Contributed by Tamara Cardan, Senior Associate, K&L Gates
Legislation was introduced into parliament to enact the Diverted Profits Tax (DPT) — the Diverted Profits Tax Bill 2017 and the Treasury Laws Amendment (Combating Multinational Tax Avoidance) Bill 2017 (collectively, the Bill) earlier this year.
This follows on from the release by Treasury of the exposure draft legislation on 29 November 2016, upon which submissions closed on 23 December 2016. The speed at which the Bill was introduced into parliament signifies that the government is treating the DPT as a high-priority measure.
On 16 February 2017, the Senate referred provisions of the Bill to the Economics Legislation Committee (the Committee) for inquiry and report by 20 March 2017. The Committee concluded that the DPT is a welcome and necessary addition to the legislative measures to combat multinational tax avoidance, and has recommended that the Bill be passed.
The DPT will apply a 40% tax rate on the diverted profits of multinationals. The penalty tax aims to ensure that tax paid by significant global entities properly reflects the economic substance of their activities in Australia, and seeks to prevent the diversion of profits offshore through contrived arrangements.
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 and the global parent has annual global income of $1b or more.
The DPT will have effect from 1 July 2017, but may also apply to schemes that were entered into before that date.
New features of the Bill
The Bill is broadly consistent with the exposure draft legislation, and the only material changes are as follows:
- Thin capitalisation modification: where the DPT tax benefit includes all or part of a debt deduction, it is necessary to determine the debt interest and interest rate that would have applied had the scheme not been entered into, and apply that rate to the actual amount of debt.
- CFC modification: where the relevant foreign entity is a CFC, the DPT tax benefit is disregarded to the extent that it arises from attributable income.
- The following types of entity are now excluded from the DPT: a managed investment trust, a foreign collective investment vehicle with wide membership, an entity owned by a foreign government that is a foreign entity, a complying superannuation entity and a foreign pension fund. These entities are considered low-risk, being sovereign owned or widely-held entities that carry on predominantly passive activities.
The government has identified that there are approximately 1,600 taxpayers with income that is sufficiently large that they potentially fall within the scope of the new law.
When the DPT will apply
The DPT will apply to a scheme, in relation to a tax benefit (the DPT tax benefit), if:
- A taxpayer (the “relevant taxpayer”) has obtained, or would but for s 177F of the ITAA 1936 obtain, the DPT tax benefit in connection with the scheme in an income year
- It would be concluded (having regard to the matters in s 177J(2) of the ITAA 1936) that the person(s) who entered into or carried out the scheme or any part of the scheme did so for the principal purpose of, or for more than one principal purpose that includes a purpose of:
- enabling the relevant taxpayer to obtain a tax benefit, or both to obtain a tax benefit and reduce a foreign tax liability, or
- enabling 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 of the taxpayer is one of the persons who entered into or carried out the scheme or part thereof, or is otherwise connected with the scheme, and
- It is reasonable to conclude that none of the following tests applies in relation to the relevant taxpayer, in relation to the DPT tax benefit:
- the $25m income test
- the sufficient foreign tax test, or
- the sufficient economic substance test.
Tax benefit in connection with a scheme
For DPT purposes, the most common tax benefits that are likely to arise in relation to a scheme are an understatement of assessable income, or an overstatement of a deduction.
A “tax benefit” is defined in s 177C of Pt IVA of the ITAA 1936. The calculation of a tax benefit requires consideration of a reasonable alternative postulate, ie identifying the tax outcome that would have occurred, or might reasonably be expected to have occurred, if the scheme had not been entered into or carried out. In a DPT context, the tax outcomes arising from a reasonable alternative postulate are determined with reference to, where relevant, the application of the transfer pricing rules to determine arm’s length conditions.
The Bill now contains two modifications to the calculation of a DPT tax benefit. The amount of the benefit may be modified if the thin capitalisation provisions apply, or if the foreign entity is a controlled foreign corporation (CFC).
Thin capitalisation modification
This modification will apply where:
- The thin capitalisation provisions apply to the relevant taxpayer for the year
- The DPT tax benefit includes all or part of a debt deduction, and
- The calculation of the amount of the DPT tax benefit involves applying a rate to the debt interest.
When calculating the DPT tax benefit, the rate is to be applied to the debt interest actually issued (rather than to the debt interest that would have existed if the scheme had not been entered into or carried out).
