2017 FINANCIAL SERVICES TAXATION CONFERENCE

Transcription

1 2017 FINANCIAL SERVICES TAXATION CONFERENCE Written by: Julian Pinson Director Greenwoods & Herbert Smith Freehills Jerome Wood Tax Manager Commonwealth Bank of Australia Presented by: Julian Pinson Director Greenwoods & Herbert Smith Freehills Mary Hu Associate Greenwoods & Herbert Smith Freehills Jerome Wood Tax Manager Commonwealth Bank of Australia 8-10 February 2017 Palazzo Versace, Gold Coast Julian Pinson, Jerome Wood and Mary Hu, 2017 Disclaimer: The material and opinions in this paper are those of the authors 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 CONTENTS 1 Overview Timeline of key documents/events Current Australian law and ATO practice Law and ATO public rulings ATO internal derivative guidelines RBA vs. AOA Overview What is the RBA? What is the AOA? Practical significance of adopting the RBA or AOA International comparison ATO focus areas in bank PE attribution Current practical issues and risks, including transfer pricing methodologies Overview Traditional banking activities Creation and management of loans with multi-branch involvement Transfer of existing loans across branches Global trading models Allocation of sales income Trading market risk management Other internal dealings Capital allocation Australian tax law treatment of capital AOA for attributing capital Liquidity management Overview Long term funding costs Julian Pinson, Jerome Wood and Mary Hu,

3 7.5.3 Liquid asset holding requirements Inter-branch loans Insurance in the banking context Future direction of Australian law and 2013 Board Report Adopting the AOA How would the AOA be implemented in Australia? Impact of BEPS, MAAL and DPT BEPS Overview Action Action MAAL and proposed DPT MAAL Proposed DPT Conclusion Julian Pinson, Jerome Wood and Mary Hu,

4 1 Overview The attribution of profits to branches or permanent establishments (PEs) is exceptionally complex under Australian law 1, although Australia is far from unique in this regard. It involves multiple areas of domestic law as well as tax treaties and a massive and forever evolving body of international practice and guidelines. It is easy to imagine branch attribution as a revenue minister s least favourite area: the issues are complex and arcane, but the perceived risks to revenue large. This historically difficult area is also becoming more complex due to the current base erosion and profit shifting (BEPS) work at the Organisation for Economic Co-operation and Development (OECD) (such as on branch mismatch structures), and Australia s own introduction of the new multinational anti-avoidance rule (MAAL) which took in effect in Some of these changes will affect the thresholds for PE status, some will affect profit attribution once a PE has been identified, and some will affect both. These issues are particularly important in the financial services industry, where branches have been widely used, particularly by banks. 2 By way of example, around 80% of foreign banks operate through a PE in Australia as opposed to a subsidiary. Bank branches will not only transact with third parties but enter into a huge number of internal dealings with head office and other branches, including loans, derivatives and foreign exchange transactions. This paper focusses on PE attribution, from an Australian inbound and outbound perspective, once a PE has been identified that is, the paper does not discuss PE status issues. The focus is also on a number of practical issues currently faced by inbound and outbound banks (although many of the issues will also be relevant to insurance companies and other financial services entities). The paper assumes a reasonable degree of knowledge of the current and historic law (and domestic and international practice) in the area, and the focus is on the practical examples and not on a theoretical description of how the law is intended to operate. Nevertheless, by way of background we have included a summarised timeline and description of the key documents/events and a summarised description of the Australian law relevant to the issues discussed in the paper. 3 Australia is at an important juncture in terms of its PE attribution rules: we either continue on with the current rules, which are piecemeal and frankly a mess, or we adopt the conceptually sounder and certainly easier to apply (at least for a bank) authorised OECD approach (AOA), which is the emerging international consensus and is already being adopted by many of our major trading partners. The paper: 1 Unless the context requires otherwise, legislative references in this paper are to provisions of the Income Tax Assessment Act 1936 and the Income Tax Assessment Act 1997, as applicable. 2 A useful summary of the relative advantages for banks of operating through a branch structure as opposed to a subsidiary is contained in the Australian Financial Markets Association s 18 December 2012 submission to the Board of Taxation s Review of Tax Arrangements Applying to Permanent Establishments Discussion Paper at pp For excellent overviews of the current law in this area, we recommend Ian Fullerton s papers at the 2013 and 2014 Financial Services Taxation Conferences (The attribution of income, losses and outgoings to foreign permanent establishments of Australian banks and The attribution of profits to permanent establishments, respectively). Julian Pinson, Jerome Wood and Mary Hu,

