INVESTMENT INTO AUSTRALIA KEY TAX ISSUES

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1 INVESTMENT INTO AUSTRALIA KEY TAX ISSUES The purpose of this paper is to highlight opportunities for New Zealand corporations (NZCs) that are currently investing or are considering investing into Australia. The information in this publication is provided for general guidance on matters of interest only. It should not be used as a substitute for consultation with professional accounting, tax, legal or other advisers. This document is not intended or written by PricewaterhouseCoopers to be used, and cannot be used, for the purpose of avoiding tax penalties that may be imposed on the tax payer. Before making any decision or taking any action, you should consult with your regular PricewaterhouseCoopers professional. No warranty is given to the correctness of the information contained in this publication and no liability is accepted by the firm for any statement or opinion, or for any error or omission. Also note that certain concepts will only apply in particular limited circumstances and are subject to the application of Australia s general anti-avoidance provisions. The key tax issues for NZCs discussed in this paper are: 1. Snapshot of tax in Australia 2. Efficient financing on acquisition, including cash repatriation and foreign exchange management 3. Debt funding and thin capitalisation limitations 4. Transfer pricing rules 5. Tax consolidation 6. Capital gains tax (CGT) provisions and application to non-resident investors 7. Trans-Tasman imputation 8. Other non-tax considerations 1. SNAPSHOT OF TAX IN AUSTRALIA 1.1 Summary of key Australian tax rates and information Companies that are residents of Australia are subject to Australian income tax on their worldwide income. Generally, non-resident companies are subject to Australian income tax on Australiansourced income only, however, where a company is resident in a country with which Australia has concluded a Double Taxation Agreement (DTA), Australia s right to tax business profits is generally limited to profits attributable to a permanent establishment (PE) in Australia. The key Australian tax rates are summarised in the table below. Type of tax Tax rate ( ) Exceptions / Notes Thresholds Company income tax 30% None Companies are subject to federal tax on their taxable income at a flat rate of 30%. There are no state or municipal taxes on Capital gains tax (CGT) 30% Assets acquired before 20 September 1985 may not be subject to CGT. income in Australia. CGT applies to assets acquired on or after 20 September Disposals of plant and equipment are generally not subject to the CGT rules. Capital losses are allowable as deductions only 1

2 Goods and services tax (GST) 10% GST free and input taxed supplies are not subject to GST. against capital gains and cannot be offset against other income. In calculating capital loses, there is no indexation of the cost base. The GST is a value-added tax (VAT) applied at each level in the manufacturing and marketing chain and applies to most goods and services, with registered suppliers getting credits for GST on inputs acquired to make taxable supplies. Food, with some significant exceptions; exports; most health, medical, and educational supplies; and some other supplies are GST free (the equivalent of zero-rated in other VAT jurisdictions) and so not subject to GST. A registered supplier of a GST-free supply can recover relevant input tax credits, although the supply is not taxable. Fringe benefits tax (FBT) Payroll tax* FBT rate for year ending 31 March %. Note: FBT rate for year ending 31 March %. New South Wales (NSW) 5.45%; Australian Capital Territory (ACT) 6.85%; Victoria (VIC) 4.90%; There are some exceptions from FBT, including some minor benefits, remote area housing in certain circumstances, and specified relocation costs. NSW - $750,000; ACT - $1,750,000; VIC - $550,000; QLD - $1,100,000. Note: QLD threshold is reduced by $1 for every $4 of Residential rents, the second or later supply of residential premises, most financial supplies, and some other supplies are input-taxed ( exempt in other VAT jurisdictions) and are not subject to GST. However, the supplier cannot recover relevant input tax credits, except that financial suppliers may obtain a reduced input tax credit of 75% of the GST on the acquisition of certain services. FBT is levied on non-salary and wages fringe benefits provided to employees (and/or employee s associates) by the employer or associates. FBT is generally deductible for tax purposes. In addition to exceptions, there are some concessional rules, in particular for motor vehicles and living-away-from-home benefits. Tax imposed by states and territories on employers payroll. The various jurisdictions have harmonised their payroll tax legislation, but some differences remain, particularly tax rates and the thresholds for exempting 2

3 Research and development tax incentive** Queensland (QLD) 4.75%; Tasmania (TAS) 6.1%; South Australia (SA) 4.95%; Western Australia (WA) 5.5%; Northern Territory (NT) 5.5%. Refundable R&D tax offset 45%; or Non-refundable R&D tax offset 40%. Australian wages over $1,100,000. TAS - $1,250,000; SA - $600,000; WA - $750,000; NT - $1,500,000. Annual turnover of less than $20 million 45%; Annual turnover of greater than $20 million 40% It is proposed that companies with annual Australian assessable income (including that of affiliates) of more than $20 billion will not be entitled to the R&D tax credit for income years commencing on or after 1 July * Other state taxes include land tax and stamp duty. Rates vary between states. ** An incentive, not a type of tax. 1.2 Company versus Branch (PE) Corporate residence employers whose annual payroll is below a certain level, after taking into account grouping rules. Under the R&D tax incentive, entities may be eligible for a tax offset for expenditure on eligible R&D activities and for the decline in value of depreciating assets used for eligible R&D activities. Generally, only genuine R&D activities undertaken in Australia qualify for the R&D tax incentive. However, R&D activities conducted overseas also qualify in limited circumstances where the activities cannot be undertaken in Australia. A company is a resident of Australia for income tax purposes if it is incorporated in Australia or, if not incorporated in Australia, it carries on business in Australia and either (i) its central management and control are in Australia or (ii) its voting power is controlled by shareholders who are residents of Australia. PE The concept of a PE is established in both domestic law and various DTAs that have been concluded with Australia. Broadly, under Australia s domestic law, a PE is a place at or through which a person carries on any business and includes: A place where the person is carrying on business through an agent (except where the agent does not have, or does not habitually exercise, a general authority to negotiate and conclude contracts on behalf of the person); A place where the person has, is using, or is installing substantial equipment or substantial machinery; A place where the person is engaged in a construction contract; and 3

