Australia s Diverted Profits Tax Bill includes updated transfer pricing guidelines and increased penalties

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1 10 February 2017 Global Tax Alert Australia s Diverted Profits Tax Bill includes updated transfer pricing guidelines and increased penalties EY Global Tax Alert Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: Executive summary On 9 February 2017, the Australian Government introduced a Bill into Parliament implementing three measures announced in the May 2016 Budget: Australia s DPT to allow the Australian Taxation Office (ATO) to impose a penalty tax rate of 40% on diverted profits, which applies in respect of income years commencing on or after 1 July 2017 to significant global entities (SGEs companies which are members of groups with global revenue of AU$1 billion or more) Incorporation of the changed Organisation for Economic Co-operation and Development (OECD) transfer pricing guidelines (CTPG) into Australia s tax law from 1 July 2016: these arose from Base Erosion and Profit Shifting (BEPS) Actions 8 to 10 and are intended to ensure transfer pricing (TP) outcomes better reflect value creation in global supply chains Increased penalties for non-compliance with tax document requirements by SGEs. Failure to lodge penalties for SGEs can be as high as AU$525,000. SGEs can include small Australian operations of global groups and companies with purely domestic Australian operations

2 2 Global Tax Alert The DPT element of the Bill (the Treasury Laws Amendment (Combating Multinational Tax Avoidance) Bill 2017) has been updated since the 2016 exposure draft. Changes include: Confirming the interaction of the DPT and Australia s thin capitalization rules, in that the DPT cannot change the amount of debt but could affect the rate applied to the debt. Excluding managed investment trusts, pension funds, sovereign wealth funds and widely held collective investment vehicles making passive investments, but not for their taxable associates. However the key DPT elements allowing the ATO to impose DPT remain: An Australian entity or permanent establishment (Australian taxpayer) is a member of an SGE A scheme involves the Australian taxpayer and foreign associated entities which have lower foreign tax outcomes (whether lower rates or tax concessions) The Australian taxpayer obtains a tax benefit in connection with the scheme (after a process which includes considering counterfactual situations) The scheme has a principal purpose of obtaining a tax benefit The entities that entered into or carried out the scheme do not have sufficient economic substance (SES) to reasonably justify their profit The DPT is particularly relevant for multinational businesses with transactions and value chains involving associated entities in overseas jurisdictions where the effective tax outcome is less than 80% of Australia s corporate tax rate, i.e., 24%. Affected businesses will need to consider the impact on global supply and value chains, to identify risks and prepare for possible ATO queries. Detailed discussion Diverted Profits Tax Objectives of the DPT The objectives of the DPT are stated to include that the Australian tax payable by SGEs 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 SGEs to provide sufficient information to the ATO to allow for the timely resolution of tax disputes. According to Treasury, 1,600 multinational groups, inbound and outbound, are sufficiently large to be affected by the DPT. Affected companies will need to prepare for an even closer interaction with the ATO to head off potential DPT risks. Changes since the exposure draft The Bill contains changes since the 2016 exposure draft after EY and other submissions. Also the full package of consequential changes was missing in the exposure draft. Some significant changes include: Clarification of start date (income year that starts on or after 1 July 2017) Reference to TP guidelines, including the CTPG to determine sufficient economic substance The interaction of DPT and thin capitalization rules Exclusion of managed investment trusts (MITs) and certain widely held collective investment vehicles (CIVs) and sovereign wealth funds from the DPT (but this exclusion does not apply to Australian associated entities of those excluded entities) The interaction with Australia s controlled foreign company (CFC) rules Exclusion of minor or ancillary entities from the SES test Improved restricted DPT evidence rules The ATO is to prepare a law companion guideline (LCG) to explain its proposed administration of the law. However the LCG has not been issued yet and the ATO plans to consult on the LCG. This is disappointing given the significance of the DPT. Overview of the DPT The Commissioner will be able to impose DPT on an entity under the general anti-avoidance law (Part IVA) rules where the following conditions are met, broadly: The relevant Australian entity or permanent establishment (PE) is an SGE for the year of income i.e., it is a global parent entity or a member of a consolidated accounting group that has annual global income exceeding AU$1 billion in the year, based on accounting principles There is a scheme (using the existing wide drafting of that term)

