BUSINESS MODELS IN THE CURRENT BEPS ENVIRONMENT DO YOU NEED TO CHANGE? Lyndon James, Partner Pete Rhodes, Senior Manager PwC

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1 BUSINESS MODELS IN THE CURRENT BEPS ENVIRONMENT DO YOU NEED TO CHANGE? Lyndon James, Partner Pete Rhodes, Senior Manager PwC

2 Agenda The current environment and the case for change Australian measures most likely to impact MnC Questions MAAL DPT Anti-hybrids Transparency measures OECD transfer pricing changes

3 The current environment and case for change Globalisation global markets, supply chains, brands Digitalisation accessing overseas markets without a signification local presence GFC and austerity measures fuel the tax morality debate and the concept of fair share Level playing field for domestic businesses Tax infrastructure not equipped to deal with new MnC.

4 Current environment BEPS Actions BEPS Digital economy Multilateral instrument 1. Address the tax challenges of the digital economy 15. Develop a multilateral instrument Coherence Substance Transparency 2. Neutralise the effects of hybrid mismatch arrangements 6. Prevent treaty abuse 11. Establish methodologies to collect and analyse data on BEPS and the actions to address it 3. Strengthen CFC rules 7. Prevent the artificial avoidance of PE status 12. Require taxpayers to disclose their aggressive tax planning arrangements 4. Limit base erosion via interest deductions and other financial payments 8. Assure that transfer pricing outcomes are in line with value creation: Intangibles 13. Re-examine transfer pricing documentation 5. Counter harmful tax practices more effectively, taking into account transparency and substance 9. Assure that transfer pricing outcomes are in line with value creation: risks and capital 14. Make dispute resolution mechanisms more effective 10. Assure that transfer pricing outcomes are in line with value creation: other high-risk transactions

5 Current environment Closer to home.. AU tax benefit Would or reasonably expected Sole or dominant purpose Aus or foreign tax benefit Would or reasonably expected Principal purpose MAAL 1/1/16 Part IVA Anti- Hybrids 1/1/18 Mismatch No purpose test AU or FOR tax benefit Mismatch DPT 1/7/17 Reasonable to conclude designed to secure tax benefit Just and reasonable alternative Transfer Pricing Thin Cap Transparency BEPS - PE Would have Would not have No purpose test

6 MAAL Artificial and contrived arrangements designed to avoid a PE in Australia Addition to Part IVA Criteria for application The foreign entity is a significant global entity Foreign entity makes supplies to Australian customers. Activities are undertaken in Australia directly in connection with those supplies by an Australian entity who is associated or commercially dependent on the foreign entity. The foreign entity derives ordinary or statutory income from those supplies, some or all of which, is not attributable to a permanent establishment in Australia of the foreign entity. The scheme was entered into for the principal purpose of enabling the taxpayer to obtain a tax benefit in Australia, or to obtain a tax benefit and reduce one or more foreign tax liabilities Satisfied Yes Yes Yes Yes Yes

7 Tax treaty 1. MAAL Case Study B Co 100% A Co (Australia) Licence Agreement Licence fees Tax treaty Significant support activities IP Co Australian business customers Description B Co is located in a low tax jurisdiction and sells enterprise software to Australian business customers. A Co is an Australian subsidiary of B Co and undertakes significant support activities for B Co in relation to the Australian customers. Sales contracts negotiated by A Co and the Australian customers are legally binding on B Co and recorded in B Co s accounts. Country B and Australia have a tax treaty which will not cause B Co to have an Australian PE. B Co pays a licence fee to a related entity, IP Co (in a no tax jurisdiction) who owns the intellectual property rights. IP Co does not undertake major business activities and does not develop or make decisions about IP. Under the Tax treaty between B Co and IP Co, no tax is payable by B Co on royalties paid to IP Co. Withholding tax would have been payable in Australia if the royalty income received by IP Co instead related to an outgoing of B Co in carrying on business in Australia at or through a PE in Australia.