5 1 describes, in very high-level terms, Australia s current approach to PE attribution (which is neither a pure relevant business activity (RBA) approach nor a functionally separate entity (FSE) approach, but closer to the former than the latter); 2 considers how Australia s approach compares to the AOA and what other countries are doing in practice; 3 discusses a number of current practical issues and ATO focus areas in branch attribution, and how those issues would be dealt with under the AOA; and 4 considers the future of Australian law in this area. The key potential change to Australian law/practice is obviously the potential adoption of the AOA, although precisely what this would look like under domestic law and our treaties is unclear. The consequences of adopting the AOA were addressed by the Board of Taxation (the Board) in its April 2013 Report on its Review of the Tax Arrangements Applying to Permanent Establishments (Board Report). However, the Board did not explicitly recommend the AOA be adopted, and despite almost four years having passed, the Government has never responded to the Board Report. After so many years of inaction, we see merit in the adoption of the AOA for the purposes of our domestic and treaty PE attribution rules. If the Government cannot get comfortable with any residual revenue risk in implementing the AOA for all taxpayers, then the AOA should at the very least be applied to inbound and outbound banks. In practice, the industry already operates on that basis, as the ATO, Treasury and the Government know. To not formally sanction the AOA for banks achieves nothing but creates the impression of tax risk and uncertainty, especially for the foreign financial services entities that the Government repeatedly states that it is trying to attract to Australia in order to establish Australia as a financial centre. Julian Pinson, Jerome Wood and Mary Hu,

6 2 Timeline of key documents/events As noted above, this paper assumes a reasonable degree of knowledge of the current and historic Australian law on PE attribution. However, the area is notoriously heavy on domestic and international laws/guidelines, and it is often unclear what particular version of a document countries have regard to. Accordingly, we have included a timeline below summarising the key documents/events relevant to the later sections of this paper (and, in particular, the key differences between some of the documents). The timeline illustrates: the increasing acknowledgement from the OECD and tax authorities of the complexity of the issues, and hence the increasing complexity of the OECD Commentary (Commentary); and that many of the current practical issues discussed in section 7 of this paper have been around for decades, and it is concerning that the outcomes in an Australian context are still so uncertain. Year Document/Event 1963 Release of Draft OECD Model Double Taxation Convention (OECD Model). Draft Article 7 (Business Profits) states that where an enterprise of a contracting state carries on business in the other contracting state through a PE there shall in each Contracting State be attributed to that permanent establishment the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment OECD Model formally introduced along with Commentary. No material changes to Article 7. The Commentary shows the drafters were relaxed about its application. Article 7 was not strikingly novel or particularly detailed. The question of what criteria should be used in attributing profits to a [PE] has had to be dealt with in a large number of double taxation conventions and it is fair to say that the solutions adopted have generally conformed to a standard pattern. It is generally recognised that the essential principles on which this standard pattern is based are well founded, and it has been thought sufficient to restate them with some slight amendments Modern commerce organises itself in an infinite variety of ways, and it would be quite impossible to specify an exhaustive set of rules for dealing with every kind of problem that may arise. This, however, is a matter of relatively minor importance, if there is agreement on general lines. Special cases may require special consideration, but it should not be difficult to find an appropriate solution if the problem is approached within the framework of satisfactory rules based on agreed principles. 4 This was found to be overly optimistic OECD Commentary paragraph 2. Julian Pinson, Jerome Wood and Mary Hu,

7 The Commentary: implied that Article 7(2) incorporated a FSE approach (although it did not use that phrase); stated that the starting point for calculating attributable profits were branch accounts (although these could be adjusted if inaccurate); and stated that the exceptions to the FSE-type approach were for interest (unless a financial institution), royalties and mark-ups for services. The Commentary states that if countries did not agree with the FSE approach, then they could agree on more detailed provisions in their treaties. Australia does not do this. Australia made a number of Observations on the Commentary, but no Reservations on the Article. The Observations did not refute the general FSE view in the Commentary Max Factor & Co. v. FC of T 15 ATR 231 (Max Factor) The NSW Supreme Court decides, broadly, that dealings between head office and a PE cannot give rise to income/deductions for Australian tax purposes Revisions to OECD Commentary, following 1994 OECD PE attribution report. Major revisions to Commentary on Article 7(2). The optimism disappears. The reference to the inability to specify an exhaustive set of rules for dealing with every kind of problem being a matter of relatively minor importance is removed and replaced: since such problems may result in unrelieved double taxation or non-taxation of certain profits, it is important for tax authorities to agree on mutually consistent methods of dealing with these problems. 5 The Commentary still generally incorporated a FSE/branch accounts approach, but now specifically provides alternative Article 7(2) language that can be used if countries do not agree with the FSE-type approach. Australia does not do this. The Commentary goes further and states that branch accounts are the starting point including in respect of internal agreements between a branch and head office, provided the branch and head office accounts are prepared symmetrically on the basis of such agreements and those agreements reflect the functions performed by the different parts of the enterprise. Considerable attention is given to the transfer of assets, whether or not trading stock, between a branch and head office (or between branches), including loan assets transferred within a bank. The Commentary indicates that the transfers should be capable of being recognised for tax. Specific mention was made regarding the difficulties in attributing capital to bank branches. Australia includes an Observation on the Commentary: Australia does not recognise intra-entity transfers for tax purposes. Accordingly, Australia does not allow a mark-up for profit on dealings between [PEs] or between a [PE] and its head office. Australia also includes a number of Reservations on the Article (such as it not covering insurance) TR 2001/11 application of the Division 13 PE rules and the business profits articles in Australia s tax treaties (see section 3 below) OECD Commentary paragraph 2. Julian Pinson, Jerome Wood and Mary Hu,

