For lower risk taxpayers, we will take a periodic monitoring approach e.g. by utilising data analytics and environmental scans. If risk is detected, we may use targeted compliance and/or service activities to further understand taxpayers tax and business activities, and to mitigate the risk in an appropriate way. Where risk is identified, possible re-categorisation to medium risk under the RDF may occur. ATO approach to B&F industry for further consideration Population only includes PG&I taxpayers who were categorised in Many lower consequence taxpayers moved to PG&I in Review of ATO processes and capability regarding options for advance pricing arrangements within the B&F industry. Formalising channels of communications between industry and the ATO s banking strategy team. Review and continued monitoring of existing debt/equity guidance to determine if the ATO can provide greater certainty considering environmental and regulatory developments that may impact debt/equity. Banking and finance population by revenue 10 9 Our risks 8 In the risks we will focus on are: Income Tax Revenue ($Billions) 7 6 Major Banks 5 Foreign Banks Regional Banks 4 Other 3 Taxation of permanent establishments and attribution issues, including taxation of global derivative trading businesses, the allocation of capital and debt, intra-entity interest charges under Part IIIB, and the allocation of expenses in relation to capital management and liquidity requirements e.g. Treasury charges, lines of credit. Thin capitalisation issues including the application of the thin capitalisation provisions to outward investing ADI entities that have a conglomerate business with one tax consolidated group. Transfer pricing related party arrangements associated with outsourcing IT and other services on an inbound and outbound basis including items such as guarantees fees and other credit management arrangements between related entities. Offshore banking unit regime issues associated with the allocation of income and expenses, structuring, funding and eligible activities. Taxation of financial arrangements. Tax consolidation. Other matters of concern are: 2 Inappropriate use and generation of imputation credits. 1 Accounting recognition of deferred tax liability in relation to consolidation entry and exit calculations (possible asset/liability mismatch) UNCLASSIFIED Financial Year Consolidation asset and liability recognition mismatches giving rise to anomalous tax outcomes (e.g. certain securitisation arrangements). E-commerce consideration of tax risks arising from increased use of internet sales and service platforms by the industry. BEPS hybrid mismatches and other jurisdictional arbitrage arrangements, use of low tax jurisdictions and related party arrangements. International structuring and profit shifting structures created to facilitate profit shifting. Page 4

6 2.2 Internal derivatives guidelines Internal Derivatives Recognition of Internal Derivatives This guidance is on the use of internal derivatives entered into between an Australian multinational bank and its permanent establishment (PE) in the ordinary course of carrying on a business at or through that PE. It confirms that the ATO will accept the use of internal derivatives, when used to appropriately allocate or attribute the bank s income (gains), expense (losses) or profit within the entity and provides guidance on the ATO s expectations from a compliance perspective based on a series of scenarios. The ATO will accept entries into a bank s book of accounts that record internal derivatives that reflect arm s length dealings as a means of determining an allocation or attribution of the bank s income (gains), expense (losses) or profit in accordance with Australia s PE attribution rules. The ATO view in relation to the operation of Australia's PE attribution rules are set out in detail in Taxation Ruling TR 2001/11 and TR 2005/11. The application of these guidelines may apply to the banks ordinary trading operations, that is situations where a bank enters into a derivative transaction with a third party through its foreign branch operation where it has sales/marketing functions located. There is a matching internal derivative recorded contemporaneously with the Australian head office, which is the location of the trader managing the risk on that particular class of derivative. The internal derivative is priced to leave an arm s length sales margin in the branch. The ATO approach recognises the internal derivative transaction, resulting in the margin generally being treated as non-assessable non-exempt (NANE) under section 23AH(2) of the ITAA 1936, provided the exceptions are not triggered. Alternatively, in the reverse scenario, where a trader is located in the offshore branch, and the sales/marketing function is in Australia, any gains made on the trader s book will be regarded as NANE under section 23AH(2) of the ITAA Any compensation paid to the sales/marketing function performed in Australia will be assessable in Australia. It should be noted that these guidelines can also be relevant in other situations where internal derivatives are used. 1

