2016 QUEENSLAND TAX FORUM

Transcription

1 2016 QUEENSLAND TAX FORUM Session 10A: Business Tax Considerations in a Global Economy Written by: Greg Travers, CTA Director William Buck NSW Presented by: Greg Travers, CTA Director William Buck NSW Queensland Division August 2016 Brisbane Marriott Hotel, Brisbane Greg Travers, CTA 2016 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 , CTA Business Tax Considerations in a Global Economy CONTENTS 1 Introduction Understanding the basics Background Controlled Foreign Companies The basics of CFCs Some common CFC issues Practical impact on the business Thin Capitalisation The basics of thin capitalisation Practical considerations from thin capitalisation rules Transfer Pricing The basics of transfer pricing International dealing schedule Transfer pricing documentation requirements Simplified transfer pricing record keeping Practical implications of transfer pricing and documentation requirements Residency, Permanent Establishments and Double Tax Agreements Residency Residency of individuals Residency of companies Residency of a trust The basics of permanent establishment The basics of Double Tax Agreements Practical impact of DTAs and PEs on the business Exempt Foreign Income and Conduit Foreign Income The basic principles of foreign income exemption and conduit foreign income Practical issues with foreign income exemption Greg Travers, CTA

3 , CTA Business Tax Considerations in a Global Economy 2.7 Foreign income tax offset When do you get a foreign income tax offset? FITO practical planning points Withholding taxes BEPS - additional rules for significant entities Schemes that limits a taxable presence Country by Country reporting General Purpose Financial Statements Diverted Profits Tax GST, VAT and equivalents USA European Union General introduction to VAT Who pays the VAT? Transactions subject to VAT Exemptions EU VAT Directive Cross-border supplies of goods and services Choice of structure and drivers Choice of structure when operating in a foreign country Tax consequences of profit repatriation Australian resident individual shareholders Australian company Foreign company Australian resident individual shareholders Australian company Foreign flow through entity Australian resident individual beneficiaries Australian Trust Foreign company Australian resident individual beneficiaries Australian Trust Foreign flow through entity Observations Greg Travers, CTA

4 , CTA Business Tax Considerations in a Global Economy 4 Examples Profit repatriation from the US Profit repatriation from US C Corp via an Australian resident company Profit repatriation from the US LLC via an Australian resident trust Profit repatriation from New Zealand Australian company with a subsidiary in New Zealand Australian Trust carrying on business via a NZ Limited Partnership Appendix: Key tax information for major trading partner countries Greg Travers, CTA

5 1 Introduction There is a growing number of Small to Medium Business Enterprises (SMEs) looking offshore to expand their customer base, raise capital and reduce costs of doing business. Advisors are increasingly being asked about how an SME should undertake this expansion. The following paper provides a general outline of the key areas which should be considered to ensure taxation obligations are managed in the optimum way. Necessarily, the paper provides an overview, rather than a detailed discussion, of the various tax issues. The paper is in three parts: The first part looks at the key tax issues, providing an overview discussion of the issue, examples of some of the issues that are likely to be encountered and comments on some of the practical impacts on business. The second part looks at the in principle scenarios that can be used the structure the overseas operations and the key tax attributes of each. The third part is a series of examples of types of structures and the tax implications. The focus is on the US and NZ (although in principle these examples apply to any jurisdiction) highlighting the use of various interposed vehicles between the ultimate Australian resident owners and the foreign operations, and its impact on the on the ultimate tax rate. As an appendix to the paper is a table summarising key tax information for four of Australia s major trading partners which, for SME businesses, tend to be the most common countries for the initial stages of international expansion. Legislative references Unless otherwise indicated, all legislative references are to the Income Tax Assessment Act 1936 (ITAA 36) or the Income Tax Assessment Act 1997 (ITAA 97) as applicable. Greg Travers

6 2 Understanding the basics 2.1 Background Understanding the basics of the tax legislation that could affect a business with international operations is critical when advising an SME expanding globally. The rules may be grouped, based on their underlying purpose, broadly as follows: 1. Legislation to prevent diversion of profit from Australia: Controlled foreign companies (CFC) (Part X of ITAA 36) Thin capitalisation (Division 820 ITAA 97) Transfer pricing (Division 815 ITAA 97) 2. Legislation to prevent double taxation and ensure correct allocation of tax between countries: Double tax agreements (DTA) and permanent establishment (PE) rules Foreign income exemption (s23ah ITAA 36, Division 768 ITAA 97) Foreign income tax offset (Division 770 ITAA 97) Withholding tax on certain classes of income (s128b ITAA 36) 3. Legislation to combat multinational tax avoidance: Denial of tax benefits arising from schemes which limit a taxable presence in Australia (s177da ITAA36) Country By Country reporting (Subdivision 815-E ITAA97) Proposed diverted profits tax (May 2016 Budget) The following sections provide an overview of each of these areas of tax law and highlight key issues to be considered when advising clients. 2.2 Controlled Foreign Companies The basics of CFCs The Controlled Foreign Companies (CFC) rules are in Part X of ITAA 36 and can operate to attribute certain income of CFCs to the Australian resident shareholders of the CFC. The main purpose of the CFC rules is to prevent the use of offshore companies to divert and accumulate income in low tax jurisdictions. Greg Travers