4 Where the person is engaged in selling goods manufactured, assembled, processed, packed, or distributed by another person for, or at or to the order of, the first-mentioned person and either of those persons participates in the management, control, or capital of the other person or another person participates in the management, control, or capital of both of those persons, the place where the goods are manufactured, assembled, processed, packed, or distributed. Where a company is resident in a country with which Australia has a DTA, it is important to have regard to the definition of PE contained therein as this will generally apply in priority to the domestic law. Under the New Zealand Double Taxation Agreement, a permanent establishment is defined as a fixed place of business through which business of the enterprise is wholly or partly carried on and specifically includes a place of management, a branch, an office, a factory, a workshop, a mine, an oil or gas well, a quarry or any other place of extraction of natural resources and an agricultural, pastoral or forestry property. Company versus PE The table below sets out a comparison of the income tax implications in setting up a company or permanent establishment in Australia. Corporate tax Income subject to tax Tax compliance Australian Resident Subsidiary (i.e. company) Resident of Australia for income tax purposes and taxed on worldwide income (Corporate tax rate - 30%). Required to lodge an Australian income tax return. Australian Branch (i.e. permanent establishment) Non-resident of Australia for income tax purposes and taxed only on Australian sourced income attributable to the branch at the rate of 30%. Required to lodge an Australian income tax return. Treatment of tax losses Repatriation of profits Tax losses may be carried forward indefinitely for offset against future Australian taxable income (subject to satisfying certain tests) of the subsidiary, or any other Australian 100% companies included within an Australian consolidated tax group. Profits repatriated to New Zealand by payment of unfranked dividends may be subject to withholding tax (see 2.3 Cash repatriation withholding tax for rates) A subsidiary must formally repatriate profits but has some flexibility in the manner and timing of repatriation. Tax losses may be carried forward indefinitely for offset against future Australian taxable income of the branch. Tax losses cannot be grouped / transferred to other Australian entities for Australian tax purposes. There is no withholding tax on branch profits being repatriated. However, there is a technical risk Australian sourced profits distributed from one foreign resident to another may be subject to Australian dividend withholding tax. No formal repatriation mechanism is required. 4

5 Eligibility to tax concessions May be eligible for Australian taxation incentives and government grants (eg. R&D tax incentive refer to section 1.1 above). Generally not eligible for taxation incentives and government grants. Capital Gains Tax ( CGT ) Transfer Pricing Australian CGT may arise in respect of any gain realised upon the disposal of shares in the subsidiary, where the subsidiary holds majority Australian real property. The subsidiary should be liable to CGT on profits on disposal of assets whether the assets are situated in Australia or overseas (subject to certain exceptions). Transfer pricing issues may arise in transactions between a resident subsidiary and its non-resident affiliates. Related party disclosures may be required to be submitted to the ATO together with the annual income tax return (International Dealings Schedule (IDS)). Australian capital gains tax liability should arise in respect of any gain realised on the disposal of branch assets. Assessable capital gains (if any) will be included in a company s taxable income and taxed at 30%. Transfer pricing issues may arise. In particular, the transfer pricing impact on the deductibility of any allocation of interest expense to the Australian branch will need to be considered. Related party disclosures may be required to be submitted to the ATO together with the annual income tax return (International Dealings Schedule (IDS)). Allocation of expenses Allocation of expenses and revenues is arguably simpler and more certain. Practical difficulties can be experienced in allocating revenue and expenses between the Australian Branch and its offshore head office. 2. FINANCING ON ACQUISITION 2.1 Debt/equity provisions Australia s debt/equity provisions take a substance over form approach to distinguishing debt and equity. In very broad terms, an instrument will be a debt interest where the issuer has an effectively non-contingent obligation to return at least the issue price of the instrument to the holder. Equity interests include ordinary shares and other instruments that provide an element of contingency on the issuer s obligation to return funds to the holder. For example, an instrument should be an equity interest if it carries a right to a return which is in substance or effect contingent on the economic performance of the company, part of the company s activities or a connected entity, or at the discretion of the company or a connected entity. The determination of whether a particular instrument is a debt interest or an equity interest is important as it governs whether the return on the instrument may be deductible (in the case of a debt interest) or frankable with tax paid credits (in the case of an equity interest). The outcome can have implications under tax law for example, both the tax consolidation and thin 5