7 Reliance on these guidelines This document is not a public ruling and therefore cannot offer protection under the law. The Commissioner accepts that taxpayers will rely on this approach in assessing the extent to which their practices present any compliance risk. Where a taxpayer follows these guidelines in good faith and the Commissioner subsequently changes his view and/or these materials are altered or withdrawn, he will apply the principles set out under PS LA 2011/27 and not take action to apply any changed view of the law to past years or periods. In these instances any action in terms of applying the ATO view of the law, will only occur on a prospective basis. This approach is based on the ATO s current level of knowledge of the industry s use of internal derivatives and the financial outcomes produced. As more information is obtained in relation to industry practice, or as industry practices change or evolve, the approach may no longer be applicable. For example, if Australia were to formally adopt the authorised OECD approach to profit attribution, the approach would need to be reviewed. To ensure that the above considerations are addressed: 1. It is envisaged that this approach will be incorporated into the ATO s banking and finance compliance strategy which will include follow up review activity at the taxpayer level. 2. It is also envisaged that the overall approach will be reviewed annually with a major review in 3 years (and each subsequent 3 year period) to ensure that they are up to date, meeting Australia s tax requirements and remain in line with industry practice. Some arrangements may fall outside the scope of these guidelines, such as those forming part of a larger structured finance arrangement. Taxpayers are encouraged to approach the ATO to seek assurance on the tax treatment of such arrangements. 2

8 What Is Being Covered Types of Transactions These guidelines cover all internal derivatives, including: internal interest rate forwards (such as forward rate agreements) and interest rate swaps, internal interest rate options (such as interest rate caps and floors), internal currency forwards, internal currency swaps, internal currency options, and derivatives on other asset classes (such as credit, commodities and equity). Specific Inclusions/Exclusions Parent/Subsidiary The approach does not apply to transactions entered into between separate legal entities, that is an Australian resident company and a related separate entity, such as a subsidiary. Domestic versus Foreign Banks This approach was produced primarily in consultation with the Australian Bankers Association and its members, and therefore applies to Australian resident financial institutions with foreign PE operations. It is anticipated that these Guidelines could equally apply to foreign resident financial institutions with Australian PE operations but will be subject to a separate consultation process prior to this occurring. OBU Issues The Offshore Banking Unit (OBU) regime provides concessional tax treatment for certain eligible activities. These Guidelines do not apply to situations where section 121EB(3) of the ITAA 1936 operates to treat activities carried on between an OBU and its overseas branch operations as giving rise to a financial arrangement for the purposes of applying the provisions of Division 230 of the ITAA Global Trading Model This approach will apply to financial institutions engaged in global trading and may cover a range of business models including Integrated Trading models or Centralised Product Management models (as defined in the 2010 OECD Report on the Attribution of Profits to Permanent Establishments 22 July 2010). A centralised product management model can involve aggregating market risk management in one location. An integrated trading model can 3

9 involve traders in a multitude of trading centres, trading off a portfolio of transactions in a trading book. Recognition of Internal Derivatives - The Arm's Length Separate Enterprise Principle Internal derivatives may be entered into by one part of a bank with another. These internal transactions are characterised and recorded in the institution's management accounts as derivatives, even though in a legal sense an entity cannot contract with itself. Taxation Ruling TR 2001/11 confirms that Australia's PE attribution rules are based upon allocating a taxpayer's actual income and deductions using an 'arm's length separate enterprise principle'. Generally, under Australian income tax law, income or expenses relating to internal derivatives are not recognised as assessable income or deductible expenses. Rather, actual income and expenses that the entity earns from, or pays to, third parties are allocated between / attributed to parts of the bank through the use of internal derivatives. However under the arm's length separate enterprise principle, the ATO will permit internal derivatives to be recognised and priced by analogy to arm's length separate enterprise transactions, for the purpose of allocating or attributing the entity's third party income and expenses. Characterising and Rewarding Functions Associated with an Internal Derivative TR 2001/11 prescribes a general approach to attributing profit to a PE that is essentially a two-step process. First, a functional analysis is performed to attribute to the PE, and any other part(s) of the enterprise, the functions performed, assets used and risks assumed by each part of the enterprise in respect of the relevant business activity. Second, a comparability analysis is performed to determine an arm's length return for the functions, assets and risks attributed. A dealing between the PE and another part of the enterprise is essentially recognised for the purposes of determining an arm's length attribution of the actual profit to reward the functions performed, assets used and risks assumed by those parts of the enterprise involved in the relevant business activity. TR 2005/11 discusses the application of this general approach where funds are transferred between parts of a bank. An analysis of the factual circumstances and the functions, assets and risks of the parts will determine how their economic relationship, and any inter-branch dealing associated with the transfer of funds, are to be characterised for the purposes of profit attribution. This characterisation will then drive the appropriate separate enterprise analogy and arm s length pricing methodology used in attributing profit in respect of the transfer of funds and the comparability analysis. This approach will be applied to internal derivatives. 4