8 2005 TR 2005/11 branch funding for multinational banks (see section 3 below) TR 2006/9 addresses withholding tax on interbranch funding. Whilst the ruling explicitly does not apply to determine attribution of profits, it further acknowledges the use of internal loans and also considers the issue of attributing interest expenses to branch operations OECD Report on the Attribution of Profits to Permanent Establishments (2008 OECD Report) endorses the FSE as the AOA, but also outlines the RBA approach. Contains specific guidance for banks (Part II), global trading (Part III) and insurance (Part IV). Major revisions to OECD Commentary: acknowledge the two different interpretations of Article 7 (RBA and FSE) and the problems this creates; refers to 2008 OECD Report, including bank-specific sections, and incorporates the conclusions in the 2008 OECD Report but only those that did not conflict with previous versions of the Commentary; supports a limited FSE approach; and refers to the 2008 OECD Report discussion on capital allocation and acknowledges different acceptable approaches OECD Report re-issued (2010 OECD Report) with amendments to clearly adopt the FSE approach so that the report could be read alongside the new OECD Model Article 7. New OECD Model Article 7 introduced reflects the FSE as the AOA. Substantial changes to Commentary specifies that FSE is the AOA. Australia does not make any Observations on the new Commentary. Australia retains its pre-existing Reservations on the Article, although none of these relate to the FSE approach. The Australian single entity Observation made in 1994 was deleted in Board October 2012 Discussion Paper on its Review of Tax Arrangements Applying to Permanent Establishments (Board Discussion Paper). Board asked to investigate impacts of Australia adopting AOA New domestic transfer pricing rules in Division 815 replace rules in Division 13. OECD BEPS project commences Government releases April 2013 Board Report. Multinational anti-avoidance law (MAAL) introduced as part of Part IVA Multiple BEPS papers released, including discussion drafts on: Additional Guidance on the Attribution of Profits to PEs (Action 7) (July 2016) Branch Mismatch Structures (Action 2) (August 2016) Exposure Draft diverted profits tax (DPT) legislation released. Julian Pinson, Jerome Wood and Mary Hu,

9 3 Current Australian law and ATO practice 3.1 Law and ATO public rulings As noted above, this paper does not focus in detail on current Australian law and ATO practice. However, the table below summarises the law applying to inbound and outbound PEs, in particular of banks, which is relevant to the practical examples in section 7. Non-resident with Australian PE Resident with overseas PE All sectors Domestic rules Broadly, Australia taxes all Australian source income except interest, dividends, fund payments and royalties to which withholding tax applies, subject to any treaty relief. Other country determines tax base for PE, subject to any treaty relief. Whether or not a treaty applies, Australia relieves double tax by exempting branch income/gains from Australian tax (s.23ah / s ) or by allowing a foreign income tax offset (FITO). Interest expense attributable to the branch would often be incurred in deriving nonassessable non-exempt (NANE) income and hence be non-deductible in Australia. Therefore, broadly, the less capital allocated to a branch the greater the non-deductible interest expense attributed to the branch. Tax treaties If there is an applicable tax treaty, business profits taxable in Australia capped by Article 7 (i.e. profits attributable to Australian PE). Australia s treaties have old (pre-2010) version of Article 7, and Australia still formally applies a form of RBA approach (see section 4 below). Business income/profits taxable in other jurisdiction capped by Article 7. Australia obliged to provide relief from double tax. Branch income/gains often NANE under s.23ah / s , although may not precisely align with amounts taxed overseas. Otherwise FITO. Transfer pricing Amounts attributed to Australian PE in accordance with arm s length principle under Subdivision 815-C (although Subdivision 815- C can only increase not decrease Australian taxable income). Article 7 of an applicable tax treaty prevails if it would produce a more favourable result for the taxpayer. Profits attributable to PE guided by arm s length principle under Subdivision 815-C (although Subdivision 815-C can only increase not decrease Australian taxable income). Income/gains generally treated as NANE under s.23ah / s Julian Pinson, Jerome Wood and Mary Hu,