6 capitalisation rules rely for their operation, in part, on the debt/equity classification of various financing instruments. The debt/equity provisions are generally relevant in the context of international structuring because it is quite unusual for 100% ordinary equity financing to be provided by an investor. Some form of debt or other financing is often used in addition to ordinary equity. This is typically driven by funding costs and a desire to build some flexibility into the structure. Accordingly, careful regard to the debt/equity provisions is required. Forms of financing investment in Australia might include: Bank and related party debt Mandatorily redeemable shares with 10 years maturity Convertible notes, convertible at the option of the holder Foreign currency loans The following table demonstrates the various forms of funding that may be used and their classification as debt or equity. 2.2 Equity override We note that whilst a financing arrangement may satisfy the debt test, it may in certain circumstances still be classified as an equity interest. The circumstances are where the related equity scheme rules (section ) apply; or 6

7 there are a series of related arrangements entered into by the company (or a connected entity) where the return to the ultimate recipient is contingent on the economic performance of the company (or a connected entity) or is at the discretion of the company (or a connected entity) (section ). The key requirement of section is that the arrangement is deliberately designed so that the flow of funds through the structure effectively means that the return on the relevant debt interest is used to fund a return to the ultimate recipient. Paragraphs 1.28 and 1.29 of the Supplementary Explanatory Memorandum to section states that the provision is intended to apply: only in those cases where the scheme or schemes are deliberately designed so that the return to the connected entity is in turn used to fund either directly or indirectly a return to the ultimate recipient. This means, generally speaking, that section would not apply unless there is a plan constituted by documented rights and obligations that provide for the direct or indirect funding of a return to the ultimate recipient. A lack of documentation would not preclude the application of the provision if the design was clear from the surrounding facts and circumstances. However, mere association between the parties would not be a sufficient indicator of the relevant design. On 19 March 2007 the ATO issued a draft Discussion Paper (Interpretive Policy Matters Concerning the Application of Section ( ATO Discussion Paper ) outlining its preliminary views regarding the operation of this provision, which took a very wide view of the way in which the provision could apply. The ATO Discussion Paper was withdrawn in August 2007 as a result of submissions from a number of professional bodies. Therefore, whilst the rules were primarily included in the debt/equity provisions to capture certain hybrid financing transactions, a literal interpretation of the rules could extend to simple transaction structures (refer to the example below). Example - Equity-funded SPV loaned money to Australia: ForCo Equity ForSub Loan Aust HoldCo We understand that the legislation is currently under review and is expected to be amended to prevent inadvertent interpretations of section in simple financing transactions such as above. However, there is no publicly available information regarding this process and outcome at this point. 7

8 2.3 Cash repatriation Withholding tax The debt/equity classification of an instrument will also determine whether the returns paid on the instrument are subject to dividend or interest withholding tax. Generally, where a non-resident holds a debt interest (including a non-equity share such as Mandatorily Redeemable Preference Shares), any return paid on the interest should be subject to 10% interest withholding tax, whether the lender is a treaty resident or not. The withholding tax rates under the Australia and New Zealand Double Taxation Agreement (DTA) can be summarised as follows: Withholding Tax Rates Dividends (10% % voting power) 5% Dividends (more than 80% voting power) 0% Dividends (all other) 15% Royalties 5% Interest (paid to banks) 0% Interest (all other) 10% Further, interest paid to an Australian branch of a foreign bank should not be subject to interest withholding tax. The rate of interest withholding tax may also be reduced to 0% for certain publicly offered debentures (e.g. large scale capital raisings in the wholesale or retail capital markets) and syndicated debt arrangements (at least two non-associated lenders required). Where the non-resident holds an equity interest, any return paid on the interest should not be subject to dividend withholding tax to the extent the return is franked (i.e. paid out of taxed profits). Where the return is unfranked, the dividend should be subject to 30% dividend withholding tax (unless otherwise reduced under the NZ tax treaty, most commonly to 5% or 0% in the case of NZ subject to certain conditions being satisfied). In addition, the conduit foreign income regime allows foreign source income to be on-paid through to a non-resident shareholder without any withholding tax. Conduit foreign income arises on receipt of various forms of foreign source income including non-assessable non-exempt foreign dividends, non-assessable non-exempt foreign branch profits and exempt foreign capital gains. Payments under currency swaps and guarantee fees should not be subject to Australian tax. Narrowing the income tax exemption for foreign dividends received by Australian companies The former Government announced as part of the Australian Federal Budget that the law will be amended to remove the income tax exemption for dividends received by Australian companies in relation to certain interests in foreign companies where that interest is classified as debt for Australian tax purposes. Currently, the exemption is available for dividends received from all non-portfolio interests in foreign companies (i.e. interests of ten per cent or more) which are legal form shares. Such dividends are referred to as non-assessable non-exempt income. The proposed amendment will remove the exemption for legal form shares that are treated as debt interests for Australian tax purposes, such as certain types of redeemable preference shares. The amendment will take effect for income years commencing on or after 1 July