10 Compliance Requirements When analysing internal derivatives, the ATO compliance approach is to apply Australia s transfer pricing rules as they would apply to branches, having regard to the dealings between the relevant parts of a multinational enterprise and the outcomes they produce. The analysis is consistent with: that required under subdivision 815-C of the ITAA 1997, OECD principles on the attribution of profits to PEs adopted by Australia, and Double Tax Agreements. In undertaking the analysis, the ATO would consider documentary evidence supporting the positions taken by taxpayers. The documentary expectations in relation to the use of internal derivatives are in line with the requirements under the transfer pricing legislation, set out in Division 815 of the ITAA The ATO would expect that sufficient documentation would be prepared and maintained as required by section of Schedule 1 to the Taxation Administration Act. In its current form, Draft Ruling TR 2014/D14 sets out the Commissioner's view on the transfer pricing documentation that an entity should prepare and keep. In the event that a transfer pricing adjustment is made and the documentation requirement is not met for the relevant matter, entities cannot have a reasonably arguable position for the purposes of working out the applicable base penalty amount. In accordance with paragraph 16 and 17 of the Draft Ruling 2014/D14, each taxpayer should maintain documents that justify their use of internal derivatives from a functional and factual perspective. As the transfer pricing rules operate on a self-assessment basis, the taxpayer needs to ensure that documents prepared and maintained demonstrate that the amounts are appropriately brought to tax in Australia, consistent with the arm s length principle as outlined in section of the ITAA The legislation does not require a taxpayer to go beyond what is reasonable in terms of documentation. What is reasonable is determined on the basis of what a reasonable business person in the taxpayer's circumstances would do, having regard to the complexity and materiality of the transaction. This will be applicable whether the case is relatively straightforward or complex, but the greater the complexity and unusualness of the case, the greater the importance that is placed on the documents to justify the outcome. The ATO has considered a number of scenarios and grouped them in terms of our perception of complexity. Complexity refers to the level of analysis that the ATO would expect a taxpayer to have done in order to justify the outcome produced from a tax compliance perspective. If the ATO were to review a taxpayer s internal derivative transactions, the level of analysis to be undertaken by the ATO would also vary depending on the extent of the complexity, as presented in each scenario. Low complexity transactions will 5

11 require lower levels of analysis and evidence. The level of analysis and documentary requirements will progressively increase for scenarios possessing features of medium complexity transactions and high complexity transactions. Any expectations on taxpayers from a compliance perspective are not meant to be prescriptive. Whilst we have attempted to provide some guidance on the level of analysis required, taxpayers need to exercise commercial judgment about the nature and extent of documentation appropriate to their particular circumstances. Compliance Framework The following provides details about each level of complexity that the ATO perceives to be inherent in internal derivative transactions. Further specific scenarios are later provided to demonstrate the application of this framework. These are examples only and do not preclude other similar arrangements involving internal derivatives from being covered by these guidelines. Low Complexity Transactions The low complexity scenarios are typically those where a bank enters into derivative positions with external third parties (e.g. through a sales/marketing function) and then moves these positions to another part of the bank through the use of internal derivatives. The internal derivative ensures the risk exposure arising from the 3 rd party transaction is effectively located in the jurisdiction of the trader managing that risk. Each internal derivative is directly related to an original actual third party derivative (where the third party derivative is not a hedging transaction of the bank), with the internal derivative being a mirror of the third party derivative other than on price. In these scenarios, the justification for the use of the internal derivative is clear and there is a reference transaction (the third party derivative) relevant to the determination of the arm s length price. The pricing of the internal derivatives can be such as to leave a sales margin, spread or equivalent that appropriately compensates a function. A low complexity scenario will be where, based on a functional and factual analysis, the internal derivative is justified (for example, moving a position from a sales/marketing jurisdiction to a trading jurisdiction) and its price (in terms of divergence from the actual price of the external derivative) is defensible, as it appropriately rewards the functions performed. In practice, the price of each internal derivative is set individually based on the price quoted by a trader. After a full evaluation of the specific functions performed, assets employed and risks assumed the internal derivative will generally be assessed as having been transacted at an arm s length price. Some features that would be typical of low complexity scenarios would include where: 6

