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Recent Developments in International Taxation in Australia

International Bar Association Conference 2017 Sydney, Australia

June 2016 May 2017

Ryan Leslie

Senior Associate Greenwoods & Herbert Smith Freehills

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+61 418 186 499

ryan.leslie@greenwoods.com.au

Recent Developments in International Taxation in Australia International Bar Association Conference 2017 Sydney, Australia June 2016

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1

Introduction 1

The recent trend of significant international tax changes in Australia has continued relentlessly in the past 12 months, with a particular focus on multinational enterprises. The key developments are addressed below, including:

the implementation of a ‘diverted profits tax’ which was announced last year;

a number of transfer pricing developments, including the Full Federal Court’s

decision in Chevron which considers the transfer pricing of debt; and further Australian developments in relation to BEPS initiatives, in particular in relation to the multilateral convention and hybrid instruments.

In addition to technical developments, the tax affairs of large companies has continued to be the subject of significant media and political focus in Australia. In particular, in the last year the Government announced that amended tax assessments issued to 7 multinational companies were expected to raise an additional $3 billion tax in the 2016-17 financial year, publicly ‘welcomed’ a court decision which (subject to being overturned on appeal) will result in $340 million of tax, interest and penalties being payable by Chevron (refer below), and passed legislation which significantly increases the penalties applicable to large entities for underpayment of tax.

Given the current climate, there is significant doubt about whether the Government will be able to achieve its plan to progressively reduce the general corporate tax rate from 30% to 25% from 1 July 2026 the law currently provides for a staged reduction in the tax rate for companies with an annual turnover of less than $50 million.

  • 2 Diverted profits tax

As foreshadowed last year, Australia has followed the UK’s lead in introducing a ‘Diverted Profits Tax’ (or DPT) which takes effect from 1 July 2017. The Australian DPT will be similar to the second limb of the UK’s diverted profits tax, however Australia’s DPT will not apply on a self-assessment basis and is more onerous in a number of respects.

In broad terms the DPT applies where:

an Australian entity, or an Australian permanent establishment of a foreign

entity, is a ‘significant global entity’ (being a member of an accounting group

with global annual turnover in excess of $1 billion);

the relevant entity has Australian turnover (calculated on a group basis and adjusted if artificially low) of $25 million or more; and

the relevant entity is involved in an arrangement with a foreign related entity, entered into for a principal purpose of obtaining an Australian tax benefit, or both an Australian tax benefit and a foreign tax benefit, which:

results in an ‘effective tax mismatch’ – the increase in the foreign entity’s tax liability is less than 80% of the reduction in the Australian entity’s tax liability; and

has ‘insufficient economic substance’ – based on the information available to the Australian Taxation Office (ATO), it is reasonable to conclude that the arrangement was ‘designed’ to secure a reduced

Australian tax liability.

  • 1 This report has been prepared with the assistance of Jessica Voong, Graduate, Greenwoods & Herbert Smith Freehills.

3 Transfer pricing Carve-outs apply for certain collective investment vehicles, government-owned entities and pension funds. The( PCG 2017/D4 ) which, although non-binding and not a technical analysis of the transfer pricing rules, sets out the principles by which the ATO will determine how to allocate compliance resources to investigate the transfer pricing of cross-border related party debt. The draft guideline sets out 11 quantitative and qualitative factors which form the basis of the risk assessment, including the interest rate and currency of the loan, whether the loan is secured or subordinated, the gearing level and interest rate coverage ratio of the borrower, and the headline tax rate which applies in the jurisdiction of residence of the lender. The ATO states an expectation that, in most cases, the cost of financing for any entity in a global group should align with the cost of financing for the parent company of the group. In that regard, the risk rating increases to the extent that an Australian subsidiary borrows funds from a related party at an interest rate that exceeds 50 basis points above the global parent’s cost of debt. Recent Developments in International Taxation in Australia page 3 " id="pdf-obj-2-2" src="pdf-obj-2-2.jpg">
  • 3 Transfer pricing

Carve-outs apply for certain collective investment vehicles, government-owned entities and pension funds.

The DPT could have very broad application because:

it can apply even where an arrangement satisfies Australia’s transfer pricing

and thin capitalisation rules; and

Australia’s current corporate tax rate of 30% is comparatively high so that any deductible payment from an Australian entity to a related party with a corporate tax rate of less than 24% (for example, Singapore or the United Kingdom) could potentially be subject to the DPT.