7 A CFC is a foreign company in which five or less Australian residents have at least a 50% controlling interest, or where a single Australian resident has at least a 40% controlling interest. There are two main types of income derived by a CFC that could be attributed back to the Australian resident shareholder, and form part of their taxable income in Australia: passive income and tainted income. Passive income includes dividends, interest, royalties (with an exception for instances where the intangible is developed or substantial value is added by the CFC), trust distributions and rental income. Tainted services income includes income derived by the CFC from the provision of services to Australian resident entities. Tainted sales income includes income from the sale of goods where the goods were sold to the CFC, or purchased from the CFC, by an associate that is an Australian resident and a substantial alteration test is not satisfied. For each of these classes of income there are other instances where passive or tainted income will arise as the definitions are extensive. It is important to review the income streams of each CFC to ensure that any potential attributable income is identified. There are seven countries which Australia considers to have tax rates and systems comparable to Australia, being USA, UK, Japan, Germany, NZ, France, and Canada. These are known as listed countries. Income (including passive and tainted sales/services income) derived by CFC residents in these countries is therefore excluded from attribution unless the income is considered Eligible Designated Concessional Income (EDCI), being income that is either not subject to tax or is concessionally taxed in that particular country. For CFCs resident in all other countries, small amounts of passive and tainted sales/services income are not attributed to Australian shareholders. This is based on what is known as the active income test. If less than 5% of the turnover of a CFC resident is made up of passive and tainted income (i.e. non active income), then the CFC passes the active income test and no attribution will occur. This test recognises that a CFC engaging in a genuine business may still generate income from passive and tainted sources, but is not being used as a vehicle to accumulate income away from Australia. Where the active income test is not satisfied, the passive and tainted income, net of allowable deductions, will be attributed to the Australian shareholders based on their ownership interests in the CFC. The attributed income is taxable at the prevailing Australian tax rate. To prevent double taxation of income that has already been attributed and taxed in Australia, section 23AI ITAA36 provides that the distribution of previously attributed income is non-assessable nonexempt income to the shareholder. Greg Travers

8 2.2.2 Some common CFC issues The following are examples where a CFC could have income attributed back to its Australian shareholders as their taxable income: 1. A NZ company derives a capital gain in NZ which is exempt from tax in NZ. This untaxed capital gain is EDCI and attributable back to the Australian resident shareholders, even though NZ is a listed country. 2. An Australian company sells its active business and invests its cash overseas by buying shares in a foreign company with passive investments. The foreign company is resident in an unlisted country. The income derived by the foreign company from passive investments is attributed back to the Australian company as passive income. 3. An Australian company transfers its IP to a foreign subsidiary resident in an unlisted country for market value consideration. The foreign subsidiary receives royalties for use of the IP from independent third parties. Unless the IP has been substantially developed, altered or improved such that its market value was substantially enhanced, the royalty income derived by the foreign subsidiary is passive income (tainted royalty income) and attributable back to the Australian parent. 4. An Australian company buys goods from a Hong Kong subsidiary, which in turn sources and buys its goods from third parties from China. The Hong Kong subsidiary makes no substantial alteration to the goods. The profit from the sale of goods derived by the Hong Kong subsidiary from the sale to the Australian associate is attributable back to the Australian parent as tainted sales income. 5. An Australian company provides services to businesses operating in multiple countries. The Australian company uses its overseas subsidiaries to provide the services required in overseas countries, with the subsidiary contracting with and invoicing the Australian company for these services. The Australian company contracts with and invoices the client under a single consolidated arrangement. The services provided by the overseas subsidiaries will give rise to tainted services income. 6. An Australian company incorporates two overseas subsidiaries to acquire a hotel complex in an overseas country. One subsidiary acquires the property and leases it to the second subsidiary which operates the hotel business. The lease income from the property will be passive income (tainted rental income) and potentially attributable back to the Australian parent under the CFC rules. The above are examples of how attribution would apply via the CFC rules. The CFC rules are complex, and an advisor would need to review the actual income derived by the CFC, in particular if it is are derived from associates or passive investments Practical impact on the business A business should consider the following when establishing an overseas subsidiary or taking a significant interest in a foreign company: Greg Travers

