Contributed by Tamara Cardan, Senior Associate, K&L Gates LLP, Melbourne
Treasury has recently released an exposure draft regarding the proposed diverted profits tax (DPT), a new anti-avoidance rule that will expand the scope of Pt IVA of the Income Tax Assessment Act 1936 (ITAA 1936).
The DPT will significantly enhance the powers of the Commissioner to deal with multinationals that transfer profits, assets or risks to offshore related parties using artificial or contrived arrangements to avoid Australian tax. The DPT, which was announced in the 2016/17 Federal Budget, will have effect from 1 July 2017.
The DPT will apply to significant global entities (with annual global income of $1b or more) operating in Australia where, based on information available to the Commissioner, it is reasonable to conclude that profits have been artificially diverted from Australia. The DPT will impose a 40% penalty tax on profits transferred offshore through related party transactions.
The Australian Government has been leading the way in implementing measures agreed by the G20 and OECD to combat international tax evasion. Recently enacted measures include the introduction of the Multinational Anti-Avoidance Law (MAAL), and the doubling of penalties on large companies that are engaging in profit shifting schemes.
Australia’s tax integrity rules currently address many multinational arrangements designed to avoid Australian income tax. However, as a practical matter, these rules can be difficult to apply, particularly when taxpayers do not cooperate with the Commissioner during an audit.
In 2015, the United Kingdom (UK) introduced a DPT to address international profit shifting arrangements which are designed to avoid having a taxable presence in the UK (“first limb”), or which transfer profits earned in the UK to an offshore related party (“second limb”). Australia introduced the MAAL which broadly replicates the first limb of the UK’s DPT. The proposed Australian DPT will be based on the second limb of the UK’s DPT and is intended to help ensure that multinationals pay an appropriate amount of tax on profits made in Australia.
The ATO is in the process of establishing a new tax avoidance taskforce to enforce the new measures seeking to combat international tax evasion. The taskforce is expected to raise $3.7b of additional revenue over the next four years.
When will the DPT apply?
The DPT will apply to an entity if, broadly:
- It is reasonable to conclude that a scheme was carried out for a principal purpose of, or for more than one principal purpose that includes a purpose of:
- Enabling a taxpayer (“relevant taxpayer”) to obtain a tax benefit, or both to obtain a tax benefit and reduce a foreign tax liability, or
- Enabling the relevant taxpayer and another taxpayer(s) to obtain a tax benefit, or both to obtain a tax benefit and reduce a foreign tax liability
- The relevant taxpayer is a “significant global entity” for the income year
- A foreign entity that is an “associate” (as defined in s 318 of ITAA 1936) of the relevant taxpayer has entered into or carried out the scheme, or is otherwise connected with the scheme, and
- The relevant taxpayer obtains a tax benefit in connection with the scheme. The most common tax benefits likely to arise are benefits relating either to the understatement of assessable income, or to the overstatement of a deduction.
Significant global entity
The DPT will apply to significant global entities that are Australian residents or foreign residents with Australian permanent establishments.
An entity is a significant global entity for an income year if:
- It has annual global income of $1b or more, or
- It is a member of a consolidated group of entities, and one of the other members of the group is a global parent entity whose annual global income is $1b or more.
“Entity” is broadly defined in the tax legislation to include corporations, partnerships, trusts, superannuation funds and approved deposit funds. The use of this term is significant as it indicates that the DPT will have broad application to various taxpayers.
The purpose test
The primary condition for the DPT to apply to a scheme is that it is reasonable to conclude that the scheme (or any part thereof) was carried out for a principal purpose of, or for more than one principal purpose that includes a purpose of:
- Enabling the relevant taxpayer to obtain one or more tax benefits, which may include a reduction in foreign tax liabilities, in connection with the scheme (proposed s 177H(1)(a)(i) of ITAA 1936), or
- Enabling the relevant taxpayer and another taxpayer each to obtain one or more tax benefits, which may include a reduction in foreign tax liabilities, in connection with the scheme (proposed s 177H(1)(a)(ii)). This will apply where the relevant taxpayer obtains a tax benefit, and another taxpayer obtains a reduction in a foreign tax liability.
The required purpose is to be established objectively based on the information available to the Commissioner at the time that the Commissioner determines to make a DPT assessment. The “principal purpose or more than one principal purpose” test threshold is lower than the “sole or dominant threshold” which is used in s 177D(1). Accordingly, the principal purpose need not be the sole or dominant purpose of the person entering the scheme, but it must be one of the main purposes, having regard to all the facts and circumstances.