9 This proposal is not new. In fact, this amendment was originally recommended by the Board of Taxation in its 2009 review of the foreign sourced income anti-tax deferral regimes and was accepted by the government at that time. While progress of these measures as a whole has now stalled, exposure draft legislation was released for public consultation in February 2011 and this included the proposed amendments to give effect to the announcement in this year s Federal Budget. The announcement in this year s Budget showed the outgoing government s intention to separate this measure from the other measures contained in that review, primarily the rewrite of the controlled foreign company (CFC) provisions and the proposed foreign accumulation fund (FAF) rule. In this respect, the former government indicated that the reform to the CFC and foreign source income attribution rules will be reconsidered after the Organisation for Economic Cooperation and Development (OECD) has completed its work on base erosion and profit shifting. Also, the former government proposed to repeal a provision that provides a tax exemption for all dividends (i.e. including portfolio dividends) received by a CFC. On the good news front, the former government had announced that it would expand the exemption for foreign non-portfolio dividends to include dividend income received through an investment in a trust or partnership. This would overcome a controversial view of the Australian Taxation Office which is inconsistent with the original intent of the exemption for foreign non-portfolio dividends. Removing the deduction for interest in relation to foreign dividend income Most controversially, there is a proposed further change which the former government said was the third part of a package of measures designed to tackle artificial loading of debt in Australia by multinationals. Under this change, the former government planned to remove the deductions available (under section or of the Income Tax Assessment Act 1997) for interest expense incurred in relation to investments in foreign companies that generate exempt dividends, with effect for income years commencing on or after 1 July Media reports quoted Commissioner of Taxation Chris Jordan as saying that he had become aware of the substantial use of interest deductions beyond what... was originally intended, and noted that it was common practice for multinational groups to restructure their arrangements to take advantage of this provision which effectively provided a deduction for expenses incurred in deriving income that was not assessable. The Treasury paper released with this year s Federal Budget states that there is now evidence that [this measure] is being used as a central step of an aggressive tax scheme. Consistent with general tax principles, entities will now need to establish a link between the interest expense and assessable income. This is not the first time that the use of this provision as a means of reducing Australian tax has been scrutinised. In 2009, the Australian Taxation Office undertook a review of so called debt generation strategies used by multinational enterprises, which included a close look at the use of this provision. The former government described section as a compliance saving measure which is being used as a means to shift profits out of Australia. In our view, this conclusion severely understates the importance of this provision to Australian based companies investing offshore and fails to address the context of the reforms to Australia s tax system made more than a decade ago. We are hopeful that the former government s promise to consult with industry on implementation of this measure will lead to a refinement of this proposal which would place Australian multinational companies at a significant competitive disadvantage internationally. Foreign exchange management Foreign currency exchange gains and losses are brought to account, generally as revenue income, when realised (refer below), irrespective of whether the foreign currency amount has actually been converted to/from Australia dollars, including when amounts are applied by way of offset. 9

10 A refinancing of a loan or a variation of the terms of a loan may also give rise to foreign exchange implications. Generally, whether an extension of a loan results in a variation of the terms of the loan or involves a discharge and the making of a new loan will depend upon the intentions of the parties, as disclosed by the agreement, and whether the actual extension is consistent with it. Where an intercompany debt may potentially be discharged and has an unrealised foreign exchange gain or loss attributable to it, companies should consider whether any alternatives are available such that the foreign exchange gain or loss is not realised. For example, can the funds that would otherwise be used to repay the debt, be used for an alternative purpose that would not give rise to a realisation of the foreign exchange gain or loss. Australia permits the use of currencies other than AUD for the purposes of determining income tax liabilities. USD functional currency is widely used in the resources sector. General application of the Taxation of Financial Arrangements (TOFA) rules It should be noted that, subject to certain eligibility requirements being met, the default method should apply under the TOFA rules unless an election is made to apply any of the other methods. Gains or losses should generally be assessable or deductible on revenue account, except in certain circumstances (for example, where the hedging financial arrangements method applies). The default method consists of the accruals method and the realisation method, however the realisation method should only apply where the accruals method does not apply. The accruals method should apply to an expected gain or loss in respect of a financial arrangement where it is sufficiently certain the gain or loss will occur. In some circumstances, the accruals method may only apply to a particular sufficiently certain gain or loss in respect of the financial arrangement. In the context of foreign denominated borrowings, the interest expense may be dealt with under the accruals method, whilst the foreign exchange gain or loss on the repayment will likely be dealt with on a realisation basis. Under the accruals method, the overall gain or loss should be spread over the life of the financial arrangement using a compounding accruals methodology. Where the realisation method applies, the gain or loss should be taken to occur for income tax purposes at the time at which the last of the financial benefits in determining the gain or loss is provided or due to be provided. 3. THIN CAPITALISATION 3.1 Overview Interest expense is deductible on funds borrowed in relation to an Australian business, the funding of a share redemption or share buyback, payments of dividends (unless out of unrealised profits) and in acquiring shares in a foreign subsidiary, even if the dividends thereon are exempt. Australia s thin capitalisation provisions apply to all debt of inbound companies or groups (i.e. foreign controlled Australian entities and foreign entities with Australian investments) and outbound companies or groups (i.e. Australian multinationals with foreign subsidiaries/branches). Broadly, the thin capitalisation provisions provide that an entity s debt deductions, including interest, will be limited to the extent the entity s debt level exceeds certain limits prescribed by the thin capitalisation provisions. An inward investor s maximum allowable debt is calculated by reference to a safe-harbour debt amount or an arm's length debt amount. Broadly, an entity s safe harbour debt amount is calculated as 75% x (Australian assets (other than deferred tax assets less certain non-debt liabilities). Non-debt liabilities include accruals, provisions (other than deferred tax liabilities and certain pension obligations) and trade creditors. 10