8 Tax treaty 1. MAAL Case Study B Co 100% A Co (Australia) Licence Agreement Licence fees Tax treaty Significant support activities IP Co Australian business customers Does the MAAL apply? Possibly. It could be concluded that B Co carried out the scheme for a principal purpose of enabling it and IP Co to obtain a tax benefit: B Co obtains a tax benefit by not paying Australian income tax on income from contracts entered into with Australian business customers. IP Co obtains a tax benefit by not being liable to Australian WHT on royalties it derives from B Co. Principal purpose test satisfied because: Most of the activities undertaken in order to bring about contracts for supply are undertaken by A Co; B Co does little to contribute to the solicitation of customers and overall customer interaction; B Co has a small number of staff who do not have capability or knowledge to undertake necessary functions for bringing about contracts in Australia; Division of activities between B Co and A Co appears contrived in order to avoid creating an Australian PE; Income from supply to Australian customers is being returned to IP Co (in a no/low tax jurisdiction) with little economic activity; Royalty income is not subject to royalty WHT in Australia because B Co does not have an Australian PE.

9 2. DPT (proposed) Based on UK DPT Will apply to income years commencing on or after 1July 2017 Addition to Part IVA Applies to significant global entities (annual group revenue of >$1b) De Minimis exception if Australian turnover is <$25m 40%tax on profits diverted

10 2. DPT (proposed) Requires 2 conditions to be met 1) Effective tax mismatch - Increased tax liability of foreign related counter party is less than 80% of corresponding reduction in Australian tax liability 2) Insufficient economic substance - Reasonable to conclude arrangement designed to secure a tax reduction - Benefit of tax reduction exceeds non tax financial benefits Not self assessment

11 2. DPT timeline Lodgement date - 7 years A provisional DPT assessment will be issued as soon as practical after the end of an income year and no later than 7 years after the income tax return is lodged 30 days The ATO will issue a final DPT assessment within 30 days of the end of the representation period. 12 months The ATO will have 12 months to review the final DPT assessment. If during this period, the ATO considers the amount of DPT charged to be insufficient, the ATO may issue a supplementary DPT assessment up to 30 days prior to the end of the review period to impose an additional charge of DPT. 30 June Year end 60 days 21 days 12 months + The taxpayer has 60 days to make representations to correct factual matters set out in the provisional DPT assessment (but not on TP matters). The taxpayer will have 21 days in which to pay the amount of the assessment. At the completion of the review period, the taxpayer has 30 days to lodge an appeal (through the court process).

12 Australian measures most likely to impact MnC 2. DPT transactions and structures to consider closely Groups paying royalties or similar fees for the use of IP. Particularly where asset previously held in Australia. Groups who have a large management presence in Australia but whereby group profits are materially taxed outside of Australia (especially those with material Australian trading businesses). Groups who have sold IP to another group company in the past. Groups Groups who who have have entities entities located located in low in low taxing taxing jurisdictions jurisdictions (especially with limited (especially substance). with limited substance). Non-Australian resident companies injecting capital into subsidiaries in low tax jurisdictions to buy assets that will be leased to Australian subsidiaries. Australian companies providing contract R&D services to offshore IP developer and/or owner. Certain real estate ownership and development structures. Australian resident companies injecting capital into subsidiaries in low tax jurisdictions to subsequently debt fund a foreign subsidiary. Online clients and inbounds could be particularly at risk. PwC 12

13 DPT Case Study 1 non arm s length expenditure Background/Facts Foreign Co (a foreign resident) provides marketing and administrative services to Australia Co and charges a fee of A$50 million. The fee is deductible in Australia, providing a 30% reduction in tax, and is taxable in Foreign Co s home jurisdiction at 17%. DPT Commentary The ATO considers that the fee is inflated compared to an arm s length amount. Australia Co does not provide any further information to support the pricing of the fee. The ATO considers issuing a DPT assessment. The effective tax mismatch test is met as the 17% rate in Foreign Co is less than the 80% of Australia s 30% corporate tax rate.

