TAX CORRS APRIL Insights and trends in Australian taxation THE THIN CAPITALISATION LANDSCAPE PROPOSALS AND REVIEWS

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1 CORRS TAX APRIL 2014 Insights and trends in Australian taxation Welcome to the April 2014 edition of the Corrs Tax newsletter. We bring you brief summaries of topical taxation issues, as well as their implications for your business. OUR EDITORS: IN THIS ISSUE: GST GOING CONCERN CHANGES MAY RESULT IN INCREASED STAMP DUTY We consider the impact that proposed changes to the GST going concern rules may have on the amount of stamp duty payable. THE THIN CAPITALISATION LANDSCAPE PROPOSALS AND REVIEWS We examine proposed reforms and current reviews of Australia s thin capitalisation rules including changes to the safe harbour test, the arm s length debt test and the worldwide gearing test. SOVEREIGN IMMUNITY BACK TO THE FUTURE We outline the Government s decision not to proceed with a legislative tax exemption for foreign governments and sovereign wealth funds. STEWART GRIEVE Partner, Melbourne Tel stewart.grieve@corrs.com.au SIMON MIFSUD Senior Associate, Sydney Tel simon.mifsud@corrs.com.au KATHRYN BERTRAM Senior Associate, Melbourne Tel kathryn.bertram@corrs.com.au How can we improve? We are always striving to improve our newsletters to make them more relevant. We welcome your feedback on suggested themes/topics and any questions or general comments. Every person whose suggestion is implemented will receive a small gift from us. Contact the editors for feedback.

2 GST GOING CONCERN CHANGES MAY RESULT IN INCREASED STAMP DUTY The Federal Coalition government announced in early 2014 that it would seek to replace the GST going concern exemption with a reverse charge mechanism. This was in response to a review by the Board of Taxation, which recommended introducing a reverse charge mechanism to eliminate complexities associated with the current going concern rules. Under the current rules, the going concern exemption allows the sale of certain assets on a GST-free basis where certain criteria are satisfied. Such assets include the business of tenanted commercial real estate. To date, purchasers have benefited from the going concern exemption through improved cash flow and a lower stamp duty liability on land transfers. The stamp duty reduction arises because duty is levied on the GST-inclusive price and where the going concern exemption applies, no GST is payable. A reverse charge mechanism would require the purchaser of a GST taxable supply to remit to the ATO the GST that would otherwise be remitted by the vendor effectively shifting the GST liability away from the vendor to the purchaser. The purchaser would then be entitled to claim an input tax credit for making a creditable GST acquisition. Depending upon the detail of the legislation introducing the change (a draft of which has not yet been released), the reverse charge mechanism may potentially lead to greater costs. The state revenue offices may be required to charge stamp duty on the GST inclusive price on the basis that, although paid by the purchaser, the GST is still part of the consideration for the supply of the property in circumstances where the vendor would not have sold the property on the relevant terms but for the purchaser s agreement to accept the reverse charge. Therefore, unless the legislation is carefully worded, or the Federal Government works with the State governments to introduce amendments to legislation to ensure stamp duty is not levied on the GST inclusive price where a reverse charge mechanism applies, there is a risk that the change may produce unintended consequences. Last month, it was reported that senior Treasury officials met with a delegation representing the property industry to ensure the change was implemented in a way that did not increase stamp duty as Treasury did not want to implement the change at the expense of creating an additional burden on the industry. Draft legislation is due to be released by mid-year, with a bill expected before Parliament by the end of the year. For further information, please contact: KATHRYN BERTRAM Senior Associate Tel kathryn.bertram@corrs.com.au Page 2