11 Special rules apply to banks and other financial entities. Where the safe harbour method is used, the value of the assets is generally determined based on accounting book values as determined in accordance with Australian accounting standards (Australian International Financing Reporting Standards - AIFRS). Accordingly, to the extent the fair value of the assets can be uplifted, potential maximum gearing may be higher. The arm s length debt test may be adopted as an alternative method of determining the maximum level of debt. Broadly, the arm s length debt amount is determined by reference to the amount that a commercial lending institution would have lent to the entity on arm s length terms and conditions (based on Australian assets), disregarding any guarantees, security or other form of credit support provided to the entity by an associate. The arm s length debt test is most often relevant to a very mature business with significant value in its goodwill that has not been recognised for accounting purposes and therefore is unable to be included in the safe harbour method calculation. While the test is complex, it requires determination of the level of debt that could be borrowed on a stand-alone basis without any associate guarantees or assets representing investments in foreign subsidiaries or associates or any foreign branch assets. The test is an annual test requiring annual consideration of the borrowing power of the company in the prevailing lending market. However, there are practical exceptions to this annual testing requirement that the ATO may accept although, this remains unresolved: a. Third party loans with banking covenants that have not been breached (including with a parental guarantee, the terms of which have not been breached); b. Related party loans, with covenants reflecting normal banking covenants which have not been breached; and c. With less certainty, related party loans with no such normal banking covenants, but where the financial performance of the company is such that, if such covenants had been imposed, they would not yet have been breached. 3.2 Proposed changes to the thin capitalisation rules Following much speculation in the lead up to the Budget, the former government announced that it would make changes to the thin capitalisation regime which limits deductions available for interest (and other defined debt deductions) for certain inbound and outbound investors. Specifically, the former government announced that it would: reduce the safe harbour debt limit for general entities from 75 per cent to 60 per cent of adjusted Australian assets (from 3:1 to 1.5:1 on a debt to equity basis), the effect of which could be to reduce interest deductions by up to 20 per cent reduce the safe harbour debt limit for non-bank financial entities from 20:1 to 15:1 on a debt to equity basis increase the safe harbour minimum capital for banks from four per cent to six per cent of the risk weighted assets of their Australian operations reduce the worldwide gearing ratio from 120 per cent to 100 per cent and make it available to inbound investors, and increase the de minimis threshold from $250,000 to $2 million of debt deductions. These changes will have effect from income years commencing on or after 1 July The alternative arm s length debt limit will remain available. 11

12 The simple example below highlights the impact of the proposed reduction in the safe harbour debt limit for general entities on the amount of debt deductions available to a taxpayer subject to the thin capitalisation regime (and assuming no change to the taxpayer s circumstances). As highlighted below, the total debt deductions will reduce by 20 per cent under this proposed change. The proposed change to the thin capitalisation ratio comes at a time when many countries, including Australia, are looking closely at ways to protect their corporate tax base and prevent profit shifting by multinational enterprises. It follows the recent release of a Treasury paper on this issue Implications of the Modern Global Economy for the Taxation of Multinational Enterprises - and the Organisation for Economic Co-operation and Development (OECD) report on base erosion and profit shifting (BEPS). The Treasury paper pointed to a recent trend by OECD member countries (including Germany, New Zealand, Canada, Sweden, Portugal and Belgium) to tighten their thin capitalisation rules to limit excessive debt deductions. Amendments to the current thin capitalisation regime were first floated by the Business Tax Working Group (BTWG) last year as a potential cost saving measure to fund a corporate tax rate reduction. The BTWG said in its discussion paper when assessed against other countries thin capitalisation regimes, the Australian rules could be seen as overly generous. Reducing the safe harbour gearing levels was one of a number of potential changes to the thin capitalisation regime put forward by the BTWG. Some specific considerations may include: There are a number of options under the thin capitalisation regime that can be explored to improve an entity s thin capitalisation position. These include alternative methods for determining the maximum allowable debt (such as the arm s length debt amount), different methods for calculating average amounts, and a choice to revalue certain assets for tax and/or accounting purposes. In the absence of a transitional rule for existing debt, it is likely that the proposed changes have a direct impact on financial models and structures for existing and proposed funding requirements. Accordingly, it may be worth reconsidering the mix of debt and equity funding that is utilised. Capitalising existing debt may have other adverse tax outcomes that should be carefully considered. These may include realisation of taxable foreign exchange gains, reduction in the ability to utilise certain tax losses within a tax consolidated group and implications under the commercial debt forgiveness provisions. The overseas tax implications will also need to be addressed. 12

