AUSTRALIA

Transfer Pricing News Issue 40 - September 2022

Treasury consultation paper details multinational enterprise crackdown

On 5 August 2022, Australia’s Treasury released a consultation paper on Multinational Tax Integrity and Tax Transparency. The consultation paper addresses what the government perceives as tax avoidance practices of multinational enterprises (MNEs) and calls for improving transparency through better tax information reporting for MNEs. These proposed integrity measures were part of the Australian Labour Party’s pre-election proposals, including:

  • Targeting MNEs that adopt increasingly sophisticated tax planning arrangements; and
  • Improving transparency to help deter MNEs from entering arrangements to minimise taxes paid.

The consultation paper includes three main proposals:

  • Changing Australia’s existing thin capitalisation rules to limit interest deductions for MNEs that are not “financial” entities, or “authorised deposit taking institutions” (ADIs);
  • Limiting large MNE deductions for certain payments relating to intangibles and royalties; and
  • Enhancing MNEs’ disclosure of tax information, such as public reporting of certain country-by-country tax information.

We expect these measures will cause a high compliance burden for a wide range of taxpayers, unless their application is limited to more significant taxpayers that have the capacity to pay for such high costs and invest the time required to deal with these new measures.

Current thin capitalisation rules

Generally, entities subject to the current thin capitalisation rules for non-ADIs are required to calculate their adjusted average debt and compare it to the maximum allowable debt prescribed under the Australian rules. Currently, the maximum allowable debt for non-ADIs that are not “financial” entities is the greatest of:

  • The safe harbour debt amount - Set at 60% of the adjusted average value of the entity’s Australian assets
  • The arm’s length debt amount - The amount of debt that could have been borrowed by an independent party carrying on the same operations as the Australian entity
  • The worldwide gearing debt amount - Allows an entity’s Australian operations to be geared up to the same level as the worldwide group to which the entity belongs.

Changes to thin capitalisation rules limiting interest deductions

Fixed-ratio rule

The government proposes to change Australia’s thin capitalisation rules to replace the current asset-based safe harbour test for non-ADIs that are not financial entities with an earnings-based safe harbour test. The earnings-based safe harbour test limits net interest deductions to a fixed ratio of 30% of earnings before interest, taxes, depreciation and amortisation (EBITDA), known as the “fixed-ratio rule.” This approach aligns with the Organisation for Economic Co-operation and Development’s (OECD’s) recommendation under Action 4 of the Base Erosion and Profit Shifting (BEPS) Action Plan.

The intent of an earnings-based fixed-ratio rule is to ensure that an entity’s interest deductions are directly linked to its economic activity and taxable income, which can help protect against tax planning practices. The fixed-ratio rule would apply only to “general entities,” meaning that financial entities and ADIs would continue to apply the existing thin capitalisation rules. The reason for this is that financial entities and ADIs are net lenders and are subject to regulatory capital rules; therefore, it would be inappropriate for them to apply the fixed-ratio rule.

The consultation paper lists the following considerations for the design of the fixed-ratio rule:

  • A potential de minimis monetary threshold based on net interest expense of the local group to remove low-risk entities from the interest limitation rule;
  • Additional flexibility for highly leveraged entities or groups, such as the arm’s length debt test or a specific group ratio rule, including considerations regarding third-party interest expense calculations; and
  • The treatment of assets or projects that provide net public benefits, or are considered nationally significant, which leverages existing legislative concepts.

Arm’s length debt test

In announcing a commitment to move to a fixed-ratio EBITDA safe harbour rule, the government indicated it would maintain an arm’s length debt test. However, the consultation paper also considers how the current arm’s length debt test may be strengthened. This is intended to prevent entities from opting into arrangements that potentially take advantage of greater debt deductions than would be available under the fixed-ratio rule. The consultation paper indicates there is concern that some taxpayers are utilising the arm’s length debt test to justify higher interest rates, despite the transfer pricing rules. It is not yet clear what changes to the arm’s length debt test will be made to address this issue.