10 Administrative approach TR 2001/11 deals with the operation of Australia s PE attribution rules under former Division 13 and Australia s tax treaties for both foreign and Australian PEs. ATO relies on Max Factor to support the view that Australia's then PE attribution rules were based upon allocating a taxpayer's actual income and deductions using an 'arm's length separate enterprise principle' (similar to an RBA approach). (This approach is now built into Subdivision 815-C, pending the Government s decision on whether to adopt the AOA under Australian law). Inbound and outbound banks Administrative approach TR 2005/11 deals with inbound and outbound inter-branch fund transfers, including inter-branch loans and capital allocations for the purposes of former Division 13 and Australia s tax treaties. The ATO reiterates the general RBA view, but acknowledges the difficulty/impossibility of tracing to third party income/expenses in the context of banking, and hence accepts the allocation of income and expenses for branches on the basis of the transfers recognised in a bank s accounts (branch and head office) prepared on an arm s length separate entity basis (i.e. as a reasonably proxy for allocating actual third party income and expense). On attribution in relation to inter-branch funds transfers: We accept entries in a bank s books of account that reflect arm s length interest charges on interbranch funds transfers as a means of determining an allocation or attribution of the bank s income, expense or profit in accordance with Australia s PE attribution rules. 6 On attribution of equity capital to a PE of a bank:.. the amount of equity attributable to an Australian bank s foreign branches for Division 820 purposes is the amount actually allocated to them in the bank s books of account. Where an amount of equity capital allocated to a foreign branch in the bank s books of account is adjusted for foreign tax purposes or by the Tax Office for other tax purposes, the adjusted amount should be used in the calculation of the equity capital attributable to the branch for Division 820 purposes. 7 There has never been a ruling covering other intra-entity dealings of banks (such as notional derivatives), although note the guidelines for derivatives discussed in section 3.2 below. Specific domestic regime Part IIIB (which is elective) applies for the purposes of determining the taxable income of an Australian branch of a foreign bank, and applies an FSE approach in relation to recognising head office-branch loans and certain derivatives. Interest deductions in relation to loans from head office are capped at LIBOR. N/A Arm s length rules in Subdivision 815-B apply to Part IIIB covered arrangements (as opposed to PE rules in Subdivision 815-C). 6 TR 2005/11 paragraph 9. 7 TR 2005/11 paragraphs 11 and 12. Julian Pinson, Jerome Wood and Mary Hu,

11 3.2 ATO internal derivative guidelines When TR 2005/11 was released, effectively permitting the recognition of inter-branch loans as a proxy for allocating third party income and expense, it was widely recognised that exactly the same practical issues in particular the inability to trace arose in relation to internal derivatives. However, an equivalent tax ruling for internal derivatives has never been issued. Industry raised this issue periodically, and in its 2013 Report the Board stated that unless the ATO could provide guidance on internal derivatives the law should be changed. Ultimately the ATO has produced compliance guidelines on internal derivatives (the Guidelines), not an actual ruling. Despite not yet being available on the ATO website (as at 20 January ), various versions were circulated by the ATO during consultation with the banks, and we understand that the Guidelines are now considered final for both inbound and outbound banks. The Guidelines essentially say that, as a matter of compliance, the ATO will accept entries in a bank s books of account recording internal derivatives that reflect arm s length dealings as a means of determining an allocation or attribution of the bank s income, expenses or profits in accordance with Australia s PE attribution rules. That is, the ATO is essentially saying that, as a matter of compliance, the TR 2001/11 and TR 2005/11 proxy approach can be applied to internal derivatives. There is a lengthy discussion of the documentary evidence the ATO requires supporting the positions taken by taxpayers, which the ATO says are in line with the requirements under the transfer pricing rules in Division 815. Although an actual tax ruling may have been preferable, the Guidelines are certainly welcome recognition by the ATO of the reasonable approach that the banks had been taking to internal derivatives for some time. The Guidelines outline a number of scenarios which are grouped in terms of the ATO s perception of level of complexity, which is said to refer to the level of analysis that the ATO would expect a taxpayer to have done in order to justify the outcome: Low complexity: a bank enters into a derivative with a third party (e.g. through a sales/marketing function) and then moves/transfers the position (i.e. the entire risk exposure) to another part of the bank through an internal derivative. That is, each internal derivative is directly related to an actual/specific third party transaction (where that third party transaction is not a hedging transaction). The internal derivative is a mirror of the third party derivative other than on price the pricing of the internal derivative can leave a margin or spread to appropriately compensate a function (e.g. sales/marketing). 8 The ATO website, as at 20 January 2017, indicates that the Guidelines project is expected to be completed on 1 February 2017, presumably meaning that is the scheduled public release date for the Guidelines. Julian Pinson, Jerome Wood and Mary Hu,

12 Medium complexity: although there is direct reference to a third party transaction, the internal derivative does not match the external transaction e.g. the internal derivative transfers or hedges only one or more components of the risks associated with the third party transaction (such as transferring credit risk on a loan asset, but retaining the FX/interest rate risk). The complexity is said to relate to the ATO s ability to verify the pricing and terms of the internal derivatives in this scenario to establish they are arm s length. The medium complexity category is also said to include internal derivatives that involve more than one type of risk, such as interest rate and FX, which would presumably include an internal cross-currency swap. High complexity: there are various features that can result in a high complexity categorisation, but most fundamentally this category includes internal derivatives that do not relate directly to any actual external transaction (such as where net exposures are moved via internal derivatives, or what the ATO refers to as bulk risk transfers ), or internal derivatives that are not entered into contemporaneously with the actual external transaction. The practical issues associated with applying current Australian law to global trading and internal derivatives are discussed in section 7 below, including the impact of the Guidelines. It must be emphasised that these are compliance guidelines only there is no substantive technical analysis of the low, medium and high complexity examples. In this regard, the distinction between low, medium and high complexity is not a conceptual or technical distinction it is not the same as low, medium and high risk. Assuming a bank s accounts are accurate, the basic consequence of low, medium or high complexity classification seems to be how detailed/robust does the (i) factual and functional analysis and (ii) documentary evidence have to be for the ATO to accept what is in the accounts. The Guidelines certainly are not prescriptive in this regard. The implication is that in terms of both steps, there is sufficient OECD PE attribution and transfer pricing guidance for the banks to know what they should be doing, and they should use their own commercial judgement as to what is required in their particular circumstances. This is the right approach it would have been highly inefficient to require banks to adopt an additional layer of documentation in order to rely on the Guidelines. Julian Pinson, Jerome Wood and Mary Hu,