14 DPT Case Study 1 non arm s length expenditure DPT Commentary The insufficient economic substance test is met as it is reasonable to conclude, (based on the information available to the ATO), that the transaction was designed to secure the tax reduction and the non-tax financial benefits referable to the transaction do not exceed the financial benefit of the tax reduction. As this is an inflated expenditure case, the DPT assessment is based on 30% of the relevant expenses. Therefore, the DPT assessment is A$6million calculated as: 1.Diverted Profits Amount = A$15million (A$50 million inflated expenses x 30%) 2.DPT Assessment = A$6million plus interest (Diverted Profits Amount x 40% = A$15million x 40%)

15 DPT Case Study 1 non arm s length expenditure Additional Facts During the 12month review period, based on information provided by Australia Co, the ATO determines the correct arm s length price for the marketing and administration services is A$45million i.e. the deduction was overstated by A$5million. This A$5million becomes the Diverted Profits Amount. The revised DPT assessment is calculated as: 1.Diverted Profits Amount = A$5million 2.DPT Assessment = A$2million plus interest (A$5million x 40%) The ATO refunds the residual A$4million DPT amount previously collected.

16 DPT Case Study 2 Loan to Low Tax Jurisdiction Background / Facts Aus Co is a Australian resident company. F Co is the group finance company X Co is resident in Country X and requires further funding for the purposes of its trade. Aus Co injects capital into F Co which is then lent to X Co. Inject Capital 30% Aus Co 12.5% F Co Low Tax X Co Country X Debt funding

17 DPT Case Study 2 Loan to Low Tax Jurisdiction DPT Commentary The ATO considers that there is insufficient economic substance to the injection of capital into F Co and the corresponding provision of debt funding to X Co from F Co. The ATO considers that the relevant alternative scenario would have been for Aus Co to provide the debt funding directly to X Co. The ATO considers issuing a DPT assessment. The effective tax mismatch test is met as interest income is subject to 12.5% tax in F Co, which is less than 80% of Australia s 30% corporate tax rate. The insufficient economic substance test is met as it is reasonable to conclude (based on the information available to the ATO), that the transaction was designed to secure the tax reduction and that the nonfinancial benefits referable to the transaction do not exceed the financial benefit of the tax reduction. A charge to DPT will be calculated on the additional profits which would have arisen if Aus Co had provided debt funding directly to X Co ( alternative provision ) The understated income would be the interest income Aus Co would have received in Australia from X Co (other foreign company).

18 DPT Case Study 3 Transfer of IP to Low Tax Jurisdiction Background / Facts C (Australia Co) contractually transfers an IP asset it has developed to A (Foreign Co in a low tax jurisdiction) for a nominal amount. C continues to develop and maintain the IP. A only pays a small amount for this service and does not contribute in any other meaningful way to the further development or maintenance. A charges annual royalties to B (another foreign Co) for the right to use the IP. Foreign Co (Low Tax) A Royalty payment Foreign Co B Transfer of IP C Australia Co Right to use asset

19 DPT Case Study 3 Transfer of IP to Low Tax Jurisdiction DPT Commentary The ATO considers that there is insufficient economic substance to the transfer of the IP and the relevant alternative scenario would have been for C (Australia Co) to retain ownership of the IP. The ATO considers issuing a DPT assessment. The effective tax mismatch test is met as royalty income is subject to 12.5% tax in A, which is less than 80% of Australia s 30% corporate tax rate. The insufficient economic substance test is met as it is reasonable to conclude (based on the information available to the ATO), that the transaction was designed to secure the tax reduction and that the nonfinancial benefits referable to the transaction do not exceed the financial benefit of the tax reduction. A charge to DPT will be calculated on the additional profits which would have arisen if C (Australia Co) had retained ownership of the IP and not made payments to IP Co ( alternative provision ) The understated income would be the royalty income C (Australia Co) would have received from B (other foreign company).