9 1. Location of the CFC: Listed or unlisted country. If it is a listed country, there is less likelihood of attribution. 2. The source of income of the CFC: From associates or unrelated? From Australian residents or foreign residents? There is less likelihood of attribution if the income is from unrelated foreign residents. 3. Activities of the CFC: Will it conduct business in the foreign country or will it be passive? There is more likelihood of attribution if the income derived is passive. 4. Taxation of the CFC: How will the CFC be taxed in the foreign country? Income is more likely to be attributable or give rise to additional tax in Australia on attribution if the CFC is in a low tax jurisdiction or is exempt from tax on its income. 2.3 Thin Capitalisation The basics of thin capitalisation The thin capitalisation rules were introduced to prevent multinationals from shifting profits out of Australia by funding Australian operations with high levels of debt, thereby reducing Australian taxable income. If not for the thin capitalisation rules, a foreign investor would be able to extract profits from Australia at the withholding rate of 10% on interest rather than the income tax rate of 30% on company profits. The thin capitalisation rules also limit interest deductions to Australian investors with overseas investments, to prevent shifting of profits overseas through excessive interest deductions in Australia. The thin capitalisation rules apply to the following types of entities: 1. Inward investing entities: a. Australian entities that are foreign controlled; and b. Foreign entities that invest directly into Australia or operate a business in Australia via a permanent establishment in Australia. 2. Outward investing entities: a. Australian entities that control foreign entities; and b. Australian entities that operate a business through an overseas permanent establishment and associated entities. The thin capitalisation rules apply to limit debt deductions. Debt deduction is defined in section ITAA 97 and includes not only interest expense, but also fees and charges in respect of debts, discounts in respect of securities, and amounts taken to be interest in respect of a lease or a hire purchase arrangement. Importantly, the following entities are not subject to the thin capitalisation rules: Greg Travers

10 1. Where a taxpayer and their associates have total debt deductions of $2M or less. This exemption excludes most smaller businesses from the thin capitalisation regime. 2. Outward investing Australian entities where the sum of its average Australian assets is 90% or more of the sum of its average total assets (including the assets of its associates). This exemption excludes from the thin capitalisation rules Australian entities whose operations are substantially in Australia. Where thin capitalisation applies, debt deductions will be reduced where the amount of debt used to fund an Australian entity exceeds a specified maximum debt amount. The calculation of the specified maximum amount of debt is different for an inward investing entity, an outward investing entity, and financial institutions. For an SME operating overseas (assuming it has debt deductions of more than $2M and less than 90% of its overall assets in Australia and so none of the exemptions apply), its maximum debt amount would be the greatest amount determined under the following tests: Safe harbour debt test: This is the test most commonly used. It sets the maximum amount of debt allowed at effectively 60% of the net value of Australian net assets (i.e. a 1:1.5 debt to equity ratio). Australian assets are calculated as Australian assets minus liabilities which do not generate a debt deduction such as trade creditors and provisions, averaged for the financial year. The calculation takes into account assets, as worked out under the accounting standards. AASB 136: Impairment of Assets requires an entity to review the carrying value of its assets at reporting date and impair this value to fair value in various situations. If an entity holds intangibles or assets denominated in a foreign currency, the fair value of these assets could be volatile and have a material impact on the thin capitalisation calculations year on year. Where assets are recorded in the accounts at less than market value, there is an ability to substitute a market value in some instances. The revaluation amount needs to be in accordance with accounting standards. The arm s length debt test: The notional amount of debt that could have been borrowed by the Australian business alone on an arm s length basis excluding its overseas operations. The challenge with this test is substantiating the position, which means that it tends only to be applied if the safe harbour debt test does not produce a suitable outcome. The worldwide gearing debt test: Is only available to entities with audited consolidated financial statements, and where the Australian assets are less than 50% of the group s worldwide assets. Under this test, Australian investments may be funded with gearing of up to 100% of the gearing of the worldwide group it controls (i.e. the gearing ratio of the Australian investments is equal to or less than the gearing ratio of the worldwide group). This test has limited relevance to the outbound SME market. Application of the worldwide gearing debt test and the arm s length debt test is optional if the safe harbour debt test is passed. While the arm s length debt amount or the worldwide gearing amount tests may give a larger maximum allowable debt as compared to the safe harbour debt amount, the calculation and documentation required can be complex and onerous. Where an entity is considered thinly capitalised, a portion of the interest expense is denied as a deduction, permanently. Where the interest deduction arises from loans from international related Greg Travers