13 4 RBA vs. AOA 4.1 Overview In this section we have commented on the basic features of and key differences between the socalled RBA and AOA approaches to PE attribution. As will be seen, the differences between the Australian RBA-type approach and the AOA are minor and often only theoretical in most cases in a banking context the two approaches should produce the same or at least a very similar result. 4.2 What is the RBA? The OECD conception of the RBA approach is described in the 2008 OECD Report: 61. The first broad interpretation, referred to as the relevant business activity approach, defines the profits of an enterprise as referring only to the profits of the business activity in which the PE has some participation (the relevant business activity ). The term does not appear in either Article 7 or the Commentary but emerges from country practices on interpreting what is meant by the phrase profits of the enterprise in Article 7(1). 62. Under the relevant business activity approach, Article 7(1) imposes a limit on the profits that could be attributed under Article 7(2) to a PE: the attributed profits could not exceed the profits that the whole enterprise earns from the relevant business activity. The profits of the whole enterprise would be those earned from transactions with third parties and those earned from transactions with associated enterprises, the latter of which would need to be adjusted under transfer pricing rules if they did not reflect the application of the arm s length principle. 63. The profits of the enterprise as a whole would be considered as comprising the aggregate of profit and losses derived from all its business activities. Any limitation on the profits attributable to a PE under paragraph 1 of Article 7 would be determined relative only to the profits of the relevant business activity. As outlined in the 2008 OECD Report, there is a vast array of different ways that RBA-type approaches are applied in different countries. Very broadly, the RBA approach to PE attribution, as incorporated into Australian law and ATO practice, requires the attribution to a given PE of actual income/expenses derived/incurred by the entity in its transactions with third parties. Regard can be had to dealings between a PE and the rest of the enterprise (which, being intra-entity have no legal basis/effect) and how those dealings are accounted for, but only for the purposes of (or as a proxy for) attributing actual third party income/expenses the dealings in and of themselves have no tax consequences. In contrast, and as discussed further below, the FSE approach more directly permits recognition of internal dealings as part of the attribution of profits to a PE. Australia s RBA approach is summarised in TR 2005/11: Julian Pinson, Jerome Wood and Mary Hu,

14 Taxation Ruling TR 2001/11 confirms that Australia s PE attribution rules are based upon allocating a taxpayer s actual income and deductions using an arm s length separate enterprise principle. An interbranch payment or charge is not itself recognised as assessable income or a deductible expense. Rather, actual income and expenses that the entity earns from or pays to third parties are allocated or attributed between branches. The arm s length separate enterprise principle permits intra-entity dealings to be recognised and priced by analogy to arm s length separate enterprise transactions, for the purpose of allocating or attributing the entity s third party income and expenses. we do not accept that Australia s tax treaties operate on a strict separate entity basis. 9 As noted above, all of Australia s tax treaties use the old (pre-2010) version of Article 7, and Australia s domestic PE attribution rules are based on an RBA-style approach both the old (TR 2001/11 and Division 13) and new (Subdivision 815-C). In relation to the new rules, this is made explicit in s (1): the arm s length profits for a PE of an entity are worked out by allocating the actual expenditure and income of the entity between the PE and the entity. The arm s length profits are to be worked out so as best to achieve consistency with: the 2010 OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrators (2010 OECD TP Guidelines); and the 2010 OECD Model and Commentary, but only to the extent that document extracts the text of Article 7 and its Commentary as they read before 22 July i.e. the 2008 OECD Model and Commentary, which are both included in full in the 2010 materials (for ease of reference given the large number of countries, Australia included, that would not (at least immediately) be adopting the new 2010 version of Article 7). Accordingly, the new domestic PE attribution rules continue to apply the RBA approach, overlaying the most appropriate transfer pricing methods (based on the 2010 OECD TP Guidelines), but only to the extent that approach is consistent with the basic RBA principle of only attributing actual income and expenditure of the entity. Subdivision 815-C recognises elements of the FSE approach, but only to the extent that it is consistent with the RBA. For instance, Subdivision 815-C recognises the approach of identifying dealings between a PE and other parts of an enterprise, but the provisions do not actually deem the dealings to produce income or expenses rather, as under the historic ATO approach, those dealings are only taken into account in allocating the actual third party income and expenses of the entity to the PE. 9 TR 2005/11 paragraphs 16 and Section (2). Julian Pinson, Jerome Wood and Mary Hu,