Where the DPT applies, Australia will tax the ‘DPT Amount’ (broadly, the amount of profits that the ATO considers has been shifted out of Australia or prevented from arising in Australia) at a penal rate of 40%. In addition, the tax will need to be paid up front but the taxpayer will not be able to contest the assessment until 12 months after it issues.

  • 3 Transfer pricing

  • 3.1 Chevron decision In April 2017, the Full Federal Court dismissed the taxpayers appeal in the Chevron transfer pricing case (Chevron Australia Holdings Pty Ltd v Commissioner of Taxation [2017] FCAFC 62). The case has been the subject of significant interest both in Australia and internationally given the court’s finding that Australia’s transfer pricing rules do not merely require determination of an arm’s length price for a transaction actually entered into, but instead allow identification of a different transaction which can then be priced. The key issue in dispute relates to how a cross-border intra-group loan is to be priced under an old version of Australia’s transfer pricing rules. Importantly, although the loan was in fact unsecured, in dismissing the appeal the Full Federal Court decided that the arm’s length rate of interest must be determined based on a loan secured or guaranteed by a parent, because an arm’s length lender would only have advanced funds on a secured or guaranteed basis. Chevron has applied for special leave to appeal the decision to the High Court of Australia.

  • 3.2 ATO response Following the Chevron decision, the ATO released a draft ‘Practical Compliance Guideline’ (PCG 2017/D4) which, although non-binding and not a technical analysis of the transfer pricing rules, sets out the principles by which the ATO will determine how to allocate compliance resources to investigate the transfer pricing of cross-border related party debt. The draft guideline sets out 11 quantitative and qualitative factors which form the basis of the risk assessment, including the interest rate and currency of the loan, whether the loan is secured or subordinated, the gearing level and interest rate coverage ratio of the borrower, and the headline tax rate which applies in the jurisdiction of residence of the lender. The ATO states an expectation that, in most cases, the cost of financing for any entity in a global group should align with the cost of financing for the parent company of the group. In that regard, the risk rating increases to the extent that an Australian subsidiary borrows funds from a related party at an interest rate that exceeds 50 basis points above the global parent’s cost of debt.

4 BEPS progress 4 BEPS progress 4.1 Multilateral instrument Australia continues to embrace the OECD’s BEPS
  • 4 BEPS progress

  • 4 BEPS progress

  • 4.1 Multilateral instrument Australia continues to embrace the OECD’s BEPS project, so it is little surprise that Australia was one of the first countries to announce an intention to sign up to the multilateral instrument (or MLI) released by the OECD in November 2016. The MLI is expected to take effect in Australia from 2019. The objective of the MLI is to have a single document which a country can sign to update its tax treaties without having to re-negotiate each one individually. However, in order to accommodate amendments to potentially more than 3,000 tax treaties, the MLI includes a significant number of elections, options and possibilities for reservations. Determining how the MLI will affect a particular treaty in practice is likely to be particularly complex.

  • 4.2 Hybrids The Government has not yet legislated to implement changes announced in May 2016 to address hybrid instrument mismatches where, for example, payment on an instrument is deductible in the jurisdiction of payment and non-assessable in the jurisdiction of receipt (which changes would include a modification to Australia’s ‘participation exemption’). However, in the 2017-18 Federal Budget, the Government announced further hybrid instrument changes targeted at ‘Additional Tier 1’ hybrid instruments issued by Australian banks through overseas branches, payments on which are both deductible for foreign tax purposes and frankable (able to carry imputation credits) for Australian tax purposes. The changes are proposed to take effect no earlier than 1 January 2018. In a further blow to Australian banks, although unrelated to BEPS, the 2017-18 Federal Budget also included an announcement that a new ‘major bank levy’ would be imposed from 1 July 2017 to raise $1.6 billion annually from Australia’s 5 largest banks (ANZ, CBA, NAB, Westpac and Macquarie).