12 internal derivatives can be identified as directly relating to actual external derivatives, internal derivatives closely mirror the terms of the actual external derivative but, through the pricing mechanism, allows a significant economic function that is performed by another part of the bank to be rewarded, internal derivatives are recorded contemporaneous to the actual external derivative, the internal derivative has the effect of ensuring the derivative position resides in the jurisdiction that maintains the risk management/trading function, justified from a functional perspective, the trading/risk management function is undertaken by a trader who manages risk on a portfolio basis, and changes in or terminations of internal derivatives are driven by the third party transactions being hedged. Medium Complexity Transactions In the medium complexity scenarios, although there is direct reference to a third party transaction, the internal derivative does not match the external transaction. For example, the internal derivative may transfer or hedge only one or more components of the market risk associated with an actual asset or liability or a derivative entered into with a third party. In these scenarios, one issue of additional complexity would be the ATO s ability to verify the pricing and terms of multiple internal derivatives or multiple aspects of an internal derivative for example an internal derivative that covers both interest and FX rate exposures. In these instances, it is more difficult to verify aspects of the transaction, including pricing, in order to establish that the arm s length separate enterprise principle has been satisfied and that the outcome is in line with Australia s PE attribution rules. Scenarios will be considered medium complexity where they do not necessarily have the features of a low complexity scenario and may present some of the following features: internal derivatives directly relate to part of an actual external transaction (the market risk aspect of an actual external transaction) and therefore may not closely mirror the actual external transaction, there may be multiple internal derivatives that relate to an actual external transaction, and/or internal derivatives that may involve more than one type of risk e.g. interest rate + FX. 7

13 High Complexity Transactions The high complexity scenarios present some of the following features: internal derivatives that do not relate directly to any actual external transaction (as seen in the case of a bulk risk transfer), internal derivatives that prove difficult to justify from a functional perspective, internal derivatives that directly relate to an actual third party transaction but that are on pricing/terms that are materially different to the actual external transaction, internal derivatives that are not entered into contemporaneously with the actual external transaction, and changes in or termination of internal derivatives that are not driven by third party transactions being hedged but by internal management decisions. Where the above features are present in a transaction, it is generally difficult to verify and justify various aspects of the internal derivative. It may therefore be difficult to prove the arm s length separate enterprise principle and that the proper allocation or attribution of the bank s income, expense or profit is in accordance with Australia s PE attribution rules. An example of a high complexity transaction is where net exposures are moved via internal derivatives (e.g. bulk risk transfers). That is, there is no direct link between the internal derivatives and any actual third party transaction. This would result in gains and/or losses which are not directly attributable to any specific external transaction being recognised for tax purposes. Another example is where the recognition of an internal derivative does not match the functional profile of individual risk centres. For example the recognition of an internal derivative to move a derivative position to a jurisdiction that did not functionally manage that type of risk. It should also be noted that the ATO s decision making process in relation to its compliance activities will be guided by the materiality present in any scenarios that are risk assessed. 8

14 Low Complexity Scenarios Scenario 1 A third party enters into a derivative with sales/marketers who are located in the foreign branch. There is a matching internal derivative recorded contemporaneously with head office, which is the location of the trader managing the risk on the particular class of derivative. The internal derivative is mirrored, or is mirrored by all factors other than price. The price of the internal derivative can be such as to leave an arm s length sales margin in the branch. The proper attribution and allocation of income, expenses or profit as between different parts of the entity based on the arm s length separate enterprise principle can be easily ascertained. Scenario 2 A third party enters into a derivative with sales/marketers who are located in Australia. There is a matching internal derivative recorded contemporaneously with the branch which is the location of the trader managing the risk on the particular class of derivative. The internal derivative is mirrored, or is mirrored by all factors other than price. The price of the internal derivative can be such as to leave an arm s length sales margin in head office. The proper attribution and allocation of income and expenses or profit as between different parts of the entity based on the arm s length separate enterprise principle can be easily ascertained. 9

15 Scenario 3 PE 2 PE1 Internal Derivative Internal Derivative Jurisdiction 1 Global Trading Book Jurisdiction 2 Internal Derivative PE3 Jurisdiction 3 A third party enters into a derivative with sales/marketers who are located in various foreign branches. Immediately there is a matching internal derivative that contemporaneously records the position into a global trading book where traders in multiple jurisdictions manage the risk on that particular class of derivative. The internal derivative mirrors the third party derivative, or is mirrored by all factors other than price. The internal derivative is priced to leave an arm s length sales margin in the branch. The proper attribution and allocation of income, expenses or profit as between different parts of the entity based on the arm s length separate enterprise principle can be easily ascertained. 10