15 4.3 What is the AOA? The 2010 OECD Report on PEs describes the AOA as follows: 8. The authorised OECD approach is that the profits to be attributed to a PE are the profits that the PE would have earned at arm s length, in particular in its dealings with other parts of the enterprise, if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions, taking into account the functions performed, assets used and risks assumed by the enterprise through the permanent establishment and through the other parts of the enterprise. The phrase profits of an enterprise in Article 7(1) should not be interpreted as affecting the determination of the quantum of the profits that are to be attributed to the PE, other than providing specific confirmation that the right to tax does not extend to profits that the enterprise may derive from that State otherwise than through the permanent establishment (i.e. there should be no force of attraction principle ). Profits may therefore be attributed to a permanent establishment even though the enterprise as a whole has never made profits. Conversely, Article 7 may result in no profits being attributed to a permanent establishment even though the enterprise as a whole has made profits. That is, under the FSE approach the PE is treated as having a greater degree of independence from the rest of the enterprise and intra-entity dealings can be recognised as having tax consequences in and of themselves this means that, importantly, Article 7 does not limit the profits that can be attributed to the PE to that of the whole enterprise. Notional income, gains or losses from internal dealings are effectively treated as if they were real for tax purposes rather than just being taken into account in attributing amounts from third party transactions to the PE. The history of the OECD s adoption of the AOA is set out in the 2010 OECD Report on PEs. A limited FSE approach was adopted in the 2008 Commentary on old Article 7 and then a more complete FSE approach adopted in the 2010 OECD Model and Commentary. Whilst the 2008 Commentary did not go so far as to deem the FSE to be the AOA, it did express a preference for the FSE by noting at paragraph 11 that the second sentence in the old Article 7(1) should not be interpreted in a way that could contradict paragraph 2, e.g. by interpreting it as restricting the amount of profits that can be attributed to a permanent establishment to the amount of profits of the enterprise as a whole. Further, under the 2008 Commentary the recognition of internal dealings would not extend to internal royalties, interest for non-financial institutions or the provision of services that are merely part of the general management of a company, for which no mark-ups (representing a profit paid to another part of the enterprise) could be charged these should be allocated on an actual cost basis only. The new Article 7 and the 2010 Commentary do not contain those restrictions. The AOA is an FSE approach, but more broadly the AOA can be thought of as currently encompassing: the 2010 OECD Model Article 7 and Commentary; the 2010 OECD Report on PEs; and the 2010 OECD TP Guidelines. Julian Pinson, Jerome Wood and Mary Hu,

16 The AOA is not precisely treating a branch as if it were a separate, independent entity sometimes it does not do this for instance, a branch is regarded as having the same credit rating as the entity of which it is a part, and nor can the rest of the enterprise guarantee the PE s creditworthiness. Broadly, the AOA relevantly involves: hypothesising, on the basis of a functional analysis, the assets, risks, capital structure and liabilities that the PE would have if it were an independent enterprise; identifying intra-entity dealings involving the PE, and applying accepted transfer pricing principles to determine whether those dealings have been appropriately valued; in undertaking the functional analysis in the context of financial services, use the key entrepreneurial risk-taking functions (KERT functions) concept as the primary basis of determining the economic contribution made by the PE, which will typically relate to the assumption and management of risk; and have regard to the specialised guidance in Parts II (attribution of profits to PEs of banks), III (enterprises carrying on global trading of financial instruments) and IV (insurance companies) of the 2010 OECD Report. Although there are clearly some differences, it must be said that the guidance in the 2010 OECD Report regarding how the AOA is to be applied is similar in practice to how the ATO accepts income and expenses are attributed to a PE in particular, the initial functional analysis prescribed is similar to the approach in TR 2001/11 and TR 2005/11. The obvious difference is the extent to or the purposes for which internal dealings may be recognised. It is important to emphasise here that the AOA does not just involve having regard to accounting records and documentation for internal dealings it still requires a functional and factual analysis of the branch s activities. The 2010 OECD Report stated: The starting point for the evaluation of a potential dealing will normally be the accounting records and internal documentation of the Permanent Establishment and ultimately it is the functional and factual analysis which determines whether the dealing has taken place, not the accounting records or other documentation provided by the enterprise. 11 There are still a number of uncertainties in relation to how the FSE applies in certain scenarios; for instance, the 2010 OECD Report allows variability in relation to capital allocation, and is unclear on debt/equity characterisation and how internal dealings can give rise to FX gains and losses, amongst other things. 4.4 Practical significance of adopting the RBA or AOA Clearly there is the theoretical potential for the RBA and AOA to produce different attribution outcomes and mismatches between countries OECD Report paragraph 177. Julian Pinson, Jerome Wood and Mary Hu,

