Australia s proposed Diverted Profits Tax to affect many multinational businesses

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1 2 December 2016 Global Tax Alert Australia s proposed Diverted Profits Tax to affect many multinational businesses EY Global Tax Alert Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: Executive summary Many multinational businesses will be affected by the proposed Australian Diverted Profits Tax (DPT) set out in the Exposure Draft (ED) issued by the Government on 29 November 2016 for comment by 23 December. Introduction of a Bill into Parliament is anticipated in early The DPT is to apply in respect of income years commencing on or after 1 July The DPT will broaden the Part IVA anti-avoidance law to allow the Australian Taxation Office (ATO) to impose DPT on multinational businesses which transfer profits to offshore associates. The ATO, through the Commissioner, will be able to impose DPT at a penalty tax rate of 40% on diverted profits, broadly, where: An Australian entity or permanent establishment is a member of a significant global entity with annual global income of AU$1 billion or more and has total Australian turnover of more than AU$25 million A scheme involves foreign associated entities in lower tax jurisdictions or jurisdictions in which they receive tax concessions The relevant taxpayer obtains a tax benefit in connection with the scheme The scheme has a principal purpose of avoiding Australian tax The foreign entities do not have sufficient economic substance for their income

2 2 Global Tax Alert Key carve outs from the DPT include: The sufficient foreign tax test. This carves out schemes, broadly, where the increased foreign taxes exceed 80% of the Australian tax reduction. The sufficient economic substance test. This will use transfer pricing principles including the recent updated guidance arising from Organisation for Economic Co-operation and Development (OECD) Base Erosion and Profit Shifting (BEPS) Actions 8 to 10. The ED has no carve outs for financing or the investment sectors (such as in the United Kingdom (UK)). The objective of the DPT is to compel voluntary disclosures to the ATO. The ATO will be authorized to use whatever information is available to it (including country-by-country (CbC) reporting data) to raise DPT assessments. The ED has measures to discourage taxpayers from holding back information from the ATO. Many hundreds of multinational groups, both inbound and outbound, might be affected by the DPT many more than those affected by the Multinational Anti Avoidance Law (MAAL). Affected companies will need to consider their positions and prepare for an even closer interaction with the ATO to head off potential DPT risks. It is imperative that affected groups consider the DPT implications of their future CbC reporting disclosures. The DPT is likely to lead to increased tax controversy with the ATO. Detailed discussion Overview of the DPT The Commissioner will be able to impose DPT on an entity under the Part IVA (anti-avoidance) rules where the following conditions are met, broadly: The relevant Australian company or permanent establishment is a significant global entity 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) The relevant taxpayer obtains a tax benefit in connection with a scheme A foreign entity that is an associate of the relevant taxpayer entered into the scheme or is otherwise connected to the scheme It is reasonable to conclude 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 Under the DPT assessment, tax is payable on the amount of the diverted profits at a penalty rate of 40%. While the DPT ED is based to some extent on the UK DPT, the rules are wider than the UK, with fewer carve outs or principles covering conventional transactions. The ED has been issued in an Australian political environment which sees continuing focus on corporate tax revenues including those from multinational businesses. That focus has intensified with the fall in tax revenues from the mining and resources sector. Table 1 below summarizes the analysis required. 1 A principal purpose The new rules apply where it would be concluded that a scheme was carried out for a principal purpose (which may be only one of the principal purposes) of either: Obtaining a (Australian) tax benefit Obtaining both a (Australian) tax benefit and a reduction of one or more tax liabilities under a foreign law It is unclear from the draft explanatory memorandum on what basis a tax benefit will be determined and quantified. A principal purpose, the threshold test for the DPT, like the MAAL, is wider than the sole or dominant purpose that applies for other purposes of Part IVA. Non-tax financial benefits which are quantifiable, e.g., commercial benefits generating economic value, may be considered in relation to the results of the scheme under the principal purpose threshold test. A transaction involving a foreign associate, with similar benefits and pricing as would apply with an unrelated party, should not in our view invoke the DPT, but that needs to be clearer in the law. There is no equivalent to the UK-legislated carve out for some such transactions.