In determining whether the purpose test is satisfied, regard must be had to:
- The matters listed in s 177D(2), ie the general Pt IVA factors including the manner in which the scheme was entered into or carried out and the form and substance of the scheme
- The extent to which quantifiable non-tax financial benefits have resulted, will result, or may reasonably be expected to result, from the scheme
- The result, in relation to the operation of any foreign law relating to taxation, that would be achieved by the scheme, and
- The amount of the tax benefit that arises in connection with the scheme.
If the amount of the quantifiable non-tax benefits (eg commercial benefits) exceeds the amount of the tax benefits arising from the scheme, then this may indicate that it is reasonable that a principal purpose of the scheme was not the purpose of enabling the taxpayer to obtain a tax benefit.
The explanatory memorandum (EM) to the exposure draft states that where a person acts on professional advice, it may be appropriate to attribute the objective purpose of the professional adviser. Accordingly, when acting for multinationals, it would be prudent for advisers to prepare contemporaneous documentation detailing the commercial and other purposes in respect of arrangements that will be entered into by the Australian member of a multinational group that may inadvertently reduce Australian tax payable.
Carve-outs to the DPT
The DPT will not apply if it is reasonable to conclude that one of the following tests apply to the relevant taxpayer:
- The $25m turnover test
- The sufficient foreign tax test, or
- The sufficient economic substance test.
The onus is on the taxpayer to demonstrate that a carve-out applies, by providing “sufficient information” to satisfy the Commissioner accordingly.
The $25m turnover test
The $25m de minimis threshold will exempt both the relevant taxpayer, and any other Australian entity that is also a member of the same global group, where the Australian turnover of each entity does not exceed $25m.
This effectively excludes multinationals with Australian operations that are relatively small. However, this test will not apply where income is artificially booked offshore rather than in Australia. Turnover of an entity will be considered to be artificially booked offshore if, for example, the turnover of the entity that is reported for Australian accounting purposes does not reflect the substance of the activities carried on by the entity in Australia.
The sufficient foreign tax test
The DPT will not apply if it is reasonable to conclude that, in relation to the scheme, the increase in the foreign tax liability is equal to, or exceeds, 80% of the corresponding reduction in the Australian tax liability.
This test ensures the DPT does not apply in circumstances where the foreign tax benefits that arise as a result of the scheme are relatively insignificant.
For this test to apply, the relevant taxpayer will need to provide information to the Commissioner detailing the increased foreign tax liability as a result of the scheme. This amount is calculated based on the amount of foreign income tax actually paid in relation to the scheme, taking into account tax relief provided by the foreign country. GST (and foreign equivalents) is not included in the calculation.
However, many cross-border transactions may be caught by the DPT due to the limited application of this test. Arguably, this carve-out will rarely apply due to the comparatively high Australian corporate tax rate when contrasted with other jurisdictions.
The DPT may apply to various cross-border transactions, as numerous jurisdictions have a tax rate that is less than 24% (being 80% of Australia’s corporate tax of 30%), including the UK, Jersey, Finland and Saudi Arabia (20%), and Sweden and Denmark (22%). Accordingly, many transactions may not result in sufficient foreign tax simply by virtue of the lower tax rates in other jurisdictions.
The sufficient economic substance test
The DPT will not apply if it is reasonable to conclude that the income derived by each entity in respect of the scheme reasonably reflects the economic substance of the entity’s activities in connection with the scheme. The focus is on the active activities (and not the passive activities) of the entity being tested. Again, this test will only apply if the taxpayer provides information to satisfy the Commissioner that the activities of the relevant entity have sufficient economic substance in relation to the income derived.
When applying this test, consideration may be given to the revised OECD Transfer Pricing Guidelines for multinational enterprises and tax administrations. These revised guidelines set out comparability factors for the purpose of determining the entity’s activities and the actual scheme. These factors include the functions performed by each party to the transaction, and how these functions relate to the wider generation of value by the multinational group. Other factors include the economic circumstances of the parties, the markets in which they operate, and the business strategies pursued by the parties.
Lack of information from taxpayer
In determining if it is reasonable to conclude one of the above tests apply to the relevant taxpayer, the Commissioner’s ability to make a reasonable conclusion is not prevented by a lack of, or incomplete, information provided by the taxpayer. Further, the Commissioner is not required to actively seek further information to reach a reasonable conclusion.
Accordingly, the Commissioner can issue a DPT assessment without first taking reasonable steps to obtain information from the relevant taxpayer. While it is noted that the EM anticipates the Commissioner will provide taxpayers with 60 days to make representations prior to the DPT assessment being issued, no safeguards for taxpayers are included in the draft legislation.