17 The Board Report includes the most oft-cited example, which is where an entity has an overall loss for a year from a particular activity, but its overseas PE is profitable (see Example 3 in Appendix C of the Board Report). In this scenario: if the profitable PE is in a country that adopts an RBA approach (based on attributing profits to the PE), the PE s net income would effectively be ignored on the basis that there are no profits of the enterprise to attribute to the PE given it has an overall loss; and if the head office is in a country that adopts the AOA, the entity would likely be able to claim its loss in full, but the PE s profit would not be taxed anywhere (assuming that the home country has a branch profits exemption). Although the ATO applies a RBA-style approach to PE attribution, the risks associated with the limitation on overall profits issue are mitigated by Australia attributing gross income and expenses (rather than net profit), and the type of limited AOA approach the ATO adopts in TR 2001/11 and TR 2005/11 (i.e. although notional income and expenses are not recognised, they are still taken into account when allocating actual income and expenses). The ATO certainly thought in TR 2005/11 that the OECD s FSE approach would be expected, at least in relation to inter-branch lending, to in practice produce similar profit attribution outcomes to the ATO s approach of allocating actual third party income/expense in TR 2005/ It is also important to remember that even if both countries adopt the RBA or AOA, there will not necessarily by symmetrical tax outcomes in terms of how each country calculates the income/profits of the PE. Differences will still arise e.g. due to variances in depreciation rates, the timing of recognition of income and restrictions on the deductibility of expenses. This can give rise to not only timing differences but also permanent differences, particularly where the difference in domestic laws relates to the types of expenses that are deductible. 13 In addition to the potential for the RBA and AOA to produce different attribution outcomes and mismatches, as a practical matter, the RBA (as conceived by the ATO) is difficult and uncertain in its application. The AOA, especially for the banks, produces clearer outcomes and is easier to apply. 12 TR 2005/11 paragraph Refer comments in paragraph 32 of the 2010 OECD Commentary on Article 7. Julian Pinson, Jerome Wood and Mary Hu,

18 5 International comparison It can often be misleading to try to summarise whether countries have adopted an FSE or RBA approach to PE attribution most countries sit somewhere on the spectrum between the two. Australia, for instance, has not adopted the AOA, but nonetheless for certain purposes internal dealings are recognised at least as a matter of administrative practice (for instance, for banks, interbranch loans and now derivatives). Around the world, relatively few treaties currently include the new Article 7. Further, through reservations and positions included in the 2010 OECD Model, a number of countries (OECD and non- OECD) have expressly stated their intention to not include the new Article 7 in their treaties. 14 The United Nations (UN) has also expressly rejected the inclusion of the new version of the article in the UN Model (and therefore full implementation of the AOA in the UN Model). That said, a number of Australia s significant trading partners do support the new Article 7, including the US, the UK, various EU member countries, Singapore and Japan. In terms of benchmarking ourselves against other countries in terms of whether to adopt the AOA, we also need to be clear on how the AOA would be implemented for instance, if the Government was considering only implementing the AOA for banks or the broader financial services sector, then it is generally the case that our major trading partners in financial services do support the AOA and so any perceived slow take-up of the AOA around the world should be largely irrelevant to how Australia should proceed. Although Australia has not formally reserved its position on the new Article 7 (unlike, for instance, New Zealand), thus far Australia has remained firm in its RBA-type approach, continuing to use the old Article 7 in its most recently negotiated treaty with Germany (2015). 14 See the Reservations of Chile, Greece, Mexico, New Zealand, Portugal and Turkey in the 2010 Commentary on Article 7 and the positions of Argentina, Brazil, China, India, Indonesia, Latvia, Malaysia, Romania, Serbia, South Africa, Thailand and Hong Kong. Julian Pinson, Jerome Wood and Mary Hu,

19 6 ATO focus areas in bank PE attribution By and large, it seems fair to say that bank branch attribution has not been a major focus area of the ATO in recent years. That said, recent ATO work has included: issuing the Guidelines on internal derivatives (see section 3.2); attribution of capital to PEs for the purposes of the thin capitalisation rules (see section 7.4.1); the tax treatment of inter-branch liquidity-type charges, generally payable by branches to head office in particular, in recent years the ATO has conducted significant compliance activity in relation to liquidity-type charges paid by the Australian branches of foreign banks (as addressed in ATO IDs 2012/90, 2012/91 and 2012/92) (see section 7.5); compliance activity in relation to the margins applied to inter-branch dealings, especially derivatives, within both inbound and outbound banks, which partly came out of work the ATO did in formulating its Guidelines; and very recently the ATO has expressed concerns with a number of what the ATO regards as tax arbitrage transactions involving overseas branches of Australian corporate groups and intra-group transactions, which in BEPS-speak can result in deduction/non-inclusion outcomes, although these do not appear to relate directly to banks For example, Taxpayer Alert TA 2016/7 (Arrangements involving offshore permanent establishments) Julian Pinson, Jerome Wood and Mary Hu,