11 parties, the transfer pricing rules can also apply to deny a deduction even where the thin capitalisation tests are satisfied. Interest that is not deductible due to the thin capitalisation provisions is still treated as interest for withholding tax purposes, so a withholding tax liability will still arise. The following is an example of the safe harbour debt test which highlights how a proportion of the interest expense would be denied as a deduction, where the actual amount of debt exceeds the safe harbour debt test: Interest expense on debt $2,250,000 Assets $30,000,000 Liabilities (all interest bearing debt) $22,500,000 Equity $7,500,000 Maximum allowable debt ($30,000,000 x 0.6) $18,000,000 Excess debt $4,500,000 % of debt deduction denied ($4,500,000 / $22,500,000) 20% Actual interest deduction allowed (($2,250,000 x (1-20%)) $1,800,000 Interest deduction denied $450,000 Additional tax payable $135, Practical considerations from thin capitalisation rules For an SME looking to expand overseas, the thin capitalisation rules should be considered when the funding of its Australian and overseas operations is being contemplated. In particular, an SME should consider the following questions in the context of the thin capitalisation rules: 1. How much of its assets will relate to the proposed foreign operations? If this is expected to be less than 10% of overall assets, then the thin capitalisation rules will not apply. 2. How much funding is required for the overseas operations? Based on an interest rate of 7%, an Australian entity should be able to borrow up to $28M without having to consider if the interest expense would be denied under the thin capitalisation rules. 3. What assets are/will be on the balance sheet and will they require impairment or can they be revalued? How will this impact on the safe harbour debt calculation each year? Greg Travers

12 4. (Even if the thin capitalisation provisions don t apply) can the debt of the business be organised in a way that produces a more tax effective outcome? 5. Be aware of arrangements which are treated as debt in one country but equity in another. Historically such hybrid arrangements have been a tax planning technique used in particular jurisdictions. Going forward, Australia has announced it will introduce anti-hybrid laws in line with the OECD recommendations. 2.4 Transfer Pricing The basics of transfer pricing Transfer pricing refers to the pricing of transactions between international related parties. For tax purposes, the overriding principle is that transactions between international related parties should be priced on arm s length terms. This ensure that an appropriate profit is allocated to each country involved with the transaction/business based on the functions undertaken in that country, the assets deployed in that country and the risks taken on by the enterprise in that country. International related party dealings have grown such that they constitute 50% of all cross-border trades and the Assistant Treasurer has claimed that profit shifting and international tax avoidance is a threat to Australia s sovereignty in his address to the Tax Institute of Australia 28 th National Convention on 15 March There is a perception, both in Australian and around the world, that the transfer pricing rules need to be strengthened in the wake of increasing globalisation in order to protect the revenue (tax collections) of countries. In Australia, the transfer pricing rules have recently been rewritten and relocated to Division 815 of ITAA 97. The current operative provisions are in Subdivision 815-B to Subdivision 815-D as follows: 1. Subdivision 815-B: Arm s length principles for cross-border conditions between entities Applies where an entity obtains a tax advantage (a transfer pricing benefit ) in Australia from cross-border conditions that are different from arm s length conditions. In this case, the Commissioner may amend income tax assessments as though those arm s length conditions exist and deny the tax advantage. 2. Subdivision 815-C: Arm s length principles for permanent establishments Applies where a permanent establishment (PE) obtains a tax advantage (a transfer pricing benefit ) in Australia, where the amount of profits (actual profits) attributed to the PE differs from the profit that would have been attributable, assuming the PE was a separate entity and operating under arm s length conditions. Again the Commissioner has the power to amend income tax assessments as though arm s length conditions exist and deny the tax advantage. Greg Travers