20 DPT Case Study 4 Transfer of IP to Low Tax Jurisdiction Background / Facts Aus Co manufactures widgets under license with the related IP being held in a company in a low tax jurisdiction (IP Co). The IP for Country A is held by F Co whilst the IP for the rest of the world is held by IP Co. IP Co charges a royalty to Aus Co and other entities responsible for manufacturing widgets. IP was previously owned by Aus Co. F Co Country A Aus Co Australia IP Co Low Tax Royalty

21 DPT Case Study 4 Transfer of IP to Low Tax Jurisdiction DPT Commentary IP Co has a few employees performing routine tasks. Senior management is Australian based with all substantive R&D activities undertaken in Australia. Based on these facts, it appears reasonable to assume that the main driver for transferring the IP was to obtain a tax benefit. The insufficient economic substance test is met. The alternative provision would have been for Aus Co to retain ownership of the IP. A charge to DPT will be calculated on the additional profits which would have arisen if Aus Co had retained ownership of the IP and not made payments to IP Co ( alternative provision ).

22 DPT Case Study 4 Transfer of IP to Low Tax Jurisdiction Additional Facts F Co has sound commercial reasons for rationalising IP ownership and Low tax country was low cost solution as well as having a source of well educated staff. Furthermore, whilst R&D activities are undertaken in Australia on a cost-plus basis, IP Co supervises these activities and has significant R&D capacity in its own right. IP is transferred to IP Co, not just from Australia but from other jurisdictions as well. On these facts, the insufficient economic substance test may not be met based on the commercial merit in transferring the IP. Therefore, no charge to DPT should arise.

23 Australian measures most likely to impact MnC 3. Anti Hybrids Principal objective Neutralise the effects of hybrid mismatches to discourage uncompetitive arrangements Australia s response Anti-hybrid rules coming as soon as 2018 Imported mismatch rule No grandfathering/transitional rules No de minimus Impact for business Highly complex, no purpose test Need clear understanding of entire group s related party arrangements Need to understand relevant foreign tax rules in detail

24 Australian measures most likely to impact MnC Anti Hybrid Case Study 1 Bank debt US Parent Loan US Parent borrows from third party bank and onlends to its Australian subsidiary (Aust Sub). Aust Sub files an election to be treated as a disregarded entity for US federal tax purposes. As such, the loan between US Parent is ignored for US tax purposes. Aust Sub Aust Sub claims a deduction for the interest expense on the loan, and withholds tax at 10% on interest payments made to US Parent. Under anti-hybrid rules, Aust Sub would be denied the deduction for the interest expense on the loan.

25 Australian measures most likely to impact MnC Anti Hybrid Case Study 2 imported mismatch rule ParentCo MNC operates principal model - principal company (B Co) bears key risks of the group and provides local in-country subsidiaries with access to group IP in order to make sales to third parties. Hybrid payment Imported mismatch payment $98 Royalty $99 Royalty $100 licence/ goods payment $120 sale to third parties A Co 1 A Co 2 B Co (Principal) Aust LRD Co $100 licence/ goods payment ROW LRD Co s $120 sale to third parties Local in-country subsidiaries operate on a limited risk distribution (LRD) basis, and pay a fee to B Co for use of the IP plus other costs of sales. Receipt of income from the LRD Cos is taxable in Country B, but B Co makes a deductible royalty payment to its parent (A Co 2). A Co 2 in turn pays a royalty to its parent (A Co 1) which is hybrid in nature and hence not taxed. Neither Country A nor Country B have introduced anti-hybrid rules. Australia s imported mismatch rule would operate to import into Australia the hybrid outcome that arises in Country A and attach it to the deduction claimed by Aust LRD Co in respect of the licence / COGS payment made to B Co. As none of the royalty income received by A Co 1 is taxed in Country A, the entire deduction in Aust LRD Co would be denied under the Australian imported mismatch rule.

26 4. Impact of Transparency Country by country reporting Voluntary tax disclosure 4. Impact of Transparency 5. OECD Transfer Pricing changes

27 Lyndon James / Pete Rhodes, 2016 Disclaimer: The material and opinions in this paper are those of the author and not those of The Tax Institute or the authors firm. The Tax Institute did not review the contents of this presentation 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.