16 Medium Complexity Scenarios Scenario 4 A cross currency interest rate swap is entered into by the foreign branch. The risk is separated into different components and hedged individually. A notional interest rate swap is entered into with the trader in Australia who manages interest rate risk. A second foreign exchange forward is entered into with a trader located in a foreign branch in a different jurisdiction who manages foreign exchange risk. The proper attribution and allocation of income, expenses or profit as between different parts of the entity based on the arm s length separate enterprise principle is more complex than the low complexity scenarios and requires additional functional and factual analysis. Scenario 5 A$ Fixed Rate Loan/ Purchase Bond Offshore US$ LIBOR (Matched or Short Term) Foreign Branch Financier A$ Fixed/ US$ LIBOR Currency Swap Australia AUS CO In this scenario a foreign branch makes a fixed rate loan to, or purchases a bond from, a third party. The asset is funded by the foreign branch. The interest rate and currency risk is separated and hedged individually. A notional currency swap is entered into with the trader in Australia who manages interest rate and currency risk. The proper attribution and allocation of income, expenses or profit as between different parts of the entity based on the arm s length separate enterprise principle is more complex than the low complexity scenarios and requires additional functional and factual analysis. 11

17 Scenario 6 Loan/ Purchase Bond London Branch/Related Party Funding Offshore Total Return Swaps; CDS (Direct; Portfolio; Proxy) or Insurance/ Put Option Australia Aus Co In this scenario, the foreign branch makes a loan to, or purchases a bond from, a third party. The foreign branch funds the loan or bond. The foreign branch hedges the credit or default risk of the loan or bond using either a total return swap, credit default swap or a put option. The foreign branch enters into the hedge with Aus Co. The proper attribution and allocation of income, expenses or profit as between different parts of the entity based on the arm s length separate enterprise principle is complex. Scenario 7 Purchase of ADR (US$) A$ Funding Foreign Branch Sale of Shares (A$) Hedge (FX; Rate): Back-to-back Portfolio Offshore Australia AUSCO The foreign branch obtains AUD funding and purchases an American depositary receipt (ADR). The foreign branch hedges the long ADR position by taking an offsetting short position in the underlying Australian shares. The foreign branch has residual interest rate or currency risk which is hedged by a cross currency swap and/or currency forwards and interest rate hedges with Aus Co. Economically the organisation has reduced its market risk as it has simultaneously bought and sold the shares (or exposure to the shares) in different markets in different trading formats. The internal derivative may result in income or losses in the foreign branch depending on changes in the AUD/USD interest and FX rates, which may offset the income or losses on the market risk on the third party transactions. 12

18 The proper attribution and allocation of income, expenses or profit as between different parts of the entity based on the arm s length separate enterprise principle is more complex and requires additional functional and factual analysis. High Complexity Scenarios Scenario 8 Mismatched Portfolio of Derivatives Foreign Branch Offshore Portfolio Hedge: 1. Direct Back-to-Back of Selected Transactions 2. Macro or Proxy Hedge" 3. Combination of 1 & 2 Australia AUSCO A number of mismatched positions arising from transactions with third parties are managed in the foreign branch by a trader. The trader enters into internal derivative(s) with the trader located in Australia. The transfer may be motivated by a variety of factors including risk limits, capital issues or naturally offsetting positions in other trading books. The internal derivatives transfer individual positions, shifting all or a portion of the risk. The transfer of risk may take the form of transferring some positions in a form similar to the original transactions, a macro or proxy hedge, or a combination. In the case of a macro or proxy hedge, transaction(s) is/are entered into to neutralise market risk, as measured by generic risk measures rather than specific matching on underlying positions by similar transactions. The proper attribution and allocation of income, expenses or profit between different parts of the entity based on the arm s length separate enterprise principle is more complex and requires additional functional and factual analysis. 13

19 Scenario 9 1. transactions entered into over time and managed in branch. Foreign Branch (trader) 2. Internal Derivative moving 20% of external positions. Offshore Australia AUS CO (trader) Like Scenario 6, a number of positions are managed in the foreign branch by a trader. This trader enters into internal derivative(s) with another trader located in Australia to transfer part of the risk. The structure is similar to that for Scenario 6. The proper attribution and allocation of income, expenses or profit as between different parts of the entity based on the arm s length separate enterprise principle is more complex and requires additional functional and factual analysis. Scenario 10 14