13 2.4.2 International dealing schedule Where an entity has dealings with international related parties in excess of $2M (including the balance of loans), it is required to disclose the quantum of the dealing, the pricing methodology applied, and how much of the transaction has its pricing methodology documented in the International Dealings Schedule (IDS) as part of the entity s income tax return. The IDS is one of the main mechanisms used by the ATO to assess transfer pricing risks and select taxpayers for audit or review Transfer pricing documentation requirements For income years starting on or after 29 June 2013, new transfer pricing rules regarding documentation were enacted in Subdivision 284-E of Schedule 1 of the TAA 53. Section sets out these specific documentation requirements as follows: Are prepared before lodgement of the income tax return for the year; Are in English, or readily accessible or convertible into English; Explain the application of the transfer pricing provisions in Division 815, and how it achieves consistency with OECD transfer pricing guidelines. The records must readily ascertain the arm s length conditions, actual conditions of the international related party transaction, the comparable circumstances, the pricing methodology used and how it reflects arm s length conditions. Subdivision 284-E itself does not require the preparation and maintenance of documentation to justify the pricing of international related party dealings. However, if the entity is found to be in breach of the transfer pricing rules and administrative penalties imposed, there is no reduction in the administrative penalty for having a reasonably arguable position if the entity has not prepared specific documentation as required. Australia is also adopting the OCED master file/local file approach to transfer pricing documentation. All Australian taxpayers, other than those that can use the simplified methods discussed below, will need to revisit their approach to transfer pricing documentation in light of this change. The ATO has released an outline of the information that it expects to see in the master file and local file. This outline is a useful reference point for the preparation of documentation for SMEs. Obviously the detail of information and analysis will greater for larger and more complex situations, but the scope of the information should be fairly consistent for most businesses. The following information should be included in the Master File: Chart illustrating the Multi-National Enterprise s (MNE s) legal and ownership structure and geographical location of operating entities. General written description of the MNE s business including: Important drivers of business profit; Greg Travers

14 A description of the supply chain for the group s five largest products and/or service offerings by turnover plus any other products and/or services amounting to more than 5 percent of group turnover. The required description could take the form of a chart or a diagram; A list and brief description of important service arrangements between members of the MNE group, other than research and development (R&D) services, including a description of the capabilities of the principal locations providing important services and transfer pricing policies for allocating services costs and determining prices to be paid for intra-group services; A description of the main geographic markets for the group s products and services that are referred to in the second bullet point above; A brief written functional analysis describing the principal contributions to value creation by individual entities within the group, i.e. key functions performed, important risks assumed, and important assets used; A description of important business restructuring transactions, acquisitions and divestitures occurring during the fiscal year. A general description of the MNE s overall strategy for the development, ownership and exploitation of intangibles, including location of principal R&D facilities and location of R&D management. A list of intangibles or groups of intangibles of the MNE group that are important for transfer pricing purposes and which entities legally own them. A list of important agreements among identified associated enterprises related to intangibles, including cost contribution arrangements, principal research service agreements and licence agreements. A general description of the group s transfer pricing policies related to R&D and intangibles. A general description of any important transfers of interests in intangibles among associated enterprises during the fiscal year concerned, including the entities, countries, and compensation involved. A general description of how the group is financed, including important financing arrangements with unrelated lenders. The identification of any members of the MNE group that provide a central financing function for the group, including the country under whose laws the entity is organised and the place of effective management of such entities. A general description of the MNE's general transfer pricing policies related to financing arrangements between associated enterprises. The MNE s annual consolidated financial statement for the fiscal year concerned if otherwise prepared for financial reporting, regulatory, internal management, tax or other purposes. Greg Travers

15 A list and brief description of the MNE group s existing unilateral advance pricing agreements (APAs) and other tax rulings relating to the allocation of income among countries. The following information should be included in the Local File: A description and copy of the organisational structure of the local entity, including a description of the individuals to whom local management reports and the countries in which such individuals maintain their principal offices A description of the local entity s business and strategy A description of any business restructures affecting the local entity in the current or previous income year, and an explanation of its significance A description of any transfers of intangibles in the current or previous income year, and an explanation of its significance A list of key competitors of the local entity. The following information for all international related party transactions for the income year: Name and country of residences of the parties to the transaction Category of the transaction (per ATO categories) Amounts of consideration payable/receivable (of a capital nature for Australian income tax purposes) or amounts of expenditure/revenue (not of a capital nature for Australian income tax purposes) The transfer pricing method relied on for the transaction (per ATO descriptors) If it is a capital transaction, the capital asset pricing methodology used The transfer pricing documentation code Whether the transaction is covered by a category on the Exclusions List (which excludes low risk, low value transactions from some parts of the documentation) Financial accounts for the Australian Reporting Entity For each transaction not covered by the Exclusions List: The transfer pricing method relied on for the transaction by the international related party (or an indication the local entity was not able to obtain the information) An indication whether there is a written agreement and, if so, whether the agreement has been previously provided to the ATO A copy of the agreement (unless previously provided to the ATO) Any foreign APAs or rulings provided by another jurisdiction in relation to an agreement (unless previously provided to the ATO). Greg Travers