13 The thin capitalisation regime applies to all types of entities including companies, trusts, partnerships and even individuals. The proposed changes, however, are likely to have a bigger impact on some industries than others. For example, infrastructure projects can usually support a higher level of debt. A reduction in the amount of debt that is able to be utilised by such entities would impact the returns to investors and increase the cost of funding for such projects. Any deductions that are denied as a result of the lower thin capitalisation ratios not only will have a direct additional income tax cost but will also have additional costs in that the excess interest may continue to be subject to non-resident interest withholding tax. 4. TRANSFER PRICING The new Australian transfer pricing laws that have come into force following the enactment of Tax Laws Amendment (Countering Tax Avoidance and Multinational Profit Shifting) Act 2013 on 29 June Under this legislation, new rules will apply to income years beginning on or after 1 July The existing transfer pricing provisions ceased to have effect at the same time. All multinationals with operations in Australia will be impacted by the new rules to some extent. Key practical issues for taxpayers to consider include: Identifying the work that will need to be done by the time of lodging the first tax return under the new rules in order to self assess whether the company has complied with the rules. Taxpayers wishing to establish a reasonably arguable position (RAP) in order to be eligible for penalty reductions will need a clear plan to ensure that transfer pricing documentation in accordance with the new documentation requirements is completed by the time of lodging the tax return. The ATO is planning to prepare new guidance addressing some of the practical issues arising from the new rules; however, this will require a significant amount of time and resources. We understand that priority will be given to preparing new guidance in respect of documentation and penalties. The new rules have been introduced to modernise Australia s transfer pricing rules and bring them into line with more recent OECD transfer pricing guidance. The new rules will be inserted in the ITAA 1997 in Subdivisions 815-B (separate entities), 815-C (branches), and 815-D (partnerships and trusts). Amendments will also be made to the Tax Administration Act 1953 to introduce documentation requirements and related penalty provisions. Features of the new rules that are consistent with Australia s previous transfer pricing rules include: The rules are based upon the arm s length principle. The rules apply only to cross border dealings and do not apply to transactions between domestic related parties. There is no requirement for the parties to a transaction to be related for the rules to apply. The rules may apply to cross border dealings between third parties if those parties have not dealt with one another on an arm's length basis. 13

14 Additional or new features in the new law include: The rules introduce self assessment for transfer pricing positions. As previously mentioned, a seven year time limit for the Commissioner to make transfer pricing adjustments was introduced. Formal incorporation of OECD guidance. Specific reconstruction provisions which allow actual transactions to be disregarded, and hypothetical arm s length transactions to be substituted in some circumstances. Specific provisions dealing with the interaction between the transfer pricing and thin capitalisation rules. Legislating a link between contemporaneous transfer pricing documentation and potential penalty protection. Under these provisions, it will not be possible to establish a RAP on transfer pricing positions unless documentation was prepared at the time of lodging the tax return for the relevant income year. This means that penalties of 25% of the tax shortfall would be likely to apply in the event of an ATO transfer pricing adjustment, rather than a reduced rate of 10%. Key practical implications of the new rules are: Stricter deadlines for preparing transfer pricing documentation The ATO s existing administrative guidance recommends preparing transfer pricing documentation by the time of lodging a tax return to be eligible for penalty reductions but, until now, this has not been a legal requirement. Under the new rules, it is clear that documentation must be completed at the time of lodging a tax return to be able to establish a RAP. A higher expectation on taxpayers and the Public Officer to voluntarily monitor their compliance with the transfer pricing rules. Under self assessment, taxpayers must form a view at the time of lodging their tax return on whether they have complied with the transfer pricing rules. Taxpayers will be expected to self assess adjustments where noncompliance with the rules has resulted in lower taxable income in Australia. Notably adjustments cannot be made to reduce taxable income in Australia. Although transfer pricing documentation is not mandatory, it is likely that a minimum level of supporting evidence and documentation will be required at the time of lodging the tax return in order to be able to form a reasonable view on whether the company s transfer pricing arrangements were arm s length during the year. The level of analysis needed to form this view is likely to depend on the risk and complexity of the company s transfer pricing arrangements. OECD based global transfer pricing studies should be reviewed to ensure that they adequately address the Australian rules. Given the expectation on taxpayers to self assess compliance, Australian subsidiaries of multinational groups will not be able to rely on global documentation prepared by the group without reviewing it to ensure the Australian transactions, business, market conditions and financial outcomes are adequately addressed. The specific requirements of the new documentation rules should be explicitly addressed. 14

15 The terms and conditions of intercompany legal agreements will become increasingly important. In light of the reconstruction provisions in the new rules, taxpayers may be required to demonstrate that the way they have structured their dealings with related parties is consistent with arm s length behaviour, not merely that the pricing is arm s length. Including terms in intercompany agreements that would not normally be agreed between third parties, or omitting terms that third parties would typically include in a similar agreement, may create a risk of challenge by the ATO. Taxpayers should ensure that all cross border intercompany dealings, including intra-group loans, are properly documented through legal agreements and that those agreements are current and reflect the underlying substance of the commercial relationships. The pricing of intercompany debt will need to consider the amount that could have been borrowed at arm s length. Although the thin capitalisation rules will continue to govern the amount of debt upon which deductions may be claimed, the arm s length interest rate will need to be determined having regard to the rate that would have applied to a notional arm s length amount of debt. 5. TAX CONSOLIDATION 5.1 Overview Australian companies that are part of the same wholly-owned group are able to form a consolidated group for income tax purposes. The consolidated group can consist of either one Australian holding company and its wholly-owned Australian subsidiaries, or two or more Australian holding companies (and their wholly-owned Australian subsidiaries) where there is a common ultimate foreign holding company (a multiple entry consolidated, or MEC group). Consolidation is elective. However, once the choice is made by a particular Australian holding company, all 100% owned entities of each Australian company must be consolidated. Once the consolidated group is formed, it will be treated as a single entity for income tax purposes. Only the head company of the consolidated group is recognised and all transactions within the consolidated group (including intra-group loans) will be ignored for income tax purposes. When an entity joins an existing consolidated group or a new consolidated group is formed, the tax basis of the assets of the entity (apart from assets such as cash and AUD receivables) is reset under the cost setting process. This may result in a tax-free uplift (or decrease) in the tax basis of the underlying assets and can sometimes result in deemed gains arising. Broadly, under the cost setting process, the total of the amount paid for the shares in the entity and the value of its liabilities will be allocated initially to the entity s cash and Australian receivables based on face value, with the remainder allocated to other assets of the entity, based on proportionate market values. Where an entity has carried forward losses, these could be transferred to the acquirer group if certain tests are satisfied. However, the rate at which these losses can be used is restricted. Accordingly, non-residents acquiring shares in an Australian entity, should take notice of the tax consolidation provisions. If a non-resident was to acquire an Australian entity or group directly, there would be no opportunity to reset the tax basis of the underlying assets of the entity/group and finance the acquisition with deductible debt. 15