3 Global Tax Alert 3 Exclusions Exclusions apply where it is reasonable to conclude that one of the following tests applies: AU$25 million or less turnover for the Australian entity (provided no Australian related entities have artificially booked turnover outside Australia ) The sufficient foreign tax test (basically, the increase of the foreign tax liability is equal or exceeds 80% of the Australian tax reduction) The sufficient economic substance test, if the income derived by each entity covered reasonably reflects the economic substance of the entity s activities in connection with the scheme Sufficient economic substance, transfer pricing and disclosures The sufficient economic substance test is very briefly expressed in the ED. This looks to whether the income derived by each entity covered reasonably reflects the economic substance of the entity s activities in connection with the scheme. This is to apply only if the taxpayer provides information to satisfy the Commissioner that the activities of the relevant entity have sufficient economic substance in relation to the income derived, received or made by the entity as a result of the scheme The draft explanatory memorandum states that the test will allow the use of transfer pricing principles and data, including the expanded global transfer pricing guidance arising from the G20 and OECD BEPS Actions That expanded guidance is planned to be adopted in Australia from 1 July The adoption is expected to be implemented in the same Bill which will introduce the DPT. There are no legislated carve outs such as those in the UK DPT for: Intragroup financing (which is covered by other rules such as Australia s thin capitalization and transfer pricing) Transactions involving managed funds Transactions which if undertaken with other parties would have similar outcomes So, based on the ED, such transactions will need exhaustive analysis under the transfer pricing and other rules. EY will, among other items, submit to Treasury that the ED needs clearer legislated principles and rules for such transactions; otherwise the compliance costs, administration issues and uncertainty will be at issue. The legislative scheme is clearly designed to enhance disclosures to the ATO. The ED provides that if taxpayers have contemporaneous information which they did not supply to the ATO when the DPT is raised, they cannot use that information in later appeals unless the ATO consents. DPT assessment and review process The ATO will be authorized to issue DPT assessments based on the best information available to it. That will include the CbC reporting data which will be first lodged in relation to tax returns for the 2017 income year. The administration and development of DPT compliance requirements is to be in the hands of the ATO and the Commissioner will issue guidance on the administrative processes prior to the decision to issue an assessment for a DPT liability. The processes will include the internal review process that the Commissioner will establish to ensure the DPT is only applied when appropriate. Table 2 below sets out the DPT assessment and review process. 2 The ED states that the ATO is unlikely to issue DPT assessments without first having notified taxpayers in the course of tax controversies. However the draft explanatory memorandum states that, after the Commissioner notifies a taxpayer of an intent to issue a DPT assessment, the taxpayer has only 60 days to provide information to the Commissioner relevant to the proposed DPT issue and payment. 60 days is likely to be a very short time for multinational groups to assemble the array of transfer pricing and other data needed to demonstrate sufficient economic substance and the purpose of global supply chains to the ATO and (potentially) in future court proceedings. Further information can be provided after the DPT assessment and payment of tax. The ED provides that appeals from the ATO DPT decisions can only be made to the Federal Court. This tight proposed time period means that affected groups will need to prepare for action on potentially risky transactions.

4 4 Global Tax Alert Many unresolved issues require Treasury and ATO clarification The ED approach to the DPT has few changes from the proposal released in the May 2016 Budget: the ED expresses the DPT at a very high level and does not address certain issues in detail. There are few exclusions, unlike the UK DPT. Many open questions exist including the need for stringent governance and controls, and EY will participate in the ongoing submission process closing by 23 December EY will highlight to the ATO and Treasury that further guidance is needed to be resolved in a time sensitive manner, given that foreign multinationals might have financial reporting requirements in relation to tax risks generated by the DPT. Implications Multinational groups with an Australian presence should start to prepare for the changed environment when the DPT commences to apply. Groups will need to identify any existing or proposed arrangements potentially within the proposed DPT scope. The interaction with CbC reporting as well as transfer pricing and other ATO interactions will be a key element. For potentially affected arrangements, groups will need to consider how to prepare for responses to be ready for potential future ATO queries within 60 days after preliminary advice from ATO, e.g., by: Identifying the principal purpose of the scheme taking into account non-tax financial benefits that are quantifiable Documenting sufficient economic substance

5 Global Tax Alert 5 Table 1: Decision tree - Is your company caught by the Diverted Profits Tax? Source Draft explanatory memorandum

6 6 Global Tax Alert Table 2: DPT assessment and review process Source Draft explanatory memorandum

7 Global Tax Alert 7 Endnotes 1. See pdf for Table See pdf for Table 2. 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 Jesper Solgaard jesper.solgaard@au.ey.com Ernst & Young LLP, Australian Tax Desk, New York Andrew Nelson andrew.nelson@ey.com

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