When the relevant foreign entity is a CFC, the DPT tax benefit is disregarded to the extent that it arises from attributable income of the foreign entity in respect of the relevant taxpayer, or an associate of the relevant taxpayer. Accordingly, where an amount of attributable income is included in the assessable income of the relevant taxpayer (or their associate), that amount reduces the relevant taxpayer’s DPT tax benefit.
The Bill was amended during its passage through the House of Representatives to clarify this point. The amendment ensures that, for example, the reduction to the DPT tax benefit is calculated correctly in situations where a partner is an Australian partnership, a beneficiary of an Australian trust or a trustee of an Australian trust is treated as having suffered a tax detriment for the purpose of s 460 of the ITAA 1936. In each of these cases, the decrease in the taxpayer’s DPT tax benefit does not include the amount of that tax detriment.
Scheme was entered into for the “principal purpose” of obtaining a tax benefit
The “principal purpose or more than one principal purpose” test has a lower threshold than the “sole or dominant purpose” test under s 177D(1) of the ITAA 1936. Consistent with the multinational anti-avoidance law (MAAL), the “principal purpose” need only be one of the main purposes of entering into the scheme, having regard to all the facts and circumstances.
The Commissioner’s ability to make a conclusion as to the purpose of a scheme is not prevented by a lack of, or incomplete, information provided by the taxpayer. Additionally, the Commissioner is not required to actively seek further information to reach a conclusion.
In ascertaining the purpose of a scheme, the deferral of a taxpayer’s liabilities to tax under a foreign law is taken to be a reduction of those liabilities, unless there are reasonable commercial grounds for the deferral.
Recognition of non-financial benefits
If the scheme produces significant quantifiable non-financial benefits, this could be a strong indicator that the purpose of the scheme was not to produce the tax benefit. Unlike the exposure draft legislation, the Bill expands on this to state that taxpayers may provide evidence to support the non-tax financial benefits of the scheme, including but not limited to:
- Representations made to management and Boards of the entities involved in a restructure, and
- Evidence of the non-tax financial benefits that have actually accrued to date and that are anticipated to accrue in the future.
Accordingly, contemporaneous evidence will be highly relevant to demonstrate the intention of the taxpayers in entering into a scheme.
The Bill provides several examples of non-financial benefits that may be considered, including any productivity gains and/or cost savings, the value added, or synergies resulting from any assets used, functions performed or risks assumed in connection with the scheme, and any reduction in non-income tax costs resulting from the scheme (for example, tariffs, payroll taxes and stamp duties).
Additional tests to determine if the DPT will apply
The DPT will apply to a taxpayer in relation to a DPT tax benefit only if it is reasonable to conclude that none of the following tests apply:
- The $25m income test
- The sufficient foreign tax test, or
- The sufficient economic substance test.
These tests ensure that the DPT is appropriately targeted and does not impose an undue compliance burden on low risk taxpayers.
The $25m turnover test
The DPT will not apply in relation to a relevant taxpayer if it is reasonable to conclude that, for the income year, the sum of the following amounts does not exceed $25m:
- The assessable income, exempt income and non-assessable non-exempt income of the relevant taxpayer
- The assessable income of an associate of the relevant taxpayer, where both the relevant taxpayer and the associate are significant global entities because they are members of the same global group, and
- If the DPT tax benefit is a tax benefit that relates to an amount not being included in assessable income, the amount of the DPT tax benefit.
In contrast to the exposure draft legislation, the test has been broadened to take into account the Australian assessable income of foreign entities that are members of the same global group, rather than just restricting the test to the Australian entities.
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 income tax liability is equal to, or exceeds, 80% of the corresponding reduction in the Australian tax liability. GST (and foreign equivalents) is not included.
The taxpayer will need to provide information detailing the increased foreign tax liability as a result of the scheme, calculated based on the amount of foreign income tax actually paid, and taking into account any specific foreign tax relief. Where entities are treated as fiscally transparent in another jurisdiction, the taxpayer must provide information to demonstrate that a sufficient level of foreign tax was ultimately paid by the holders of membership interests in the entity, which would be onerous.
A primary concern is that this test will have limited application due to the comparatively high Australian corporate tax rate when contrasted with other jurisdictions. The DPT may accordingly apply to numerous transactions where the foreign jurisdiction has a tax rate of less than 24% (being 80% of Australia’s corporate tax rate). For example, the UK, Jersey, Finland, Iceland, Russia and Croatia have a corporate tax rate of 20%. Lower rates are also found in Sweden and Denmark (22%), Hungary and the Czech Republic (19%), Singapore (17%) and Hong Kong (16.5%).