3 Global Tax Alert 3 The Australian taxpayer obtains a tax benefit in connection with the scheme (after a process which includes considering reasonable alternative situations) A foreign entity that is an associate of the relevant taxpayer entered into the scheme or is otherwise connected to the scheme It would be concluded that the scheme (or any part of a scheme) was carried out for a principal purpose of enabling the relevant taxpayer (and/or associate) to obtain a tax benefit, or both to obtain a tax benefit and reduce a foreign tax liability of an associate Relevant exclusion criteria such as SES are not met Under the DPT assessment, tax would be payable on the amount of the diverted profits at a penalty rate of 40%. Tax benefit involves considering reasonable alternative postulate The DPT is inserted into Australia s existing Part IVA, using the Part IVA concept of tax benefit without much new drafting inserted. The tax benefit determination is critical. The Explanatory Memorandum (EM) explains the tax benefit process: The calculation of a tax benefit requires consideration of a reasonable alternative postulate. That is, it requires identifying the tax outcome that would have occurred, or might reasonably be expected to have occurred, if the scheme had not been entered into or carried out. This necessitates that the tax outcomes arising from reasonable alternative postulate are determined with reference to the ordinary provisions in the income tax law, including, where relevant, the application of the transfer pricing rules to determine arm s length conditions. It is therefore important to identify the reasonable alternative postulate, including the TP aspects of the transaction, at the very first stage of identifying and considering the tax benefit. This involves some similar concepts to those in the United Kingdom (UK) DPT. Considering the reasonable alternative postulate may be a significant task. A principal purpose A precondition for the DPT is that it would be concluded that a scheme was carried out for a principal purpose (which may be only one of the principal purposes) of: Obtaining a (Australian) tax benefit, or Obtaining both a (Australian) tax benefit and a reduction of one or more tax liabilities under a foreign law The principal purpose threshold test is wider than the sole or dominant purpose that applies for other purposes of Part IVA (and has not been tested by Australian Courts). It is deliberately aligned to the OECD approach being pursued in the BEPS reforms and for double tax treaty purposes. A principal purpose is determined by reference to the various factors laid out in Part IVA which include the commercial outcomes of a scheme. As well the determination is to include non-tax financial benefits which are quantifiable, e.g., commercial benefits generating measurable economic value, may be considered in relation to the results of the scheme under the principal purpose threshold test. Exclusions Exclusions apply where it would be concluded that one of the following tests applies: The AU$25 million test (basically, the relevant Australian entity has less than AU$25 million income the test is restated with several calculation steps) The sufficient foreign tax test (basically, the increase of the foreign tax liability is equal or exceeds 80% of the Australian tax reduction) This test will require careful analysis and, given the many potential issues which will arise, the Bill contains a power for the Government to introduce regulations to specify the calculations of sufficient foreign tax for all or some situations. When calculating sufficient foreign tax, practical issues include the treatment of foreign losses, and transparent entities. The SES test, which analyzes whether the profit derived by each entity covered reasonably reflects the economic substance of the entity s activities in connection with the scheme. This applies to associated entities which participated in or were connected with the scheme, but not where an entity s role is minor or ancillary. This determination is based on TP principles, considering the functions, assets and risks of the foreign entity, the guidance used for TP purposes including the revised guidelines arising from BEPS Actions 8 to 10 and any other relevant matters. In this regard, this analysis will focus on the actual functional activities performed in each location as opposed to the passive holding of intellectual property (IP) or the inappropriate assumption of risks. Therefore, low function high profit locations may be particularly targeted.