  • 4.3 Transparency The push for tax transparency both globally and in Australia continues unabated with the Common Reporting Standard (or CRS) being implemented in Australia from 1 July 2017. The CRS is a single global standard for the collection, reporting and exchange of financial account information in respect of account holders resident in more than 90 jurisdictions. Broadly, it will require Australian financial institutions (including banks, asset managers and investment funds) to collect and report to the ATO financial account information in respect of account holders who are resident for tax purposes outside Australia. The ATO will exchange this information with the tax authorities of other countries that participate in the CRS and those jurisdictions will provide the ATO with similar information in respect of Australian tax residents holding financial accounts in other CRS jurisdictions. Australia also commenced a consultation process in February 2017 in relation to establishing a register of beneficial ownership of companies consistent with the G20 High-Level Principles on Beneficial Ownership Transparency. In addition, the ATO publicly released its second report containing details of the revenue earned and tax paid by large corporate groups in December 2016.

5 Other key developments 5 Other key developments 5.1 Corporate residency In November 2016, the High( TR 2017/D2 ) . The draft ruling accepts that the central management and control of a company will ordinarily be exercised by its directors, provided proper governance measures are in place, i.e. directors are suitably qualified and briefed. However, the ruling also states a view that a company will always carry on business where its central management and control is located (previously this only applied to investment businesses with limited operating activities) – a view that, if correct, would result in any foreign incorporated company that holds a majority of board meetings in Australia being a resident of Australia for Australian tax purposes. 5.2 Taxation of stapled structures Trusts are the most common collective investment vehicle used in Australia because, subject to satisfying certain requirements, they are transparent entities for tax purposes and, unlike partnerships, offer the advantage of limited liability. For a widely held trust to qualify as ‘tax transparent’, or for any trust to qualify as a ‘managed investment trust’ and access con cessional withholding tax rates for distributions to non-resident investors, the trust must not carry on or control an active business. For these purposes, active business is defined broadly to include any business other than investing in property primarily for the purpose of deriving rent, or investing in certain financial instruments. As a result, it is common for Australian investment vehicles, particularly in the real estate and infrastructure sectors, to be structured as 2 separate ‘stapled entities’, for example a trust and a company where units in the trust cannot be traded separately from shares in the company. Under these structures, the trust can own real property which is leased to the company for use in carrying on an active business. In March 2017, the Government announced a review of the taxation of stapled structures. A public consultation paper lists 3 potential options to amend the tax rules, each of which would have the impact of increasing the amount of tax paid by stapled structures, or investors (particularly non-resident investors) into those structures. The consultation period runs until 31 July 2017. 5.3 Non-resident tax changes (a) Taxable Australian property Australia only taxes non-residents on capital gains if the gains relate to an asset that is ‘taxable Australian property’, which includes direct and certain indirect interests in Australian land. In respect of indirect interests, taxable Australian property includes a Australian law does allows the created of limited partnerships. However, Australian tax law treats most limited partnerships (with the exception of a limited class of Venture Capital Limited Partnerships) as companies. Recent Developments in International Taxation in Australia page 5 " id="pdf-obj-4-2" src="pdf-obj-4-2.jpg">
  • 5 Other key developments

  • 5 Other key developments

  • 5.1 Corporate residency In November 2016, the High Court delivered its judgment in Bywater Investments Ltd v Federal Commissioner of Taxation (2016) 91 ALJR 59, a case that considered whether certain companies incorporated outside Australia were residents of Australia for tax purposes on the basis that ‘central management and control’ was exercised in Australia. Each of the companies had a board of directors that met outside Australia, but was found to be effectively controlled by an individual in Australia. The facts were quite extreme, with the Court finding that the real business of the companies was conducted by the individual in Sydney and everything else was ‘a crooked pantomime’. In response to the decision, the ATO withdrew its 2004 ruling on corporate residency and replaced it with an updated draft ruling (TR 2017/D2). The draft ruling accepts that the central management and control of a company will ordinarily be exercised by its directors, provided proper governance measures are in place, i.e. directors are suitably qualified and briefed. However, the ruling also states a view that a company will always carry on business where its central management and control is located (previously this only applied to investment businesses with limited operating activities) a view that, if correct, would result in any foreign incorporated company that holds a majority of board meetings in Australia being a resident of Australia for Australian tax purposes.