The Bill contains the following information which was not contained in the exposure draft legislation:
- Where the tax benefit is an allowable deduction and the taxpayer must withhold an amount in respect of withholding tax, the Australian tax liability is reduced by the amount withheld, and
- The income tax regulations may provide for a method of working out the amount of the foreign tax liability under this test potentially for all situations, or for specific situations.
The sufficient economic substance test
The DPT will not apply if it is reasonable to conclude that the profit derived by each entity in respect of the scheme reasonably reflects the economic substance of the entity’s activities in connection with the scheme. This differs from the former wording of the test, which focused on the income, not profit, derived by each entity to the scheme.
This test ensures the DPT will not apply where there is a commercial transfer of economic activity and functions to another jurisdiction, notwithstanding the lower tax rate in that jurisdiction.
In determining the profit level of each entity, regard should be had to the functions that the entity performs in connection with the scheme, taking into account the assets used and risks assumed by the entity. The Bill now prescribes that the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the OECD Guidelines) should be taken into account where relevant. These Guidelines provide guidance on how a functional analysis is performed, and outlines a number of economically relevant characteristics to ensure that such a functional analysis reflects the accurate delineation of the transaction. The exposure draft legislation did not prescribe the use of the Guidelines.
Minor or ancillary role in the scheme
In another change to the proposed legislation, the Bill now states that if the entity’s role in the scheme is minor or ancillary, the entity is disregarded for these purposes. This will be the case if the entity has no material bearing on the effectiveness of the scheme, and receives minimal income from the scheme.
The role of the entity will not be considered minor or ancillary where:
- An integral part of the scheme involves the fragmentation of functions to different associated entities, with the result that each of the entities are carrying only a minor part of the scheme, and
- When considered together, the scheme gives rise to combined profits that are not commensurate with the collective activities undertaken.
Further changes to the sufficient economic substance test
The Bill contains the following additional modifications to this test:
- The entity’s role and activities within the overall scheme are relevant in determining the economic substance of those activities. For example, self-cancelling, offsetting or circular transactions, and “back to back” arrangements where the entity does not deliver on its contractual obligations directly but reassigns this role to another entity, indicate another entity is in fact carrying out the economically significant functions.
- The Bill no longer states that only active activities of the entity will be tested. This is significant as it indicates that passive activities may be considered when ascertaining an entity’s profit levels. Notwithstanding, the examples in the Explanatory Memorandum indicate that active, as opposed to passive, activities will have the most significance.
DPT assessment process
The DPT assessment and review process largely remains unchanged from the exposure draft legislation.
If the DPT applies to a scheme, the Commissioner may issue a DPT assessment to the relevant taxpayer. Tax at a rate of 40% is payable on the diverted profit, with interest charges.
It is concerning that the Commissioner can reach a conclusion as to the application of the DPT in the absence of any necessary information from the taxpayer. The Bill confirms that the Commissioner can issue a DPT assessment without first taking reasonable steps to obtain information from the relevant taxpayer.
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.
In a change from the exposure draft legislation, the Bill states that the ATO will ensure a rigorous framework for introducing the DPT that encompasses several levels of oversight, senior executive sign-off and additional safeguards. Further, the Commissioner will establish a Panel relating to the DPT that will include at least one external member. Except in very limited circumstances, the Commissioner will seek endorsement from the Panel to make a DPT assessment.
DPT is payable upfront
The DPT is due and payable at the end of 21 days after the notice of assessment is issued. Accordingly, the DPT must be paid irrespective of whether the assessment is the subject of an unresolved dispute.
As with the current transfer pricing regime, the DPT due and payable will not be reduced by the amount of foreign tax paid on the diverted profits. Further, an income tax deduction is not allowed for the DPT paid.
Period of review
The period of review is unchanged from the exposure draft legislation — 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 can be shortened if the taxpayer specifies a shorter period by written notice to the Commissioner. 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 taxpayer can give notice for a shorter period of review where the taxpayer considers the Commissioner has been furnished with all relevant information and documents relating to the DPT assessment.
Further, the period of review can 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 Commissioner has not completed an examination of the taxpayer’s affairs and cannot practically complete the examination within the shorter review period because of any action, or failure to take action, by the taxpayer.
As a result of receiving additional information, the Commissioner may amend the DPT assessment to either reduce or increase the DPT liability, or make no change to the DPT assessment. The Commissioner may also agree to an outcome with an entity that involves both an amendment to reduce a DPT assessment, and an amendment to increase an income tax assessment.