3 THE THIN CAPITALISATION LANDSCAPE PROPOSALS AND REVIEWS The Australian thin capitalisation rules are in a state of flux with changes proposed to the safe harbour test, a current review of the arm s length debt test and possible changes proposed to the worldwide gearing test. What does the current landscape mean for planning for the future? The tax deductibility of interest (and other debt related expenditure) may be an important consideration in determining the income tax expense of a business. Multinationals with operations in Australia (those either controlled by inbound investors and/ or Australian entities with controlled outbound investments) need to make this determination through the prism of the Australian thin capitalisation rules. The Australian thin capitalisation rules contained in Division 820 of the Income Tax Assessment Act 1997 (Cth) operate to deny debt deductions to certain multinationals with operations in Australia to the extent that their adjusted average debt exceeds their maximum allowable debt. The policy behind the rules is to prevent multinationals allocating an excessive amount of debt to their Australian operations. A taxpayer s maximum allowable debt is determined by reference to the greater of the safe harbour debt amount and the arm s length debt amount and, for certain taxpayers, the worldwide gearing debt amount. The safe harbour test Many multinationals will focus their attention on whether they satisfy the safe harbour test. This is natural considering that the safe harbour debt amount is objectively measurable under a specific legislative formula. Coming within the safe harbour debt amount means that there is no need to explore in any detail whether the arm s length debt amount or the worldwide gearing debt amount could produce a greater maximum allowable debt. The Proposal On 6 November 2013, the current Coalition government confirmed that it would proceed with a number of announced, but unlegislated, tax measures. One such measure was the proposal announced by the former Labor government as part of the 2013/14 Federal Budget to amend the thin capitalisation rules to reduce the safe harbour debt amount from the current 3:1 debt to equity ratio to 1.5:1 (ie a reduction from 75% to 60% of average Australian assets). The proposed amendments are expected to apply to income years commencing on or after 1 July The Australian operations of multinationals may end up highly geared for a number of reasons. For example, a transformative M&A transaction may have been funded predominantly by debt. For any such entity that is currently within the safe harbour, it will be necessary to consider: Will the current finance structure result in excessive debt under the new safe harbour debt amount? If so, what hurdles are there to restructuring the financing to come within the new safe harbour? The proposed amendments do not contain any grandfathering rules that would allow the current debt to equity ratios to continue to apply to existing financing arrangements. Page 3

4 It will be important to consider whether debt facilities already in place and spanning the commencement of the new rules have any in-built flexibility to accommodate the changes (eg do they allow debt to be repaid without penalty from the proceeds of an equity raising?). Is there scope to revalue a group s underlying Australian assets which may result in an increased safe harbour debt amount when using the new ratios? What is the risk of the income tax general anti-avoidance rule (GAAR) applying to any debt restructure? In a National Tax Liaison Group consultative workshop on the recently amended GAAR, the Australian Taxation Office (ATO) flagged its view that the GAAR may apply in such circumstances. However, the fact that the reforms are yet to be enacted may be a hurdle for the ATO in applying the GAAR. For taxpayers that already exceed the safe harbour debt amount, or would be likely to do so under the new ratio, it will be necessary to consider whether recourse may be had to the arm s length debt test. The arm s length debt test (ALDT) For multinationals that may find themselves with debt exceeding the safe harbour debt amount once it is reduced from the current 3:1 debt to equity ratio to 1.5:1, the ALDT will gain a new prominence. The ALDT is an alternative test and is directed towards determining whether the level of debt is commercially justifiable having regard to the amount that the entity would be reasonably expected to have borrowed and an independent lender would have lent in the relevant circumstances, subject to some modifications. For those multinationals seeking to rely on the ALDT, the current test is onerous and brings with it considerable compliance costs. Uncertainty arises due to the subjective nature of the test and the risk of taxpayers and the ATO forming different conclusions regarding the commercially justifiable debt levels. The Review The previous government commissioned a review of the ALDT by the Board of Taxation and, on 16 December 2013, the Board released a Discussion Paper in this regard. The Board s review is focused on: How to reduce the compliance burden for taxpayers when determining their arm s length debt amount. How to reduce the burden on the ATO in administering the ALDT. Whether there should be restrictions on eligibility to use the ALDT. Measures to reduce the cost to taxpayers in assessing their ability to rely on the ALDT will be welcomed by multinationals with Australian operations. Of particular interest is the floating of: A move from annual testing of the ALDT to a singular test at the time of the relevant borrowing (subject to a reassessment where there is material change to the arrangements). Additional safe harbour tests based on earnings (eg EBITDA). The paper acknowledges that this may subject certain taxpayers to lumpy thin capitalisation positions depending on cyclical factors or abnormal profit and loss movements. Simplification of the ALDT in circumstances where there is no related party debt. Allowing a consideration of credit support from related parties where such support is consistent with ordinary commercial dealings. A system of advance thin capitalisation agreements between a taxpayer and the ATO. There is already a precedent in Australia for such arrangements, namely advance pricing arrangements for transfer pricing purposes. One particular policy discussion that should continue to be monitored is that regarding any limitations on eligibility to apply the ALDT. In framing the issues on which the Board of Taxation has sought input, the discussion focused on the particular needs of capital intensive industries, large scale projects and the property sector. The attention given to such sectors seems to suggest that there is recognition at a policy level that they are more likely to need to rely on the ALDT. However, the difficulties will concern how eligibility is to be narrowed and then how the relevant sectors will be defined. Page 4