4 4 Global Tax Alert Related-party financing and thin capitalization interaction The Bill implements the previously foreshadowed exclusion for debt deductions subject to Australia s thin capitalization rules. Debt deductions include any costs directly incurred in obtaining or maintaining a debt interest for example, interest or amounts in the nature of interest, guarantee fees, line fees and discounts on commercial paper. As outlined in the EM, the DPT process for debt deductions may be applied by the Commissioner as follows: First, if the DPT analysis includes a debt deduction, identify the debt interest that would have been issued (a hypothetical counterfactual debt amount) and the rate (the counterfactual rate) that would have applied absent the scheme. Second, modify the calculation of the DPT tax benefit so that the counterfactual rate is applied to the actual amount of debt for that debt interest. Thus the DPT will involve considering whether a counterfactual rate should apply to the rate of the actual debt. This is a narrower exclusion than in the UK DPT. An example illustrates that an Australian entity s counterfactual in respect of a borrowing from a low-taxed associate might be to borrow from the parent company, at a different rate. Similar issues arise in a TP context. Exclusion for some entities with passive activities A limited exclusion has been added for MITs as well as pension funds, sovereign wealth funds or widely held entities that carry on predominately passive activities (selected CIVs), to exclude the selected CIVs from themselves being subject to the DPT. However this exclusion does not apply to associates of such CIVs, including their payments to CIVs. So Australian taxpayers making payments to selected CIVs will need to consider the DPT analysis. CFCs and attributed income A new provision clarifies the interaction with Australia s CFC rules to ensure DPT is not imposed on CFC income which is attributed to an Australian resident under the Australian CFC rules. As a result, income of a foreign associate CFC that is attributable to the relevant Australian taxpayer does not form part of the DPT tax benefit. The DPT process and evidence If the DPT applies to a scheme, then, broadly: The ATO will develop its positions that the DPT applies using its internal processes. These will involve preliminary discussions with the relevant taxpayer: The ATO internal processes are under consultation (EY is involved) but are yet to be finalized. The Commissioner may issue a DPT assessment to the relevant taxpayer with DPT on the amount of the diverted profit at a penalty tax rate of 40%. The taxpayer will then be able to provide the Commissioner with further information disclosing reasons why the DPT assessment should be reduced (in part or in full) during a period of review (generally 12 months after the DPT assessment). At the end of that period of review, the relevant taxpayer will have 60 days to challenge the assessment by making an appeal to the Federal Court. If an appeal is made to the Federal Court, restricted DPT evidence is not admissible. Restricted DPT evidence is any information or document that the relevant taxpayer does not provide to the Commissioner during the period of review, or that the Commissioner did not already have prior to the period of review. However, restricted DPT evidence is admissible if any of the following exists: The court considers that its admission is in the interests of justice The evidence is expert evidence that comes into existence after the period of review and is based on evidence the ATO had at any time in the period of review The Commissioner consents to its admission So the design features are that: The DPT assessment will result in a 40% DPT cash flow obligation on the taxpayer to be paid within 21 days of the DPT assessment. After a DPT assessment the taxpayer can reduce or eliminate that in negotiations with the ATO. One way of eliminating a DPT assessment or risk would be to increase taxable income (subject to Australia s normal income tax rates). These rules tilt the playing field in favor of disclosure to the ATO and enhance the pressure the ATO can bring to bear on taxpayers.

5 Global Tax Alert 5 Regrettably, the Bill has not taken up EY recommendations for stronger governance over the ATO notices of intent to issue DPT assessments. Incorporating changed OECD transfer pricing guidelines in domestic law The 2016 Australian Federal Budget announced adoption into domestic law, with application from 1 July 2016, of the OECD BEPS amendments to the CTPG. These were approved by the OECD Council on 23 May 2016 and are set out in the 2015 BEPS Report Aligning Transfer Pricing Outcomes with Value Creation, Actions Final Reports (2015 OECD Report). The CTPG implement BEPS Actions 8-10 on aligning TP outcomes with the value chain and provide guidance on what are considered to be high risk related party dealings. The Bill now updates the TP law by a cross-reference to ensure arm s length conditions are identified by reference to the CTPG. Taxpayers with the following intragroup arrangements may be significantly impacted by the CTPG and these arrangements may also create significant exposures under the determination of the sufficient economic substance required under the DPT: Assumption of risks and attribution of associated profits by a group member on a contractual basis including the use of limited risk entities in the global value chain without the activity of managing those risks Commodity transactions not currently priced by applying the Comparable Uncontrolled Price (CUP) method or where there are significant discounts to the CUP in connection with marketing hubs Transfers of IP where, when using up to five years hindsight, the transfer value of the IP is inconsistent with actual profits attributed to such IP Attribution of profits associated with the use of intangibles that is inconsistent with the Development Enhancement Maintenance Protection Exploitation activities Significantly increased penalties for SGEs The Bill increases administrative penalties for SGEs as previously announced in the 2016 Budget. From 1 July 2017, for SGEs: Penalties will be doubled for false or misleading statements made to the ATO. Penalties will be doubled for failure to lodge documents necessary to determine tax-related liabilities on time, where the ATO determines the liability without the assistance of that document (e.g., ATO default assessments). The base amount for other failure to lodge penalties will be multiplied by 500, instead of the existing multiplication by 5, for large entities (relevant for General Purpose Financial Statements, Country-by-Country reporting (CbCR), tax returns and other). SGE status needs to be determined at the time of the relevant obligation (e.g., due date for lodging a tax return), but SGE status will generally be based on the test entity s most recent tax return. It is disappointing that there is no exclusion for subsidiaries that have <AU$ 25 million income, compared to the DPT. SGEs must take note of the significantly increased failure to lodge penalties. Taking into account the MYEFO proposal to increase the amount of each penalty unit (from AU$180 to AU$210) from 1 July 2017, failure to lodge penalties for SGEs will range from AU$105,000 to AU$525,000 (the maximum will be AU$450,000 prior to the penalty unit increase). The penalties are designed to ensure SGEs cannot afford to ignore the new requirements such as lodging General Purpose Financial Statements or documents required by CbCR. However, the increased penalties can apply to a failure to lodge any ATO approved form, irrespective of the cause, where obtaining fair and proper outcomes will be reliant on the ATO s discretions to remit penalties. There is a risk these measures will place unnecessary added compliance costs on taxpayers (for penalty remission requests) and also a potential added workload burden on the ATO, for potentially minor breaches. ATO guidance on its approach to administering these SGE penalties is urgently required. Implications Multinational groups with an Australian presence should start to prepare for the changed environment when the DPT commences to apply. Businesses will need identify any existing or proposed arrangements potentially within the proposed DPT scope. These might also figure in the interaction with CbCR, TP and other ATO interactions.