Federal Court appeal
The taxpayer may appeal to the Federal Court against a DPT assessment within 60 days of the end of the period of review (as opposed to 30 days under the exposure draft legislation).
“Restricted DPT evidence” is not admissible in any appeal proceedings. Such evidence constitutes any information or documents that the taxpayer does not provide to 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
- The Court considers its admission is in the interests of justice, or
- The restricted evidence is expert evidence that comes into existence after the period of review and is based on evidence that the Commissioner has in his/her custody or control during the period of review.
Other tax measures
In addition to the DPT, the Bill also increases penalties for significant global entities and updates Australia’s transfer pricing rules.
Increasing penalties for significant global entities
- Failure to lodge penalties: the base penalty amount for failure to lodge taxation documents on time will be multiplied by 500 for significant global entities. This results in a maximum penalty of $450,000 which applies where the lodgment is more than 16 weeks late.
- Administrative penalties relating to statements and failing to give documents necessary to determine tax-related liabilities will be doubled for significant global entities.
- Significant global entities that have not already provided a general purpose financial statement to ASIC must provide a general purpose financial statement to the Commissioner. An entity that fails to provide such a statement by the due date or in the manner specified by the Commissioner is liable for an administrative penalty.
The above penalty amendments will take effect on or after the later of 1 July 2017 and the day the Act commences (on the first 1 January, 1 April, 1 July or 1 October to occur after the day the Act receives Royal Assent).
The amendment to require significant global entities to provide a general purpose financial statement to the Commissioner applies on or after the later of 1 July 2017 and the day the Act commences.
Transfer pricing amendments
Under Australia’s transfer pricing rules, arm’s length conditions and arm’s length profits are required to be identified consistently with the OECD Guidelines, as approved by the Council of the OECD and last amended on 22 July 2010 (2010 OECD Guidelines). In October 2015, the OECD released the 2015 OECD Report which includes additional guidance on intellectual property, hard-to-find intangibles and other high risk areas. Under this amendment, the application of the transfer pricing rules in Div 815 of the ITAA 1997 is required to be consistent with the new 2015 OECD Report. This amendment will apply to income years commencing on or after 1 July 2016.
Committee inquiry and report
Various submissions were received by the Committee as part of its inquiry into the Bill. Some submitters considered the DPT was likely to increase investment uncertainty and sovereign risk in Australia, and will cause Australia to fall out of step with the majority of OECD countries in relation to collective action being taken to address profit shifting. It was also submitted that the DPT was a punitive measure that will impose ongoing compliance costs to taxpayers investing in Australia, and for Australian-based international companies.
Stakeholders also advocated for the explicit incorporation of the DPT as a provision of last resort in the tax legislation. The Committee considered that while this approach would give comfort to multinationals, it may reduce the flexibility the Commissioner could use in the application of the DPT, particularly where significant global entities are not being compliant and not providing the information required to properly assess their tax obligations.
The Committee recommended that the Bill be passed. While noting that extensive discretionary powers had been afforded to the Commissioner in relation to undertaking DPT assessments, the Committee felt that this was a necessary step to promote greater compliance and deter significant global entities from “gaming the system”. The Committee had confidence that the Commissioner will take a measured approach in exercising those powers and will not use them unnecessarily.
The DPT will place significant pressure on taxpayers to provide information or concede transfer pricing outcomes in transfer pricing audits. Such taxpayers that are involved in transfer pricing disputes will be at high risk under the new DPT regime. Further, multinationals involved in cross-border transactions or that have undertaken business restructures must hold robust contemporaneous evidence to demonstrate the sufficient economic substance of the arrangement.
Several new features of the Bill are welcomed, such as the ability of taxpayers to provide evidence to demonstrate the non-tax financial benefits of the scheme, and the formation of an ATO Panel that will be consulted prior to a DPT assessment being issued. Another significant change is the exclusion for sovereign owned or widely-held entities, which will be a relief to various entities including managed investment trusts, complying superannuation entities and foreign pension funds.
The introduction of the DPT highlights that the Australian Government is committed to implementing measures as agreed by the G20 and OECD to combat international tax evasion. The DPT complements the raft of powerful measures to deal with multinational arrangements and profit-shifting schemes, including the MAAL and the doubling of penalties on companies that engage in profit-shifting schemes. Accordingly, taxpayers should be prudent in documenting international dealings, as the DPT is a penalty regime under which the Commissioner will have significant powers that may be applied arbitrarily.