The consultation paper also refers to the Australian Taxation Office’s (ATO) guidance on applying the arm’s length debt test in PSLA 2020/7. It states that despite this guidance, taxpayers continue to report complexity and high compliance costs in applying the arm’s length debt test. There is no indication whether the government is simply acknowledging these compliance costs or intends to simplify the operation of the arm’s length debt test.

Initial observations and impact

Early-stage businesses

There is a concern that moving to a 30% of EBITDA net interest limitation will act as a disincentive for investment, particularly for early-stage businesses with no or low revenue and fixed or higher start-up costs. These entities may have little to no EBITDA, whether based on income tax or accounting concepts, and may be required to use the arm’s length debt test to support reasonable debt funding. This may increase costs for such entities because, as the consultation paper acknowledges, the arm’s length debt test is neither a certain test, nor a cheap exercise.

Carry forward of denied deductions

To alleviate some of the potentially detrimental effects of the proposed 30% of EBITDA test on early-stage businesses, we suggest that the government consider allowing the disallowed interest deductions to be carried forward until the business passes the 30% of EBITDA threshold. This is particularly important for start-ups that are likely to have no or low revenue as early-stage businesses. The OECD has suggested the ability to carry forward denied deductions, but the consultation paper does not mention this possibility.

Safe harbour debt test

The current safe harbour test was already made more restrictive in 2014, with the reduction of adjusted Australian asset value from 75% to 60%. The replacement of the safe harbour debt test with the 30% of EBITDA test could indicate that the government still thinks the safe harbour debt test is too concessional. It could also indicate that it is looking to be more aligned with international trends in thin capitalisation rules, because most other countries do not use a safe harbour debt test.

If the concern is that the current safe harbour debt test -- based on 60% of adjusted Australian asset value -- is too generous, why not simply lower the 60% threshold instead of using the 30% of EBITDA test? A lower threshold could still allow a reasonable level of debt to be deducted, provided the debt funding results in assets being acquired and recognised on the balance sheet, without resorting to the arm’s length debt test.

Arm’s length debt test

The proposed changes to the arm’s length debt test mean that the denial of interest deductions under the main thin capitalisation approach will become far more volatile, as it will vary with profits. If the proposal were to allow the carry-forward of interest deductions temporarily denied under the 30% of EBITDA test, then profit fluctuations would not be as punitive, because any period of higher profits could allow for recoupment of prior denied deductions during a down cycle.

Changing the existing arm’s length debt test would mean that taxpayers who have used or considered using the test would need to recalculate the comparisons between the tests, which would give rise to even more compliance costs. We suggest that the government consider grandfathering the new rules so that existing projects are not adversely affected.

Highly profitable entities

There may be some winners under the proposed 30% of EBITDA test, particularly highly profitable entities that distribute a large portion of their profits, which requires them to borrow to fund their operations. In such situations, the 30% of EBITDA rule may allow an increase in the maximum allowable debt amount, compared to the current safe harbour debt test.

Deductions for intangibles and royalties

The consultation paper indicates that the government has concerns that MNEs can currently shift profits to low- or no-tax jurisdictions by using arrangements involving intangibles to avoid paying tax in Australia. In addition, taxpayers may enter into arrangements involving intangibles and royalties seeking to reduce Australian tax by avoiding royalty withholding tax. This occurs when the cost of tangible goods or services is inflated to include an “embedded royalty” component, thus avoiding royalty withholding tax.

Australia’s existing integrity rules, including the transfer pricing rules and general anti-avoidance provisions, go some way in addressing these issues. However, the government believes that Australia’s tax framework needs a specific measure targeting the integrity issues associated with intangibles and royalties.