16 In order to reduce any potential adverse consequences and achieve a possible tax free uplift in the tax basis of the underlying assets of the acquired entity/group on acquisition, a non-resident should consider establishing one or more Australian holding companies to make the acquisition (depending on the structure of the target). The most common practice is for a non-resident acquirer to establish an Australian holding company, which establishes an Australian Bidder company, which forms a tax consolidation and then purchases the shares of the Australian target. This reduces the complexity and potential deemed taxable gains from the transaction. The following structure outlines where it may be beneficial to form a MEC group to make an acquisition, rather than utilising an existing holding group structure. The benefits are: The level of debt used in the acquisition will be based on the MEC group s thin capitalisation capacity; and It provides the opportunity for foreign parent to divest either company without Australian capital gains tax (subject to certain requirements, see 6.1 below). Where a decrease in the inside basis of the Target is expected, Foreign Parent may acquire shares in the Target directly. However, this may make the benefits in relation to leverage more challenging to achieve. 16

17 5.2 Recent developments Retrospective amendments Amendments to the tax consolidated measures contained in the Tax Laws Amendment (2010 Measures No 1) Act 2010 (which) came into force with effect from 1 July 2010, which included an allowance for tax deductions to be claimed by a consolidated group for the tax cost setting amount of certain assets such as consumable stores and rights to future income of a joining entity have been subsequently wound back, with a degree of retrospective application. Recent changes The long-awaited amendments to the tax consolidated measures came into force as part of the 2013 Federal Budget. The following five tax measures are to take effect as of 14 May 2013 subject to the relevant legislation being passed: Deductible liabilities of joining entities - head company to include a corresponding amount in assessable income; Non-residents no longer able to buy and sell assets between consolidated groups to allow the same ultimate owner to claim double deductions; Intra-group assets not recognised for purposes of applying "principal asset test" in working out indirect Australian real property interests of a foreign resident; Consolidated groups cannot access double deductions by shifting the value of assets between entities; and Only net gains and losses are recognised for tax purposes for certain intra-group liabilities and assets that are subject to the TOFA regime, upon exit of a member from a consolidated group. 6. NON-RESIDENT CAPITAL GAINS TAX (CGT) 6.1 Background A non-resident company should only be subject to Australia s CGT provisions where the CGT asset in question is taxable Australian property (TAP). The four categories of assets for companies that are TAP are as follows: 1. Taxable Australian real property (TARP) TARP is defined as real property situated in Australia or a mining, quarrying or prospecting right, if the minerals, petroleum or quarry materials are situated in Australia. 2. Indirect Australian real property interests Broadly, an indirect Australian real property interest is defined as a share membership interest held by a foreign entity in another entity where the entity s underlying value is principally derived from Australian real property. The share may be in an Australian entity or a foreign entity. Where the interest disposed of is an interest in an entity, there are two tests that must be passed before the interest will be TAP. The first test broadly requires a minimum interest of the nonresident (and its associates) in the relevant entity of shares that hold at least 10% of the voting, dividend or capital rights. The second test requires that the relative value of TAP assets exceeds 17

18 the value of non-tap assets in the relevant entity. That is, where TAP assets comprise more than 50% of the gross assets (by market value) of the relevant entity, the second test will be passed. 3. CGT assets used in carrying on business through an Australian permanent establishment 4. Option or right to acquire an asset covered by 1, 2 or Issues for non-residents to consider It s all or nothing There is no pro-ratarata approach in the principal asset test. For example, assume Aus Co, held by a non-resident (Foreign Co), holds $51 of Australian real property which it purchased for $41 (i.e. Aus Co has an unrealised gain on the property of $10), and $49 of other assets (which had an unrealised gain of say $30). Assuming Foreign Co had a CGT cost base in the shares of $60 (equating to the cost incurred by Aus Co on its various assets) and sold the shares for their market value of $100, the full gain of $40 on the sale of the shares by the non-resident would be subject to CGT as the market value of the TAP asset is more than 50% of the market value of the gross assets, even though only $10 of that gain would relate to Australian real property. A similar issue arises in respect of interposed non-resident companies that hold assets other than TARP. Provided TARP accounts for more than 50% of an interposed non-resident company s value, any gain on the sale of shares in that company will be subject to the Australian CGT provisions, even if all the gain is economically attributable to unrealised gains on its foreign (i.e. non-tarp) assets. No foreign blocker The indirect Australian real property interest provisions are intended to apply equally to the disposal of shares in Australian companies and non-australian companies. For example, a resident of UK can be subject to the Australian CGT provisionsons on any gain or loss arising on the disposal of shares in a US resident company if the non-portfolio interest test and the principal asset test apply to the US company. This could be a considerable issue for multinational groups that have chains of companies which hold interests in Australian real property. This is vitally relevant to foreign group reorganisations. We note that in certain circumstances, there appears to be a legislative shortcoming in circumstances where shares in a non-australian company are sold. 18

