By Zara Richie, Head of Global Transfer Pricing Services, BDO, Melbourne
The Australian Tax Office’s (ATO’s) latest guidance issued in relation to the diverted profits tax (DPT) will be a useful practical tool for Australian taxpayers even though the draft comes nearly a year after the DPT was introduced.
The DPT is an anti-avoidance provision affecting significant global entities (where global turnover is A$1bn or more). When the DPT is found to apply, a penalty tax rate of 40% plus interest will be imposed with no access to Australia’s double tax treaties.
The ATO issued in draft it’s practical guidance as PCG 2018/D2 in February 2018. This information is part of a suite of guidance already issued in relation to the DPT. It will be of particular use to taxpayers’ in self-assessing their level of DPT risk and what, if any, further work is required to support their position and avoid the application of the DPT.
Among other aspects, PCG 2018/D2 provides example scenarios of ‘high-risk’ and ‘low-risk’ cases to assist in determining whether sufficient economic substance exists to support the allocation of profit or prices set between international related parties. These scenarios highlight the far-reaching nature of the DPT legislation and the extent of analysis and evidence needed to prove that the DPT provisions do not apply in the taxpayer’s circumstances.
Although still in draft, recent experience suggests that changes to the final PCG are unlikely to be material. Given the potentially significant impact of DPT legislation companies will need to act early.
DPT law
The DPT law is an anti-avoidance measure that was introduced in the 2016/17 Budget and that came into effect on 1 July 2017. It was designed to ensure that significant global entities (SGEs) do not reduce the amount of Australian tax by diverting profits offshore (to low tax jurisdictions) through arrangements with related parties.
In general terms, the DPT law applies if, under a scheme or in connection with a scheme:
- A taxpayer has obtained a tax benefit in connection with the scheme in an income year;
- A foreign entity, that is an associate of the taxpayer in question, entered into or carried out the scheme or is otherwise connected with the scheme;
- The principal purpose, or one of the principal purposes of the scheme, is to obtain an Australian tax benefit or to obtain both an Australian and foreign tax benefit (i.e., the so-called “principal purpose test”); and
- None of the following exceptions apply:
- The A$25 million income test;
- The sufficient foreign tax test; and
- The sufficient economic substance test.
The DPT law is applicable to income years starting on or after 1 July 2017. However, it can apply to schemes entered into before 1 July 2017 (which continue after 1 July).
Given DPT is part of Australia’s avoidance provisions, it will override Australia’s double taxation treaties and effectively leave affected taxpayers open to double taxation.
ATO compliance and engagement approach
The draft PCG 2018/D2 provides guidance on the ATO’s compliance approach to the DPT. In addition, it outlines the client engagement framework, framing questions to aid in risk assessment as well as suggested documentation and information requirements. Also included are 10 high and low-risk scenarios to test the extent of sufficient economic substance.
Any DPT risk will generally be identified in the normal course of the ATO’s compliance activity. If identified, the ATO will decide whether to conduct a review at that time or continue monitoring the perceived risk.
The ATO expects taxpayers to self-assess their DPT risk and then engage with the ATO under their client engagement framework. The main avenues of engagement with the ATO include:
- Applying for an advance pricing arrangement (APA);
- Applying for a private ruling; or
- Contacting the ATO’s DPT specialist team to discuss specific arrangements.
Any of these avenues are likely to involve comprehensive review of information, documentation, and evidence to support the company’s position and, undoubtedly, a quasi-audit.
Framing questions
The PCG includes a guide as to the framing questions the ATO might ask. The nature of the questions highlights the transactions the ATO believes will be of higher risk for the DPT to apply.
The initial questions will cover whether DPT applies in principle.
If the answer to the initial questions is yes AND international related party dealings are with an entity with an effective tax rate of 24% or lower, the arrangement may be within the scope of DPT.
The ATO has identified the following transaction specific areas to assess DPT risk:
- the transfer or effective transfer of valuable intangible assets offshore
- the transfer or effective transfer and/or centralisation of functions and/or risks offshore
- a significant transfer of value relative to overall profitability
- the mischaracterisation of payments (for example, service fees rather than royalties)
- the use of hybrid entities and/or instruments
- back-to-back or flow-through arrangements
- the booking of profit offshore in a manner disproportionate to staff headcount and/or capability, or
- any other features that are unusual having regard to the nature of the relevant business operations.
Sufficient economic substance (SES) test
The ATO has identified areas to assess to determine whether an arrangement satisfies the SES test. This is the most critical and comprehensive section of the guidance and, depending on the quality of existing transfer pricing analysis and documentation, could result in considerable additional work for SGEs with potential DPT risk.
The areas identified are as follows:
- commercial rationale and whether objectives were achieved
- legal form v substance
- evidence of market conduct and industry experience
- where a business restructure has occurred, assess the competencies of overseas parties to manage assets, carry out functions and manage, control and fund risks
- a heavy focus on risks. including commercial and financial capacity to bear risk
Principal purpose test (PPT)
Additional questions the ATO may consider in determining whether or not the principal purpose test has been satisfied may cover:
- commercial assessment of the arrangements
- alternatives/options available
- commercial versus tax reasons for the arrangement
- quantifiable non-tax financial benefits of the arrangement.