6 6 Global Tax Alert An overall DPT and TP health-check will include: Review of required evidence to support global value chain Review whether profit attribution in connection with IP aligns with changed OECD TP guidelines For potentially affected arrangements, groups will need to consider how to prepare for responses to be ready for future ATO queries with a potential DPT orientation. Groups might wish to undertake preparatory work by: Documenting the tax benefit and principal purposes analysis of relevant schemes, or Documenting sufficient economic substance of foreign entities As well, given the increased penalties, businesses will need to review their tax processes and systems around: Lodgment of documents with the ATO, to avoid failure to lodge penalties Oversight over ATO interactions to avoid increased penalties for incomplete disclosures For additional information with respect to this Alert, please contact the following: Ernst & Young (Australia), International Tax Services, Sydney Sean Monahan sean.monahan@au.ey.com Michael Anderson michael.anderson@au.ey.com Jim Axiomakarou jim.axiomakarou@au.ey.com David Burns david.burns@au.ey.com Stephen Chubb stephen.chubb@au.ey.com Lachlan Cobon lachlan.cobon@au.ey.com Tony Cooper tony.cooper@au.ey.com Daryn Moore daryn.moore@au.ey.com Leonid Shaflender leonid.shaflender@au.ey.com David Short david.short@au.ey.com Ernst & Young (Australia), International Tax Services, Melbourne Brendan Dardis brendan.dardis@au.ey.com Peter Janetzki peter.janetzki@au.ey.com Ernst & Young (Australia), International Tax Services, Perth Mathew Chamberlain mathew.chamberlain@au.ey.com Martin Webster martin.webster@au.ey.com

7 Global Tax Alert 7 Ernst & Young (Australia), Transfer Pricing, Sydney Paul Balkus paul.balkus@au.ey.com Jesper Solgaard jesper.solgaard@au.ey.com Danielle Donovan danielle.donovan@au.ey.com David Tracey david.tracey@au.ey.com Jason Vella jason.vella@au.ey.com Ernst & Young (Australia), Transfer Pricing, Melbourne Keir Cornish keir.cornish@au.ey.com Julian Hine julian.hine@au.ey.com Ernst & Young (Australia), Transfer Pricing, Perth Joe Lawson joe.lawson@au.ey.com Ernst & Young (Australia), Transfer Pricing, Adelaide Michelle Fardone michelle.fardone@au.ey.com Ernst & Young (Australia), Transfer Pricing, Brisbane Kevin Griffiths kevin.griffiths@au.ey.com Ernst & Young (Australia), Financial Services Office, Sydney Grant C Peters grant.c.peters@au.ey.com Rosalind Myint rosalind.myint@au.ey.com Ernst & Young (Australia), Tax Policy, Sydney Alf Capito alf.capito@au.ey.com Ernst & Young (Australia), Controversy, Sydney/Perth Martin Caplice martin.caplice@au.ey.com Craig Jackson craig.w.jackson@au.ey.com Ernst & Young (Australia), Controversy, Melbourne Sue Williamson sue.williamson@au.ey.com Ernst & Young LLP, Australian Tax Desk, New York Andrew Nelson andrew.nelson@ey.com

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