16 2.4.4 Simplified transfer pricing record keeping The ATO s publication Simplifying transfer pricing record keeping allows eligible taxpayers to keep simplified transfer pricing records if they meet certain conditions. This is by the choice of the taxpayer and is required to be disclosed as part of its International Dealings Schedule. Where a taxpayer meets the conditions, the ATO undertakes not to examine the taxpayer s transfer pricing records (paragraph 4 of PSLA 2014/3:Simplifying Transfer Pricing Record Keeping), but the taxpayer would need to document why they are eligible: 4. What do you do when a taxpayer has elected to apply a STPRKO? If an entity has elected to apply one or more STPRKO (Simplified Transfer Pricing Record Keeping Options), then you are not to review the records that relate to the relevant CBCBE's (cross border conditions between entities) of that entity for the income years that fall within the assurance given by the Commissioner beyond conducting a check to confirm an entity's eligibility to elect the option(s) they have. An entity is expected to have kept contemporaneous documents that corroborate their eligibility as mere assertion will not suffice. They do not have to be comprehensive, but should simply and sensibly explain how and why the entity was eligible to apply an option or options. You should refer to the online guide for details as to the relevant options, the eligibility requirements and their conditions of operation. There are seven options available with different applicable dates. The following were available from 29 June 2013: 1. Small taxpayers: Applicable to taxpayers with a turnover between $0 to $25M with no sustained losses. 2. Distributors: Applicable to taxpayers with ANZIC Wholesale Trade Code and profit before tax ratio no less than 3%. 3. Intra-group services: Taxpayers receiving or providing intragroup services and the intragroup services received/provided do not form more than 15% of the total revenue/expenses of the Australian economic group, and mark-up of costs is no more than 7.5% for services received/provided. 4. Low level loans (inbound): Taxpayers with combined cross-border loans of $50M or less, and the interest rate is no more than the RBA rate for small business; variable; residential-secured term, and the loan is in Australian dollars. The following became available from 1 July Materiality: Taxpayers with international related party dealings of less than or equal to 2.5% of the turnover of their Australian economic group. 6. Management and administration services: Taxpayers with management and administration services not being more than 50% of total international related party dealings of the Australian economic group and mark-ups of 5% or less for such services provided/received. 7. Technical services: Taxpayers with technical services not more than 50% of total international related party dealings of the Australian economic group, and mark-ups of 10% or less for services received/provided. Greg Travers

17 Each option has a separate set of conditions to be satisfied prior to the taxpayer being eligible. In addition to the above, a taxpayer would not qualify for the simplified transfer pricing record keeping option if the taxpayer has dealings with specified countries, had a restructure during the year and/or had capital transactions. The simplified transfer pricing record keeping options should be the first point of reference for all SMEs. If it is possible to fit within these guidelines, compliance costs can be reduced significantly Practical implications of transfer pricing and documentation requirements An Australian business seeking to expand overseas should consider the following practical issues: 1. What are the transactions that will occur between the Australian business and the overseas business? Consider: Supplies of goods, raw materials, services, etc that relate to the goods or services that the business supplies as part of its business operations. Support services such as marketing, IT, finance, administration etc, both in terms of external costs and the time spent by employees. Shared costs, insurance being a common one. The use of brands and other intangibles. How the overseas business is to be funded? 2. What is the nature of the overseas business operations? Is it a limited risk situation, e.g. a limited risk distributor, an internal service provider or a contract manufacturer? In these cases, a cost plus model for remunerating the overseas business may be appropriate, with the Australian business taking the residual risk. Where the overseas business has a broader business function, a transfer pricing policy that exposes the overseas business to greater upside and downside risk may be required. 3. Does any of the simplified documentation options published by the ATO apply? 4. What are the transfer pricing obligations in the overseas country? Are these consistent with the Australian approach? 5. Does the transfer policy support the overall business strategy? Does the transfer pricing policy support the overall tax strategy? Greg Travers