Consultation paper proposal

The government proposes the introduction of a new rule to deny deductions to multinationals that are significant global entities (SGEs). The new rule would apply to payments relating to intangibles and royalties paid to a low- or no-tax jurisdiction, or to arrangements that lead to “insufficient tax being paid on the royalty.” The definitions of low- or no-tax jurisdiction and insufficient tax have not yet been developed, but the consultation paper indicates the following options are being considered:

  • Hybrid mismatch targeted integrity rule of 10% or less
  • Global Anti-Base Erosion Rules (GloBE) minimum tax rate of less than 15%
  • Sufficient foreign tax test (Income Tax Assessment Act (ITAA) 1936, section 177L) - Payments made to jurisdictions with a corporate tax rate of less than 24%
  • Patent box regimes - Payments made to jurisdictions with an intellectual property (IP) tax preferential regime, commonly referred to as “patent box regimes”
  • Low- or nominal-tax jurisdiction lists - Payments made to jurisdictions listed on low- or nominal-tax jurisdiction lists published by international organisations.

The consultation paper suggests the following questions be considered in the design of the measures:

  • Taxpayers in scope – Should the measures apply to SGEs in general, or only to corporate SGEs?
  • Payments in scope – Should the measures cover both royalties and embedded royalties?
  • Related and unrelated parties – Should the measures apply to both related and unrelated entities?

Considerations relating to embedded royalties

There are some inappropriate “embedded royalty” arrangements that warrant further scrutiny, and we commend the government for considering the appropriate legislative changes to deal with them. However, the identification of what are and are not “inappropriate embedded royalties” may be difficult to legislate. It will be difficult to identify what part of the cost of a product is an embedded royalty, particularly when the product is acquired at arm’s length prices as required under the current transfer pricing rules. For example, in recent years the ATO has alleged embedded royalties in various instances, such as inbound pharmaceutical sales, but has found it difficult to prove the case in many of these situations.

The taxpayer compliance and ATO administration costs associated with this measure could be significant. This could have considerable flow-on effects if the seller is subject to increased Australian tax on a cost that presumably is otherwise arm’s length.

Multinational tax transparency

The consultation paper states that public tax transparency plays an important role in ensuring MNEs pay their fair share of tax. This transparency is a key factor underpinning the integrity of the tax system. Accordingly, the consultation paper proposes the following measures designed to strengthen multinational tax transparency:

  • Public reporting of tax information on a country-by-country basis;
  • Mandatory reporting of material tax risk to shareholders. In this regard, the government announced it will require companies to disclose to shareholders “material tax risk” to help shareholders better understand their investments and any tax structuring arrangements of the company they are investing in;
  • Requiring tenderers for Australian government contracts to disclose their country of tax domicile; and
  • Considering merits of mandating the voluntary Tax Transparency Code (the Code) and including the government’s transparency commitments for MNEs as part of revisions to the Code.

Considerations relating mandatory tax transparency

The mandatory reporting of material tax risks may give rise to significant uncertainty as to what constitutes a “material risk.” Australia already imposes stringent requirements for the disclosure of tax risk to shareholders, under the financial reporting standards and for Australian Stock Exchange (ASX) listed companies under the listing rules. The ATO already requires most larger companies to lodge Reportable Tax Position schedules with their income tax returns, and any cross-border structuring or restructuring generally requires Foreign Investment Review Board (FIRB) approval.

Rather than introducing another set of rules around tax risk reporting, we suggest that any further tax risk reporting should apply only to entities that are not already subject to the current tax risk reporting rules.

The ATO already has the Voluntary Tax Transparency Code (VTTC), where medium-sized to large businesses are encouraged to provide greater public tax transparency. If the government considers that the current level of voluntarily disclosed information is sufficient, it could consider making the VTTC mandatory for those entities not sufficiently covered by existing tax risk reporting mechanisms.

Proposed effective date

The previously announced start date for the above measures is 1 July 2023. However, the consultation paper does not list a proposed start date, nor does it contain any transitional measures.

The closing date for submission of comments on the consultation document to Treasury was 2 September 2022. BDO in Australia has lodged a submission as part of this consultation.

Following consideration of the responses to the consultation paper, the government is expected to issue and consult further on exposure draft legislation, prior to introducing any legislation into parliament.
 

Zara Ritchie
zara.ritchie@bdo.com.au