20 This scenario relates to an internally recorded derivative between two offshore branches of Aus Co, or alternatively, an offshore related party and an offshore branch. A second derivative is entered into between the New York branch and Australia. The proper attribution and allocation of income, expenses or profit as between different parts of the entity based on the arm s length separate enterprise principle is more complex and requires additional functional and factual analysis. Scenario 11 Loan/ Purchase Bond/ Derivatives Funding Operating Entities (Parent; Branches) Multiple CDS/ Insurance Contracts Full or Partial Hedge Credit Risk Centre In this scenario, the foreign branch makes loans or purchases bonds from third parties, which are funded by borrowings of the foreign branch. The head office consolidates and manages its credit risk through a central credit portfolio trading book. The foreign branch hedges the credit or default risk of individual loans or bonds with this central entity. In turn, the central credit risk centre manages the portfolio using a variety of instruments, including a total return swap, credit default swap or put option. The proper attribution and allocation of income, expenses or profit as between different parts of the entity based on the arm s length separate enterprise principle is difficult to ascertain. 15

21 Scenarios Dealing with Transactions that are Outside the Scope of these Guidelines Scenario 12 In this scenario, the foreign branch enters into AUD/Japanese Yen currency swaps with a third party to undertake a carry trade to take advantage of the differential between Australian dollar and Japanese Yen interest rates. The foreign branch transfers the currency risk to Aus Co, which in turn enters into a series of transactions with third parties. This results in the bulk of the market risk being defeased. As a whole, the transactions leave the combined entities with a position between Australian dollar long term and short term rates with different income profiles as between the foreign branch and Aus Co. This scenario is not within the guidelines as it appears, based on a functional and factual analysis, that there is no commercial reason for the overall transaction. Scenario 13 16

22 No internal derivatives have been recorded in this example. The foreign branch is recording the transaction but the risk associated with the third party transaction is being managed in Aus Co. The proper attribution and allocation of income and expenses as between different parts of the entity based on the arm s length separate enterprise principle is more complex and requires additional functional and factual analysis. The absence of an internal derivative may result in an inappropriate tax outcome if no adjustment is made to compensate Australia for its risk management function and to ensure the foreign branch does not derive gains or losses related to market risk where it does not have such a function. Scenario 14 17

23 As with Scenario 13, no internal derivatives have been recorded. The foreign branch is recording the transaction but the risk associated with the third party transaction is being managed in Aus Co. We would need to consider the proper attribution of the third party transaction. The proper attribution and allocation of income and expenses as between different parts of the entity based on the arm s length separate enterprise principle is more complex and requires additional functional and factual analysis. The absence of an internal derivative may result in an inappropriate tax outcome if no adjustment is made to compensate Australia for its risk management function and to ensure the foreign branch does not derive gains or losses related to market risk where it does not have such a function. 18

24 2.3 Administrative solution AUD LIBOR Cap ADMINISTRATIVE SOLUTION EXTERNAL JUNE 2014 UNCLASSIFIED FORMAT AUDIENCE DATE CLASSIFICATION Administrative solution: proxy for the Australian Dollar London Interbank Offered Rate (AUD LIBOR) What this administrative solution is about 1. Section 160ZZZA of the Income Tax Assessment Act 1936 (ITAA1936) enables the Australian branch of a foreign bank or foreign financial entity to claim a deduction on the notional interest payment arising from an intra-bank loan. The amount of the deduction is limited to the interest amount calculated by reference to the London Interbank Offered Rate (LIBOR). 2. AUD LIBOR is no longer quoted as of 31 May As a result, a proxy rate has been produced for the operation of section 160ZZZA of the ITAA 1936 in relation to Australian dollar notional intra-bank loans. Administrative solution Proxy rates for AUD LIBOR for the purpose of section 160ZZZA of the ITAA The ATO and the Australian Financial Markets Association (AFMA) have agreed upon the following proxy rates for AUD LIBOR for the tenors for which LIBOR continues to be published. LIBOR Proxy rate Overnight LIBOR 1 month BBSW 1 week LIBOR 1 month BBSW 1 month LIBOR 1 month BBSW + 50 bp 2 month LIBOR 2 month BBSW + 50 bp 3 month LIBOR 3 month BBSW + 50 bp 6 month LIBOR 6 month BBSW + 50 bp 12 month LIBOR 6 month BBSW + 80 bp UNCLASSIFIED PAGE 1 OF 3