18 2.5 Residency, Permanent Establishments and Double Tax Agreements Residency The determination of taxable income for Australian purposes is centred around the concept of residency. A resident taxpayer is taxed on their worldwide income, whilst taxation of a non-resident is restricted to Australian sourced income. Residency is firstly determined based on Australia s domestic laws. Where a taxpayer is also tax resident in another country that Australia has a double tax agreement with, the terms of that agreement are then relevant. The double tax agreements often (but not always) include tie-breaker provisions that apply when a taxpayer is a resident of both countries. These rules will treat the taxpayer as a resident of one of the countries for the purposes of applying the terms of the double tax agreement. For domestic purposes (to the extent the double tax agreement does not override the domestic laws) the taxpayer can continue to be treated as a resident even if they are a non-resident under the tie-breaker provision in the double tax agreement. Ceasing residency can have tax implications, in particular CGT Event I1, and careful planning is required. Whilst taxable Australian property (mainly direct and indirect interests in Australian real property) will remain subject to Australian tax, under CGT Event I1 the default position is that CGT assets that are not taxable Australia property will be disposed of for their market value at the time of ceasing Australian tax residency (with individuals able to make an election to keep these assets in the Australian tax system) Residency of individuals Individuals are residents of Australia if one of four tests are satisfied. In broad terms the tests are: If they reside in Australia If they are domicile in Australia, unless they have a permanent place of abode outside of Australia If they are physically located in Australia for more than 183 days in the income year, unless their usual place of abode is outside of Australia and they don t intent to take up residence in Australia If they have certain superannuation entitlements (this test is really just relevant for Australian public servants). Similar concepts, such a permanent place of abode and centre of vital interests are usually used in the various tie-breaker provisions. Determining residency is a question of both fact and intention. A person does not simply choose to be or not be a resident, but their intention does play a significant role. However, their intention must be consistent with the facts, i.e. their behaviours will demonstrate their real intentions. Whilst all the Greg Travers

19 various factors noted by the courts and in ATO rulings should be considered, it is not a mechanical exercise and ultimately it is the overall picture that matters Residency of companies Under 6(1), a company is a resident of Australia if: it is incorporated in Australia, or although not incorporated in Australia it carries on business in Australia and has either: its central management and control in Australia, or its voting power controlled by shareholders who are residents of Australia. Although not defined in the legislation, the phrase central management and control has been dealt with by the courts on many occasions over time. According to the courts, the place of central management and control ordinarily coincides with the place where the directors of the company exercise their power and authority (generally where they hold their board meetings). However, the test must be considered on the particular facts of each case. Notably, in a recent case involving a group of companies, the courts looked through the façade of non-resident directors to conclude that in fact, the companies were controlled and managed by an Australian resident. The Courts found that the directors merely executed instructions from the Australian resident controller and did not adequately discharge their duties as directors. The tie-breaker provisions in the double tax agreements often refer to place of effective management or a similar concept. Guidance has been provided by the OECD on different terms used in a similar context, for example effective management is described as: The place of effective management is the place where key management and commercial decisions that are necessary for the conduct of the entity s business as a whole are in substance made. All relevant facts and circumstances must be examined to determine the place of effective management. An entity may have more than one place of management, but it can have only one place of effective management at any one time. The OECD guidance provides examples of factors that authorities would be expected to consider in determining the location of effective management : Where the meeting of its board of directors are usually held Where the directors reside (or those making the strategic decisions) Where the CEO and other senior executives usually carry on their activities Where the senior day-to-day management activities of the entity are carried on Where the entity s headquarters are located Greg Travers

20 Where the business operations are actually conducted Legal factors such as the place of incorporation, the location of the registered office, public officer etc. Where controlling shareholders make key management and commercial decisions in relation to the company Which country governs the legal status of the entity Where the accounting records are kept Residency of a trust Section provides that a trust (other than a unit trust) is a resident trust for CGT purposes for an income year if, at any time during the year, the trustee is an Australian resident or the trust s central management and control is in Australia. Similarly, section 95(2) defines a resident trust estate as where: A trustee of the trust estate was a resident at any time during the year of income or The central management and control of the trust estate was in Australia at any time during the year of income. The double tax agreements generally apply to Australian companies and persons who are resident of Australia. A person is generally defined as an individual, a company and any body of persons, corporate or not corporate. It is arguable that a trust, not being a natural or legal person nor a body corporate or non-corporate, does not fall into any of these categories and so does not come within the terms of the double tax agreement. However, it would be prudent to ensure that the tax residency of the trustee is consistent with the targeted tax residency position of the trust The basics of permanent establishment Under the business profits article of a double tax agreement, a country may only tax the business profit of a non-resident if it is attributable to a permanent establishment (PE) in that country. Article 7 of the UK Convention with Australia is an example of such a business profits article: The profits of an enterprise of a Contracting State shall be taxable in that State unless the enterprise also carries on business in the other Contracting State through a permanent establishment situation in that other State. If the enterprise carries on business in that manner, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to that permanent establishment. A PE is separately defined in the double tax agreement. The definition of PE is based around the concept of a fixed place of business through which the business is carried on. This requires an actual place of business that has permanence in a physical sense (i.e. a shop or an office) and time sense (i.e. it exists for an extended period of time, usually at least 6 months). The PE concept originated from a time of bricks & mortar and does not deal well with the digital economy. The OECD has recognised this in its Base Erosion and Profit Shifting (BEPS) related action plans. Greg Travers