What is most concerning with this line of questioning is the implied commercial assessment of the arrangements by the ATO.
Time will tell how the ATO accepts a taxpayer’s own commercial assessment/objectives versus imposing their own assessment.
Risk assessment scenarios
The ATO has outlined a number of scenarios to illustrate some of the matters they will consider in assessing risk in relation to satisfying the test of SES.
There are 10 scenarios and, in most cases, both high- and low0risk scenarios for each. Notably, there is only a ‘high-risk’ scenario for marketing hubs. The examples cover:
- Lease in and lease out arrangement (foreign head-lessor)
- Intangibles migration overseas in pharmaceutical group
- Australian limited risk distributor
- Intangibles migration (run up run down scenario, i.e. IP transfer from Australia overseas where new IP is created overseas and Australian IP value is wound down)
- A marketing hub, which is only high-risk
- An insurance arrangement, which is only low-risk
The threshold for moving from high0risk to low-risk appears narrow, subjective, and is based on the facts and circumstances (rather than legal agreements). This highlights the need for multinationals to maintain robust, comprehensive, and sophisticated transfer pricing analysis to support arrangements with related parties in low tax jurisdictions if there is any possibility that the transactions are within the scope of DPT.
Remaining uncertainty
The guidance provided by the ATO in relation to the DPT is welcome, although doesn’t resolve all of the uncertainty in relation to the application of the law. There are many concerns for Australian taxpayers.
More clarity is needed to understand when the ATO would seek to apply DPT rather than Australia’s ‘ordinary’ transfer pricing provisions. Effectively, all SGEs can be within the scope of DPT where any arrangements with related parties in low tax jurisdictions fall within the higher risk scenarios.
This is unfortunate because, for example, transactions with UK and US-related parties can also be subject to DPT and one would not normally expect such interactions to fall within the scope of an anti-avoidance provision.
Moreover, in an environment where many countries have reduced or are planning to reduce their corporate tax rates, the DPT may trigger unintended consequences, which means all or most transactions may require an increased level of analysis/evidence to reject a potential DPT application.
Heightened analysis
Despite the final set of guidance material issued by the ATO, DPT assessment remains a complex matter that requires comprehensive and thoughtful case-by-case analysis by SGEs,
In most cases, the level of analysis already undertaken is likely to fall short of what is needed to dis-prove a DPT assessment. Therefore, this legislation and guidance imposes a heavy compliance burden.
If a taxpayer has transactions that fall within the framing questions or structures that look like ATO identified scenarios, advice will be required to determine how best to manage and respond to the risk of DPT.
Self-assessment of risk
The ATO expects taxpayers to self-assess the risk of a DPT assessment, however, this is not required under the law.
This expectation is part of a suite of ‘behavioural expectations’ continually expanded by the ATO to influence how they will deal with taxpayers.
Vague guidance
Much of what is outlined by the ATO’s guidance is open to interpretation – or one might say miss-interpretation.
Conclusions must be drawn based on commercial assessments and the extent of any non-tax financial benefits (which are undefined). Moreover, even if a taxpayer believes it has demonstrated its commercial reasons for a particular business structure there is no guarantee the ATO will agree.
One might expect a taxpayer to be in a better position to assess the commercial drivers for its own business operations; however, the last word will be with the ATO.
Changing behaviour
Like other anti-avoidance legislation, the DPT and guidance issued by the ATO is intended to change behaviour.
The ATO does not wish to spend significant resources disputing SGE’s business operations; instead, it seeks to encourage SGEs to (re)structure their operations into more conservative arrangements which arguably favours the Australian tax net.
However, any decisions by SGEs to restructure Australian operations should be approached with caution as there is always more than one side to global business arrangements; and adopting transfer pricing models in favour of Australia may expose the group to challenge elsewhere.
Changed tax environment
The DPT is an anti-avoidance provision with very broad potential application.
SGEs with Australian turnover exceeding A$25m and related party dealings with low tax jurisdictions will need to assess whether or not the DPT and more technical aspects of the law apply (such as the principle purpose test and foreign tax test).
In cases where the DPT could apply, a more detailed analysis of existing transfer pricing documentation, including substantial economic substance, will need to be assessed in relation to each transaction and compared against the ATO’s suggested evidence set out in the draft PCG.
Two or multi-sided analysis is required and it is unlikely most groups’ existing transfer pricing analysis (usually prepared for compliance purposes or penalty mitigation) will be sufficient to reject a potential DPT assessment.
Where the group believes Australia’s DPT provisions could apply, a structured approach is needed to decide how to engage with the ATO to most effectively navigate the DPT.
This requires the taxpayer to understand the ATO’s multi-step process in formulating a DPT assessment; assess DPT risk levels for current and future transactions and appropriately collate evidence for the group’s transfer pricing position both before and after a DPT assessment notice issues.
— Zara Ritchie is BDO’s Head of Global Transfer Pricing Services and Australian Practice Leader. Zara is based in Melbourne and can be reached at [email protected]
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