Proposals paper on Addressing profit shifting through the artificial loading of debt in Australia

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1 22 July 2013 Ms Kristy Baker International Tax Integrity Unit Corporate and International Tax Division The Treasury Langton Crescent PARKES ACT Dear Kristy Proposals paper on Addressing profit shifting through the artificial loading of debt in Australia The Institute of Chartered Accountants Australia (Institute) welcomes the opportunity to make a submission on the proposals paper entitled Addressing profit shifting through the artificial loading of debt in Australia released by the government on 14 May The Institute is the professional body for Chartered Accountants in Australia and members operating throughout the world. Representing more than 73,000 current and future professionals and business leaders, the Institute has a pivotal role in upholding financial integrity in society. Members strive to uphold the profession s commitment to ethics and quality in everything they do, alongside an unwavering dedication to act in the public interest. There are a number of points that we would like to make in advance. 1. We recognise the very complex task confronting the Government and Treasury in balancing a number of considerations. In particular, we acknowledge that there is clearly a need to ensure: A solid budget position for Australia in the future The Australian corporate tax base does not suffer from erosion, whatever its form Our tax rules encourage increased economic activity in Australia Our tax rules are as simple and efficient as practicable Taxpayers in a similar position are not treated differently, and The tax rules are perceived to operate fairly. These are very difficult issues. We acknowledge that reasonable people can come to different views as to the weight to be placed on each of these goals. 2. We recognise that the ultimate goal of ensuring we have rules to prevent the artificial loading of debt in Australia is appropriate and welcome. That is clearly in the national interest. 3. We note that a number of other countries have considered the problem of debt loading in their own jurisdictions and have taken measures to deal with this issue. Some responses are more complex than others. None have embraced the model under consideration in Australia. 4. The Institute would welcome involvement in further consultation on these issues as they evolve.

2 2 Overview At the level of the big picture, the Government is considering a trilogy of measures to deal with the Australian debt loading issue. They involve: Changes to the thin capitalisation rules including modification of the safe harbour debt and capital limits, opening the world-wide gearing test to inbound investors but reducing it to 100% and lifting the de minimus threshold to $2 million of debt deductions. Changes to the participation exemption such that in substance debt interests do not obtain the benefit of Section 23AJ; and Changes to our interest deductibility rules where the interest is referable to the derivation of exempt income from overseas investments. Thin capitalisation Broadly the Institute recognises the Government s objectives in modifying the thin capitalisation rules and believes the modifications are appropriate in the circumstances. We welcome lifting the de minimus level of debt deductions to $2 million and in principle have no concerns with the reduction in the various gearing limits. Two additional comments are made. Firstly, the question of whether Australia s rules are currently more generous than other countries in general terms is a difficult one. Headline thin capitalisation ratios can be deceptive without consideration of the underlying detail of the thin capitalisation rules. In particular, consideration needs to be given to whether a system deals with related party debt and whether determination of the asset base from which the calculation is made is limited to domestic assets. For example, a number of our major trading partners, such as China, Indonesia, Germany and the United Kingdom, only target related party debt, whereas here in Australia, third party debt is also included in the definition of maximum allowable debt for thin capitalisation purposes. A further point to note is that although the thin capitalisation rules in the United States (US) could be said to be comparable to those proposed for Australia, any disallowed interest expense in the US can be carried forward to a future income year. A breach of the Australian regime results in a permanent denial. Therefore, Australia s thin capitalisation rules are less generous than the headline rate of 75% might otherwise suggest. The structure and features of our thin capitalisation rules should be monitored along with other international developments, such that Treasury should be open to consider recommending to Government that it reverse either in part or in full the initiatives currently proposed to tighten Australia s thin capitalisation rules if the international landscape changes. In this regard, it should be acknowledged that the appropriate comparisons may not be developed OECD countries, but our Asian neighbours and certain developing countries in the extractive industries sectors. That is, Australia needs to continually monitor the international landscape to ensure our tax system is internationally competitive. Secondly, it is noted that the Business Tax Working Group raised the possibility of an earnings based test. That is a test related to available cashflow or Earnings Before Interest, Depreciation and Amortisation (EBITDA). While such a test would certainly not suit all taxpayers and would need to be considered only as optional for particular taxpayers, it is considered by many to be a more appropriate test for service industry companies. Such companies may well be an important part of our future in the Asian Century. They involve businesses that are not asset heavy (with the possible exception of goodwill, which if internally generated does not contribute to the thin capitalisation base). We have previously indicated that we believe further work should be undertaken to determine the efficacy of such an option. Possibly, now is the time to commence that work. We do emphasise that we consider that an earnings based test should be optional and not a substitute for an assets based test. In substance debt interests do not obtain the benefit of Section 23AJ