20 7 Current practical issues and risks, including transfer pricing methodologies 7.1 Overview In this section, we discuss practical issues in applying the AOA and RBA approaches to profit attribution to the activities of banks. The activities are primarily drawn from Parts II and III of the OECD 2010 Report on PEs which cover traditional banking activities and global trading of financial instruments respectively. In addition to the specific activities related to traditional banking and global trading, there are activities which are required to be undertaken by financial institutions which are common to both which we have also covered below e.g. liquidity management and capital allocation. A common theme in the issues discussed below is that in addition to addressing challenges in applying the arm s length principle for internal dealings within an integrated global banking business, satisfying both the jurisdictions which do adopt the AOA and those that do not is particularly difficult. In some instances, namely TR 2005/11 and the Guidelines, the ATO has provided administrative concessions to, in effect, allow banks to apply the separate entity principle. However, for situations faced by banks outside the facts on which those administrative concessions have been provided, there may be practical challenges in meeting both the OECD AOA and Australian RBA approaches. 7.2 Traditional banking activities Creation and management of loans with multi-branch involvement Part II of the 2010 OECD Report outlines how the AOA applies to a number of factual situations commonly found in what the OECD refer to as traditional banking activities, being the borrowing and on-lending of money. The process for attributing profit to enterprises with PEs undertaking traditional banking activities follows the prescribed two-step process for all PEs, being: Step 1: Hypothesise the PE as a separate and independent enterprise; and Step 2: Determine the profits of the hypothesised separate and independent enterprise based upon a comparability analysis. Julian Pinson, Jerome Wood and Mary Hu,

21 In preparing a functional and factual analysis required under step one, the OECD places particular importance on determining who undertakes the KERT functions involved in creating and subsequently managing a loan. The loan is then attributed to the branch which undertakes the KERT functions in respect of those assets. 16 The OECD acknowledges that joint economic ownership may occur if KERT functions are undertaken in more than one location. 17 Under the second step, transfer pricing methodologies are required to be followed to determine the arm s length price between the PE and the other parts of the enterprise as if it were a distinct and separate enterprise. Comparing firstly step one with the RBA approach, whilst TR 2001/11 deliberately did not address certain issues associated with banking such as inter-branch fund transfers, the principles for determining which branch has economic ownership of external loans should follow the methodologies set out in that ruling. 18 Those principles are broadly consistent with step one of the AOA and therefore the determination of economic ownership of assets, including potential joint ownership, should be no different. Whilst both the AOA and RBA approaches acknowledge joint economic ownership, in practice recognising loans on two balance sheets (and consequently income and expenses in two different parts of the enterprise) may not be practically easy to apply. Similarly, attributing value to each of the KERT functions in order to determine the relevant percentages for each booking location can be subjective as there is not any clear guidance nor may there be comparables easily found that could be used. Once economic ownership has been established, analysing dealings with other parts of the same enterprise as required under Step 2 of the AOA can be challenging. Due to the wide array of business models employed by global financial institutions undertaking traditional banking activities, the OECD does not provide a prescriptive methodology for analysing dealings between parts of the same enterprise. In all fact patterns, there are limited situations where a comparable uncontrolled price (CUP) would be available to price the internal dealings and therefore other methodologies would need to be relied upon (e.g. cost-plus). Further complicating matters, determining the reward of the other parts of the same enterprise may result in different outcomes under the AOA and FSE. 16 Part II of the 2010 OECD Report paragraph Part II of the 2010 OECD Report paragraph TR 2001/11 paragraph 6 sets out exclusions to that ruling. Julian Pinson, Jerome Wood and Mary Hu,

22 For example, the ongoing management and maintenance of a loan or portfolio requires a number of support functions such as those outlined in the 2010 OECD Report 19 e.g. loan administration and credit exposure monitoring. Some of these activities are likely to be centralised in a global bank. The provision of these services by the non-booking location may require an allocation of the relevant costs (rather than an allocation of income) under the principles in TR 2001/11 20 however under the AOA a full transfer pricing analysis may show that a mark-up is required on the inter-branch dealing or an alternate methodology (e.g. CUP) be used to determine what an arm s length fee would be for this service. 21 For completeness, we note that this conflict continues to exist post the introduction of Subdivision 815-C as the discussion in TR 2001/11 is broadly consistent with that in the pre-2010 Article 7 Commentary as it applies to the RBA approach Transfer of existing loans across branches There may be circumstances where the ongoing KERT functions related to an existing loan (e.g. the decision to retain credit risk) move from one part of an enterprise to another such that it necessitates a transfer of booking location. This may occur due to either employees of the enterprise themselves moving locations or employees in another jurisdiction assuming responsibility for the relevant functions. This may also occur due to a branch being closed down. Under the AOA, the transfer of an existing financial asset generally represents a deemed disposal and acquisition at fair value. In some cases, the credit quality of the loan may have deteriorated from when it was originally funded such that market value of the loan is less than its fair value (being the amount for which it was funded) and therefore the original booking location should suffer a loss. Alternatively, the market value of the loan may be greater at the time of transfer than on acquisition (e.g. as a result of purchasing the loan at a discount) such that the original booking location should recognise a gain. Prima facie, under Australia s RBA approach, there would be no deemed disposal on the transfer of functions and therefore no taxing event. In many cases, the loan may be immediately or soon thereafter disposed of by the internal recipient (e.g. the responsibility for managing distressed debt is assumed by a centralised structuring department which seeks to sell down exposure as soon as possible) however there may be situations where the exposure continues to stay on foot for a longer period after the transfer OECD Report paragraph 7 provides a summary of functions involved in managing an existing financial asset. 20 TR 2001/11 paragraph 5.27 to OECD Report paragraph 216 to 220; see also Commentary to Article 7 paragraph 40. Julian Pinson, Jerome Wood and Mary Hu,