  • 5.2 Taxation of stapled structures Trusts are the most common collective investment vehicle used in Australia because, subject to satisfying certain requirements, they are transparent entities for tax purposes and, unlike partnerships, offer the advantage of limited liability. 2 For a widely held trust to qualify as ‘tax transparent’, or for any trust to qualify as a ‘managed investment trust’ and access concessional withholding tax rates for distributions to non-resident investors, the trust must not carry on or control an active business. For these purposes, active business is defined broadly to include any business other than investing in property primarily for the purpose of deriving rent, or investing in certain financial instruments. As a result, it is common for Australian investment vehicles, particularly in the real estate and infrastructure sectors, to be structured as 2 separate ‘stapled entities’, for example a trust and a company where units in the trust cannot be traded separately from shares in the company. Under these structures, the trust can own real property which is leased to the company for use in carrying on an active business. In March 2017, the Government announced a review of the taxation of stapled structures. A public consultation paper lists 3 potential options to amend the tax rules, each of which would have the impact of increasing the amount of tax paid by stapled structures, or investors (particularly non-resident investors) into those structures. The consultation period runs until 31 July 2017.

  • 5.3 Non-resident tax changes

    • (a) Taxable Australian property

Australia only taxes non-residents on capital gains if the gains relate to an asset that is

‘taxable Australian property’, which includes direct and certain indirect interests in

Australian land. In respect of indirect interests, taxable Australian property includes a

  • 2 Australian law does allows the created of limited partnerships. However, Australian tax law treats most limited partnerships (with the exception of a limited class of Venture Capital Limited Partnerships) as companies.

5 Other key developments greater than 10% investment in an entity whose assets primarily (i.e. 50%
  • 5 Other key developments

greater than 10% investment in an entity whose assets primarily (i.e. 50% or more) comprise interests in Australian land, commonly referred to as a ‘land rich’ entity.

The 9 May 2017 Federal Budget announced changes to clarify the operation of the indirect interest test to ensure that Australian tax applies regardless of whether the 10%

investment is held by a single entity or a group of ‘associate’ entities. Prior to the change,

it was possible for a non-resident to hold a greater than 10% investment in an Australian land rich entity through a number of subsidiaries, each with a less than 10% investment, and dispose of its investment without being liable for Australian tax on any capital gain.

  • (b) Non-resident CGT withholding changes

Australia has applied a US FIRPTA-style non-final withholding tax since 1 July 2016 to require purchasers of direct and certain indirect interests in Australian real property to withhold 10% of the purchase price where the vendor, or one of the vendors, is (or is deemed to be) a non-resident. From 1 July 2017, the rate is set to increase to 12.5%.

The rules have significant practical implications, including for mining M&A deals. Importantly, vendors of direct real property interests are deemed to be non-residents for the purposes of these rules and will need ATO-issued clearance certificates to avoid withholding. Real property valued at less than $2 million is excluded from the regime, however the threshold will reduce to $750,000 from 1 July 2017.

  • (c) Foreign investment in Australian residential property

A number of measures have been introduced over the last 12 months which have increased the costs of non-residents investing in Australian residential property. The changes are largely a response to public concern about rising property prices in Australia’s capital cities, and a perception that young families are being ‘priced out’ of home ownership. Key changes include increases in stamp duty and land tax in some States, as well as a proposed ‘vacancy tax’ where a foreign-owned property is not occupied or available for rent for 6 months in a year, and increase in restrictions on foreign ownership of new developments and subdivisions.

  • 5.4 New German treaty As noted in last year’s report, Australia and Germany entered into a new tax treaty in November 2015 which reflects a number of changes to the OECD model treaty recommended as part of the BEPS process. The treaty came into force in December 2016, and applies from 1 January 2017 in respect of withholding taxes and from 1 July 2017 in respect of income tax.

  • 5.5 Goods and services tax As reported last year, from 1 July 2017 Australian GST will apply in respect of services or intangibles provided to Australian consumers offshore (this so-called ‘Netflix tax’ was announced in the 2014-15 Federal Budget). However, the Government has announced that digital currency (such as bitcoin) will be treated as money, rather than intangible property, for GST purposes so that supplies of digital currency will not be subject to GST. The proposal described in last year’s report to apply Australian GST to ‘low value’ goods imported into Australia (previously goods valued at less than A$1,000 were exempt) using a ‘vendor registration’ model is likely to be legislated. However, the start date is likely to be deferred from 1 July 2017 to 1 July 2018. Disclaimer: The material contained in this article is current at the date of publication and is in summary form designed to alert readers to tax developments of general interest. It is of a general nature only, is not comprehensive and is not offered as advice and should not be used to formulate business or other fiscal decisions. Readers should seek their own professional advice before relying on the material contained in this article. Liability limited by a scheme approved under Professional Standards Legislation.