3 The Institute supports this measure. The current anomaly lies in the history of the introduction of the first stage of the Taxation of Financial Arrangements in July The first stage dealt with insubstance debt-equity rules and thin capitalisation, but did not apply the in-substance rules to other parts of our international tax system. The proposed change to Section 23AJ is in effect the adoption of an in substance approach to the participation exemption. It is appropriate. However, the proposed change should also address legal form debt that is in-substance equity. We believe that for consistency and coherence, such an instrument should be granted a Section 23AJ exemption. This would be consistent with a Treasury discussion paper of 12 May 2009 where it was said that Section 23AJ should apply to a non-share dividend (that is, a return on a non-share equity interest). 3 It is recognised that treating the return on a non-share equity interest as one subject to section 23AJ may invite planning whereby a non-share dividend is considered to be deductible in the paying jurisdiction and non-assessable in Australia. This potential arises because the tax rules are based on the in substance position in one jurisdiction whereas in another jurisdiction they are based on the legal form. However, a response to this issue which adopts in-substance rules and legal form rules only if it favours the revenue would appear to be inappropriate. The Australian rules need to be coherent, then consideration needs to be given to how they may interact with the rules of other jurisdictions. The issue concerning the repeal of Section This is the issue that is causing the Institute, and indeed the broader tax community, the most concern. Ultimately, the Institute would welcome detailed consultation on an alternative solution if it is considered that there is significant revenue at risk in relation to this measure. Much has been said about this issue in general discussion so far some of it has substance and some of it is rhetorical. We would like to articulate six main reasons why we believe the simple repeal of Section is problematic. They are as follows: 1. Section is not simply a compliance saving measure. It is an integral part of our international tax system. Australia has adopted an exemption system to avoid international double taxation for non-portfolio dividends rather than a foreign tax credit system, a rebate system or a deduction system. In the latter three, there is assessable income in Australia which, at least prima facie would support an interest deduction. A credit, rebate or deduction rather than an exemption is put in place to deal with double taxation. While it is recognised that a company can earn active income in a foreign jurisdiction, not pay tax in that jurisdiction and pay an exempt Section 23AJ dividend, this would appear to be rare. In most cases, tax is paid in the foreign jurisdiction on active business income. Indeed, the amendments made in 2004 to Section 23AJ (extending the exemption approach to all foreign non-portfolio dividends) were expressed to be principally aimed at removing the Australian company tax burden from active business income earned by a foreign subsidiary company resident in any foreign country. CFC rules deal with passive and base company income. We submit that an exemption under Section 23AJ is qualitively different from an exemption, say, from income from the operation of a goldmine as existed in Australia until the 1990s. That is, the 23AJ exemption is primarily there as a mechanism to deal with a coherent system of international taxation. 2. The structure of our thin capitalisation rules largely protects the Australian tax base by excluding investments in foreign equity from the thin capitalisation asset base. That is, the current thin capitalisation rules substantially deal with artificial loading of debt in Australia. We recognise, however, that it does not fully deal with the issue. In particular, foreign owned Australian entities can load debt into Australia up to the thin capitalisation limit. However, these limits are being reduced, resulting in the headroom available for loading being reduced (in most cases from 75% to 60%). This, combined with the denial of a double advantage afforded by in-substance debt and legal form equity instruments under Section 23AJ will further reduce the problematic area.