25 UNCLASSIFIED INSERT DOCUMENT TITLE 4. For the purpose of this Administrative Solution, 'BBSW' represents the midpoint of the nationally observed best bid and best offer for AFMA Prime Bank Eligible Securities, calculated as per the Bank Bill Swap (BBSW) Benchmark Rate Conventions, as published on the AFMA website. Reliance on this administrative solution 5. This document is not a public ruling and therefore cannot offer protection to the taxpayer under the law. The Commissioner accepts that taxpayers may rely on this administrative solution in assessing the extent to which their practices present any compliance risk. 6. Where a taxpayer follows this administrative solution in good faith and the Commissioner subsequently changes his view and/or this administrative solution is altered or withdrawn (whether by the Commissioner, change of law or otherwise), he will apply the principles set out under PS LA 2011/27 and not take action to apply any changed view of the law to past years or periods. In these instances any action in terms of applying the new view of the law will only occur on a prospective basis. 7. Where a taxpayer departs from this administrative solution, the ATO s view of the taxpayer s level of compliance risk may increase. Applicable period 8. This is an interim administrative solution that applies for income years starting on or after 1 January 2013 and until: a legislative solution is effected, or in consultation with the AFMA, the ATO reassesses this interim administrative solution, determines this approach no longer has application and an alternative administrative solution is put in place. This will not occur to income years commencing prior to 1 January Implications on withholding tax 9. Interest withholding tax is payable under section 160ZZZJ of the ITAA 1936 on 50% of the amount of interest taken to be paid under section 160ZZZA of the ITAA 1936 (that is, withholding tax is payable on the section 160ZZZA [of the ITAA 1936] interest deduction UNCLASSIFIED PAGE 2 OF 3

26 UNCLASSIFIED INSERT DOCUMENT TITLE amount capped at the LIBOR available in the same currency of the borrowing). On this basis, withholding tax is not payable on non-deductible amounts in excess of the relevant LIBOR cap. 10. Accordingly, in relation to Australian dollar loans, those taxpayers who limit their deduction to an interest amount calculated with reference to the above administrative solution will not be liable to pay withholding tax on non-deductible amounts in excess of the administrative solution. Currencies for which LIBOR continues to be published 11. LIBOR will continue to be published for the following currencies: CHF, EUR, GBP, JPY and USD. For those currencies, LIBOR continues to be published for the following tenors: Overnight, 1 week, 1 month, 2 months, 3 months, 6 months and 12 months. 12. Section 160ZZZA of the ITAA 1936 continues to operate in its current form for all notional intra-bank loans in the above listed currencies. UNCLASSIFIED PAGE 3 OF 3

27 2.4 Review of public advice and guidance - overview REVIEW OF PUBLIC ADVICE AND GUIDANCE PRODUCTS BACKGROUND The ATO Executive has endorsed a project to examine the ATO s current suite of public advice and guidance, from rulings to fact sheets to determine whether they represent the best and most effective mix of products and how the effectiveness and timeliness of the production of these products could be improved. The objective of this review is to identify ways to improve the client experience by providing timely, tailored public advice or guidance to the audience and matching user needs and expectations. The primary focus of this review is to: Confirm existing issues and benefits of the current public advice and guidance products, Identify further issues and concerns with the current public advice system, Identify any new areas for improvements, and Develop solutions to improve the current public advice and guidance products. Make recommendations for improvement to the current system Phased internal and external consultation will occur in order to better understand how ATO guidance products and processes can be calibrated to best respond to community needs and enable identification and assessment of the costs, risks, opportunities and challenges that may be involved in effecting changes in products, processes and delivery platforms. The Inspector General of Taxation s review into improving the self-assessment system identified a number of issues with the current public advice and guidance products. Preliminary consultation undertaken during the scoping process for this project identified similar issues. The issues were broadly categorised under five key aspects: timeliness, content, certainty, strategic management and development of products and accessibility. For example: Lack of strategic management of selection of subject matters, suitable products and their development, Lack of clarity of content including appropriate differentiation, style and format to suit the target audience, Difficulty in accessing advice including searchability, delivery platforms and product mix, Timeliness of provision of the products, and Confusion over the certainty provided by the various products. 1