It would be preferable that the Commissioner be legislatively required to have regard to the records prepared by taxpayers as required under Subdiv 284-E of Sch 1 to the Taxation Administration Act 1953 (Cth) (“TAA”) in respect of transfer pricing, and records kept pursuant to the general record-keeping obligation imposed on all taxpayers, including those in a transfer pricing context, under s 262A of ITAA 1936. However, it may be the case that the new DPT power will be predominantly used in a transfer pricing context when the Commissioner has gone down these avenues to source information to no avail. Nevertheless, the problem remains that the Commissioner is not legislatively required to obtain any information from the relevant taxpayer prior to issuing a DPT assessment.
DPT assessment process
If the DPT applies to a scheme, the Commissioner may issue a DPT assessment to the relevant taxpayer. The assessment will impose 40% penalty tax on the amount of diverted profits, plus interest charges. Consistent with the current transfer pricing rules, the DPT due and payable will not be reduced by the amount of foreign tax paid on the diverted profits.
The taxpayer will have 21 days to pay the amount set out in the DPT assessment. Accordingly, Australian companies will be forced to pay the tax upfront and then seek to have the assessment reduced or reversed.
The EM states that the Commissioner will issue guidance on the administrative processes prior to the decision to issue a DPT assessment. The processes will include internal review, advice from the Commissioner to the taxpayer of an intention to issue a DPT assessment, and a period of 60 days for the taxpayer to make representations before a DPT assessment is made.
The production of a notice of a DPT assessment will be conclusive evidence that the assessment was properly made. This ensures that the validity of an assessment is not affected by the fact that any provision of the tax legislation has not been complied with. The issue on any appeal to the Federal Court under Pt IVC of the TAA is whether the assessment is excessive (FC of T v Sleight (2004) 136 FCR 211; 2004 ATC 4477 and George v FC of T (1952) 86 CLR 183; (1952) 9 ATD 421).
The Commissioner may make a DPT assessment at any time within seven years of first serving a notice of assessment on the taxpayer for an income year.
Period of review
Where the Commissioner issues a DPT assessment, a 12-month period of review will commence from the date the Commissioner gives the entity a notice of a DPT assessment. The period of review gives the taxpayer the opportunity to provide additional documents and information to the Commissioner.
The taxpayer may request a shorter period of review by written notice to the Commissioner, which may be appropriate where all necessary information has been provided to the Commissioner and the taxpayer wishes to imminently institute appeal proceedings. The period of review will end on the date specified in the notice, unless the Commissioner applies to the Federal Court for additional time.
The period of review may also be extended by application to the Federal Court by either party, or by the taxpayer consenting to a request by the Commissioner for an extension. This may be necessary where the taxpayer provides information to the Commissioner close to the end of the 12-month period, and additional time is required to properly examine this material.
Based on the additional information provided, the Commissioner may amend the DPT assessment and reduce the DPT liability, or increase the DPT liability (with interest payable). An amended DPT assessment to increase DPT liability must be issued no later than 30 days prior to the end of the review period.
Federal Court appeal
Under Pt IVC of the TAA, the taxpayer may make a “taxation objection” against an assessment of DPT liability within 30 days of the end of the period of review. The taxation objection must be an appeal to the Federal Court. There is no ability to object to the Commissioner; the DPT assessment is treated as an objection decision (proposed s 145-20(4)(a) of Sch 1 to the TAA).
In any appeal to the Federal Court, “restricted DPT evidence” is not admissible. Restricted DPT evidence is any information or documents that the relevant taxpayer does not provide the Commissioner during the period of review, or that the Commissioner did not already have prior to the period of review. However, such evidence will be admissible if the Commissioner consents to its admission, or if the court considers its admission is in the interests of justice.
DPT and transfer pricing audits
The Commissioner’s powers under the DPT provisions will be highly relevant in transfer pricing audits. The Commissioner will have the ability to put pressure on taxpayers to provide information or concede transfer pricing outcomes, which may be a better result than incurring a 40% penalty tax that is non-deductible.
Under the new DPT rules, at any point during the transfer pricing review period, the taxpayer will have the option to amend their income tax return to reflect transfer pricing outcomes, with the DPT amount correspondingly reduced. Accordingly, where the taxpayer amends their income tax return, the resulting taxable income will be taxed at 30% rather than 40% (although penalties may apply).
The new DPT power clearly gives the ATO the “upper hand” in any transfer pricing audits.
The measures will apply to tax benefits in income years commencing on or after 1 July 2017, but may apply to a scheme that was entered into, or commenced to be carried out, before that date.