21 The PE definition is expanded through a range of inclusions, but limited through a range of exclusions. The following is a sample of a PE definition per Article 5 of the Australia/UK DTA: 1 For the purposes of this Convention, the term "permanent establishment" means a fixed place of business through which the business of an enterprise is wholly or partly carried on. 2 The term "permanent establishment" includes especially: (a) a place of management; (b) a branch; (c) an office; (d) a factory; (e) a workshop; (f) a mine, an oil or gas well, a quarry or any other place relating to the exploration for or exploitation of natural resources; and (g) an agricultural, pastoral or forestry property. 3 An enterprise shall be deemed to have a permanent establishment in a Contracting State and to carry on business through that permanent establishment if: (a) it has a building site or construction or installation project in that State, or it undertakes a supervisory or consultancy activity in that State connected with such a site or project, but only if that site, project or activity lasts more than 12 months; (b) it maintains substantial equipment for rental or other purposes within that other State (excluding equipment let under a hire-purchase agreement) for a period of more than 12 months; or (c) a person acting in a Contracting State on behalf of an enterprise of the other Contracting State manufactures or processes in the first-mentioned State for the enterprise goods or merchandise belonging to the enterprise. 4 (a) The duration of activities under subparagraph (a) of paragraph 3 will be determined by aggregating the periods during which activities are carried on in a Contracting State by associated enterprises provided that the activities of the enterprise in that State are connected with the activities carried on in that State by its associate. (b) The period during which two or more associated enterprises are carrying on concurrent activities will be counted only once for the purpose of determining the duration of activities. (c) Under this Article, an enterprise shall be deemed to be associated with another enterprise if: (i) one is controlled directly or indirectly by the other; or (ii) both are controlled directly or indirectly by a third person or persons. 5 Notwithstanding the preceding provisions of this Article, an enterprise shall not be deemed to have a permanent establishment merely by reason of: (a) the use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise; (b) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery; (c) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise; Greg Travers

22 (d) the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise, or collecting information, for the enterprise; or (e) the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character. 6 Notwithstanding the provisions of paragraphs 1 and 2 of this Article, where a person - other than an agent of an independent status to whom paragraph 7 of this Article applies - is acting on behalf of an enterprise and has, and habitually exercises, in a Contracting State an authority to conclude contracts on behalf of the enterprise, that enterprise shall be deemed to have a permanent establishment in that State in respect of any activities which that person undertakes for that enterprise unless the activities of such person are limited to those mentioned in paragraph 5 of this Article which, if exercised through a fixed place of business, would not make this fixed place of business a permanent establishment under the provisions of that paragraph. 7 An enterprise shall not be deemed to have a permanent establishment in a Contracting State merely because it carries on business in that State through a broker, general commission agent or any other agent of an independent status, provided that such brokers or agents are acting in the ordinary course of their business as such. 8 The fact that a company which is a resident of a Contracting State controls or is controlled by a company which is a resident of the other Contracting State, or which carries on business in that other State (whether through a permanent establishment or otherwise), shall not of itself make either company a permanent establishment of the other. A common issue relates to whether a sales and marketing function can give rise to a PE. Under the current PE definition, even though the activities of a local entity (be it a commissionaire, agent or subsidiary) are intended to generate customers and result in contracts to be performed by the foreign entity, as the contracts are not concluded by the local entity, a PE does not arise for the foreign entity in that country through the actions of the local entity. That is, a local sales and marketing function would not give rise to a PE in that country for its foreign parent. However, this position is likely to change. BEPS Action 7 recommends that where a person habitually negotiates the material elements of contracts on behalf of a foreign entity, the foreign entity will be deemed to have a PE in that country. Australia has adopted this wording in its latest double tax agreement (with Germany) and is intending to adopt similar wording in all future new or revised double tax agreements. When a business has ongoing operations in another country that do not give rise to a PE, it tends to be referred to a representative office. In most cases (in particular in countries where Australia has a double tax agreement) a representative office does not create a taxable presence in that other country. When a business has a PE in another country, it tends to be referred to as a branch. Branches are generally taxed on a basis comparable to companies, but there can be some local variations, for example the branch profits tax in the US. A key issue with branches is the determination of the profits attributable to the branch. In principle this is done based on a separate notional taxpayer approach i.e. treat the branch as if it was an entity in its own right. However, this allocation can be a very subjective exercise. Particularly problematic is the allocation of expenses between the parent and the branch, noting that costs of the parent can be allocated to the branch but there is no ability to add a mark-up or charge a market rate on internal functions on the basis that legally, an entity cannot transact with itself. Greg Travers