19 The anti-stuffing rule The anti-stuffing provision provides that where an entity acquires an asset for a purpose (other than an incidental purpose) that includes ensuring that a membership interest in an entity would not pass the principal asset test, the market value of that asset is to be disregarded. Without the anti-stuffing rule, it might otherwise be possible to inject non-tarp assets (most simply, cash) into an interposed entity immediately before sale in order to fail the principal asset test (however, the general anti-avoidance rules would also need to be considered in this context). Assets held on revenue account A non-resident is also subject to tax under Australia s ordinary income provisions where they hold the asset on revenue account and the gain is sourced in Australia. Whether a non-resident holds an asset on revenue or capital account is not solely based on the length of time the asset is held, but depends upon the non-resident s intention at the time of acquisition. Generally, where an asset is purchased for the purpose of resale at a profit, it is more likely that the asset is held on revenue account. Where the intention is to hold the asset for the long-term to derive income, it is more likely that the asset is held on capital account (refer comments on TD 2010/21 below). The source of any gain is a question of fact and there is no legislation such that case law principles will need to be applied. Factors that non-residents will need to consider include: The essence of the taxpayer's business Activities that actually realise the profit Place where decisions are made Place where the contracts for purchase of sales of the assets are concluded Location of the stockbroker who concludes the buy or sell order (where relevant) Location of the entities whose shares or options are traded Where the non resident is taxable on revenue account they may seek to rely on the business profits article in a relevant tax treaty to reduce any taxable amount where they do not have a permanent establishment in Australia (refer comments on TD 2010/21 below). However, where the predominant underlying value of a company is represented by real property then the alienation of property article in the treaty is likely to apply such that the non resident would be taxable in Australia (irrespective of the percentage shares held in the Australian company). Where gains are assessable under ordinary provisions and CGT provisions, the amount taxable under the CGT provisions is reduced so there is no double taxation. TPG/Myer Case The ATO has issued two final Taxation Determinations, TD 2010/21 (formerly issued in draft as TD 2009/D18) and TD 2010/20 (formerly issued in draft as TD 2009/D17) which outline the Commissioner's views in relation to the taxation of non-resident private equity investments in Australia. In particular, the final rulings address the Commissioner s view on the capital versus revenue distinction and what is generally referred to as 'treaty shopping'. TD 2010/21 Revenue or capital for foreign private equity investments? 19

20 TD 2010/21 contains the Commissioner's view that profits from the disposal of shares in a company acquired in a leveraged buyout (LBO) or a non-resident private equity entity are likely to be treated as an income gain, rather than capital gain. The Commissioner acknowledges that the revenue or capital nature of the gain will depend on the circumstances of each particular case. An example has been included in the Determination that contemplates the disposal of an Australian entity by an off-shore entity which the ATO considers to be on capital account. However, the facts outlined in this example appear to be of limited practical application to foreign private equity entitles investing in Australia (i.e. the example considers an open ended fund that is not required to return funds to investors and within a particular timeframe which is not common in the Australian market). The Determination states that the profit making purpose of the foreign investor, which will determine the income or capital nature of the gain, should be considered from the perspective of the non-resident private equity entity itself. The consequence of this is that domestic capital gains tax exemption for non-resident private equity entity is not available. Where the gains are treated on revenue account, the private equity entity may be able to rely on the business profits article of the relevant tax treaty (subject to TD 2010/20 in relation to treaty shopping arrangements). Where the treaty applies, the private equity entity should only be taxed in Australia on the gains where it has a permanent establishment in Australia. TD 2010/20 Treaty shopping TD 2010/20 contains the Commissioner's view that the insertion of a holding company resident in a treaty country between an Australian entity and the foreign investor which lacks sound commercial reasoning may give rise to a tax benefit that would otherwise not be available if the foreign investor located in a non-treaty country invested directly into Australia. Where this can be proven, this position allows the Commissioner to apply Australia's general anti-avoidance rule (Part IVA) to effectively ignore the treaty country in levying Australian income tax. The Commissioner concluded that where there are no significant commercial activities present in the holding company resident in a treaty country, the reason for the interposition of the holding company is likely to be for tax purposes. Some factors which may indicate the presence of a tax purposes are as follows: an unnecessary hierarchy of holding companies; each of the interposed entities is a mere holding company, that is, it's primary undertaking is to legally own the shares of the next company in the chain; each has little or no other business activity; the time at which the scheme is entered into corresponds with the timing of the acquisition and holding period of target assets; the arrangement to adopt the interposed entities would result in a tax benefit when compared with an investment into Australia by a non-treaty country; and there are no regulatory reasons for these companies to be there. Where the treaty platform is respected, even if the gain is of an Australian source, it should only be taxable in Australia where it is made in connection with a permanent establishment. Generally, a permanent establishment may exist where the ultimate investment decisions are in form and/or in substance being made in Australia. 20