4 4 3. The repeal of Section without more will potentially damage companies that have not deliberately streamed funding into Australian based assets in the past (relying on the former tax policy), thus giving rise to a capricious result when compared with a taxpayer in an identical position who has streamed funding into Australian based assets. This is an inequity based on the past. 4. For the future, a repeal of Section will reinvigorate tax planning around tracing amongst other measures. It will invite the use of stapled structures to stream borrowing costs. It will invite a planning whereby early returns are assessable (when debt deductions arise) but later returns are not where Section 23AJ kicks in. Some of this planning will be entwined with commercial factors which will make it very difficult to unpick. This, of itself, is problematic. That is, the system itself promotes an artificiality which is not good tax design. 5. In our view, the proposed rules are damaging to Australian multinationals, particularly those in a growth cycle where it is difficult to place debt outside Australia in newly established subsidiaries in the early stages of growth. It is clear that Australia has benefited enormously by opening up its economy to international forces in the last 30 years. It is equally clear that we are the beneficiaries of substantial demand for our resources in the last 10 years. However, the future lies in our ability to become a clever economy. While in some cases that will involve the simple export of goods and services into the international, and in particular, the Asian economies, it will increasingly involve Australian businesses establishing a presence offshore. Sometimes through joint ventures and sometimes through wholly owned subsidiaries. Three things come to mind about this future. Rapid expansion will be critical. Debt funding on competitive terms is unlikely to be available at the local level and will need to come from the Australian parent. An Australian tax system that would effectively require raising capital rather than debt will put Australian growth businesses at an international competitive disadvantage to other countries and impede the speed of growth. 6. Finally, the rules are out of step with what is happening internationally. Some jurisdictions recognise the artificial loading of debt in their own jurisdiction has the potential to erode their tax base. Of these all have understood the counter-veiling need to protect genuine business expansion and to provide support for their domestic businesses internationally. This has given rise to a combination of different rules some quite complex and not without criticism. But internationally countries have avoided a blanket denial of interest deductions referable to dividend income which is subject to a participation exemption. Canada came close. It announced such a system in 2007, renounced it in 2009 and introduced an alternative in France, Spain, Germany, Netherlands and Finland have embraced changes to minimise the prospect of what the Canadians have called debt dumping, and the UK has a series of measures (including a worldwide gearing test) to prevent debt loading in UK companies in global groups. None have adopted a blunt instrument such as a straightforward denial of interest deductions on participation income for fear of damage to their own multinationals. Ultimately, if it is decided that changes to the thin capitalisation rules and the operation of Section 23AJ does not address the questions that the Government is seeking to deal with, then we believe it would be advantageous to search for an alternative to the repeal of Section and we would be pleased to assist in such a process. It is recognised that these will not be easy solutions, but finding a better path should be an important goal for all of us. Alternative solutions to the simple repeal of Section A number of alternatives should be considered. It is possible that a combination of measures may be the solution. Some possibilities are as follows: A specific anti-avoidance rule aimed at debt dumping in Australia; Repeal of Section for foreign controlled groups only, but maintenance of the rule for Australian listed companies or predominantly Australian owned companies; Imposition of a secondary thin capitalisation test to try and capture some of the headroom where the level of Australian gearing is above the world-wide gearing; Provide a partial exemption and not a full exemption under Australia s participation exemption;

5 5 Apply Section where the multinational group is Australian controlled or if it is not Australian controlled, where the Australian owner of the subsidiary has a close business connection with the overseas subsidiary and no other group company has a closer business connection (similar to the Canadian rules). Transitional issues and grandfathering With any major change, there is a difficult balance of dealing with concerns around fairness for those that have acted in good faith on a previous policy setting, concerns around the economic costs to business of modifying their current capital profile (eg termination fees) as well the risk of reputational damage with lenders, the need for the measure to raise revenue, the need to ensure that business is not locked-in to a particular structure for tax reasons that do make sense economically and the need for simplicity. We note that Treasury has expressed a view that complete grandfathering of current arrangements will not achieve the right balance. We understand this position. We also acknowledge that a different transitional rule is likely to be required for each of the trilogy of measures under consideration. In relation to the repeal of Section 25-90, we would recommend consideration of a transitional rule that allows: Grandfathering of current arrangements put in place prior to 14 May 2013, up to the earlier of the period of expiration of the arrangement or 30 June 2016; A general period to allow companies to reorganise their affairs for say 12 months after introduction of the rules without denial of an interest deduction under Section 23AJ. The transitional rule should be subject to deeper consultation closer to the formulation of the main body of rules. *** If you would like to discuss any aspect of this submission or require any further information, please do not hesitate to contact me on at first instance. Yours sincerely Yasser El-Ansary CA General Manager Leadership & Quality Institute of Chartered Accountants Australia