5 Stakeholders, especially those in capital intensive industries that are more likely to need recourse to the ALDT, should continue to monitor the development of the proposed changes to the ALDT after the Board of Taxation completes its review (noting that submissions closed on 14 March 2014). The worldwide gearing test The worldwide gearing test may also be of assistance when determining a multinational s maximum allowable debt, but it is generally only available for entities that are not foreign controlled. This test effectively enables the entity to be geared to a ratio up to 120% of the actual gearing of the entity (including the group that it controls). Changes announced in the 2013/14 Federal Budget and adopted by the current government propose to extend the scope of the worldwide gearing test to make it available to inbound investing entities, but would be coupled with a reduction in the gearing ratio from 120% to 100%. The proposed amendments are expected to apply to income years commencing on or after 1 July 2014 Where to from here? The Australian thin capitalisation landscape is clearly evolving rapidly. Stakeholders should: Assess the impact, if any, of the proposed amendments to the safe harbour debt test on the financial arrangements for their Australian operations. Review current finance arrangements to determine whether they are flexible enough to make changes to accommodate the new safe harbour debt ratios. Continue to monitor the development of the proposed changes to the ALDT after the Board of Taxation completes its review. For inbound investing entities, monitor the developments in respect of the worldwide gearing test and determine whether there may be an opportunity to avail themselves of that test (if required) if it is extended as proposed. For further information, please contact: RHYS JEWELL Special Counsel Tel rhys.jewell@corrs.com.au KAZ FIELD Associate Tel kaz.field@corrs.com.au Page 5

6 SOVEREIGN IMMUNITY BACK TO THE FUTURE The new Federal Coalition government has recently announced that it will not proceed with the 2005/06 proposal to codify into legislation the exemption from Australian tax of certain passive income derived by foreign governments and sovereign wealth funds (SWFs). The exemption has its foundation in the doctrine of sovereign immunity, but its precise scope is unclear. As a result, foreign governments and SWFs are faced with a compliance burden of applying to the Australian Taxation Office (ATO) for a private binding ruling if they require certainty that certain income from their non-commercial investments into Australia is exempt from Australian income tax and Australian withholding tax. The proposed measures would have enshrined the ATO s current administrative practice in legislation, thereby allowing affected entities to effectively self-assess the Australian tax implications of their passive investments into Australia. The proposals were the subject of detailed consultation in 2009 and 2011, but were never finalised. In November 2012, after the election of the current Federal government, the Australian Assistant Treasurer announced that the above proposal was amongst a suite of proposed but not enacted measures that would be the subject of further consultation with relevant stakeholders before a decision would be made whether to proceed with those measures. However, on 14 December 2012, the Assistant Treasurer made a further announcement confirming that the proposal had been shifted to the not to proceed category. Although the demise of the above proposal may be seen to represent a missed opportunity to reduce the compliance burden on those looking to invest in Australia, it remains open to foreign governments and SWFs to apply to the ATO for confirmation of the exemption by way of a private binding ruling. There are more than 100 examples of such rulings on the ATO s register of private binding rulings. For further information, please contact: RHYS JEWELL Special Counsel Tel rhys.jewell@corrs.com.au Corrs Chambers Westgarth, 2014 This publication does not constitute legal advice and should not be relied on as such. You should seek individualised advice about your specific circumstances. We have sent this publication to you because you have requested to receive these publications from us. If you do not wish to receive such publications, please send an with Unsubscribe in the subject heading and containing your name and contact details to privacy@corrs.com.au Page 6