Australia – Key Income Tax Developments – March 2018

18 April, 2018

 

This Bulletin outlines the key Australian income tax developments in the last month affecting your business, including the ATO's Draft Practical Compliance Guideline PCG 2018/D2 on the Diverted Profits Tax.

 

Top 5 developments in tax this month you need to know

 

RELEVANT AREA	AT A GLANCE
CGT for foreign residents and affordable housing	The Treasury Laws Amendment (Reducing Pressure on Housing Affordability Measures No. 2) Bill 2018 has passed the House of Representatives. The Bill proposes to remove the CGT main residence exemption for foreign residents and modify the principal asset test (relevant for shares held by a foreign resident) in the foreign resident CGT rules so it applies on an associate-inclusive basis. The Bill also proposes to increase the CGT discount by 10% for individuals who invest in residential premises used to provide affordable housing (whether directly or through a trust).
Income tax treatment of long-term construction contracts	The ATO has issued Taxation Ruling TR 2018/3, which explains the methods acceptable to the Commissioner on the recognition of income and expenses in long-term construction contracts. The ATO confirms that it is not acceptable to defer the bringing of profits or losses to account until the contract is completed. The ATO accepts either the "basic approach" method (recognise income and expenses on a year to year basis) or the "estimated profits method" (spread the ultimate profit or loss over the period of the contract, if reasonable to do so).
Revised draft legislation on hybrid mismatch rules	Treasury has released revised exposure draft legislation to address "hybrid mismatches". The revised draft incorporates the terms of the previous draft that was released on 24 November 2017 and includes new provisions to reflect OECD recommendations to address branch mismatch arrangements and a targeted integrity rule to address certain financing arrangements.
OECD mandatory disclosure rules for advisors	The OECD released model disclosure rules that require lawyers, accountants, financial advisors, banks and other service providers to inform tax authorities of any schemes they put in place for their clients to avoid reporting under the OECD Common Reporting Standards (CRS) or prevent the identification of the beneficial owners of entities or trusts. The release of the rules is part of a wider strategy of the OECD to prevent behaviour that purports to avoid reporting under CRS and disclosure of assets offshore.
Diverted profits tax	On 9 March 2018, the ATO closed submissions on the draft Practical Compliance Guideline PCG 2018/D2 on the Diverted Profits Tax. We discuss this draft guideline in further detail below.

 

Spotlight on the ATO's draft Practical Compliance Guideline PCG 2018/D2 on Diverted Profits Tax 

 

What you need to know

 

The Australian Taxation Office (ATO) has released a draft Practical Compliance Guideline (PCG 2018/D2) on the Diverted Profits Tax (DPT).  

 

The draft guideline outlines the ATO's compliance approach to DPT and provides some examples of the ATO's application of the sufficient economic substance test, which is one of the exceptions to the DPT applying.

 

If the draft guideline is finalised as currently drafted, the ATO expects taxpayers to self-assess the risk of the DPT applying to their cross-border arrangements having regard to the guideline and initiate engagement with the ATO if they assess that there is a higher than low risk of DPT applying. 

 

Overview of DPT

 

Broadly, the DPT is designed to target arrangements entered into by large multinational taxpayers (global turnover of A$1bn or more) which have Australian resident entities or Australian permanent establishments where:

 

• the taxpayer "diverts" profits offshore to a low-tax related party which results in an overall tax reduction on the profit by more than 20%; and 
• it would be concluded that the arrangement does not have "sufficient economic substance". 

 

The Commissioner is empowered to impose a significant "diverted profits charge" on the taxpayer at a rate of 40% of the diverted profit, and if invoked, there will be prescribed periods in which the taxpayer may request a review and/or challenge the assessment.

 

Overview of Draft Practical Compliance Guideline (PCG 2018/D2)

 

On 7 February 2018, the ATO released the draft Practical Compliance Guideline (PCG 2018/D2) on the DPT and invited comments on the draft by 9 March 2018.

In the draft guideline, the ATO outlines its compliance approach to DPT and provides some high and low risk examples of the ATO's application of the "sufficient economic substance" test.  We discuss these aspects below.

 

Compliance approach to DPT 

 

Overall, the guideline outlines the ATO's expectation that identification of DPT risks is a two-way process between the ATO and taxpayers. 

 

The ATO states that it expects that a DPT risk will usually be identified in the course of its ordinary compliance activity. If such a risk is identified, the ATO's approach depends on the circumstances of the taxpayer and the arrangement and may range from, for example, ongoing monitoring of the risk or escalating the matter to audit. 

 

Notably, the ATO states that it also expects taxpayers to initiate engagement with the ATO if the taxpayer considers that there is a DPT risk associated with its arrangements that is higher than low risk.  

 

The framework provided in the guideline for determining the level of DPT risk is as follows:

 

Firstly, no taxpayer engagement is expected by the ATO if the taxpayer's arrangement is covered in the green zone or white zone of PCG 2017/1 (which deals with transfer pricing issues related to centralised operating models involving procurement, marketing, sales and distribution functions) or PCG 2017/4 (which deals with cross-border related party financing arrangements and related transactions). 

Broadly, an arrangement is in the green zone if the taxpayer assesses that the arrangement is low risk within the relevant guideline, or is in the white zone if the arrangement is already covered by an Advanced Pricing Arrangement (APA), settlement or other agreement with the ATO or has been the subject of an ATO review within the last 2 years, and there have been no material changes in the circumstances of the arrangement since the agreement or review. 

 

If the taxpayer's arrangement is not covered in the green or white zone of PCG 2017/1 or PCG 2017/4, the taxpayer is to self-assess the level of DPT risk of their arrangement.  To assist, the ATO provides various framing questions in the guideline which are stated to be indicative of the matters that the ATO is likely to consider in assessing the level of risk.  

These questions include whether the arrangement involves:

 

• 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. 
   

If the taxpayer assesses that the DPT risk level is higher than low risk, the ATO expects that the taxpayer will initiate engagement with the ATO on their arrangements, with the main avenues of engagement being:

 

• seeking an APA on the arrangement (discussed further below);
• applying for a private ruling; and
• contacting the ATO's DPT specialist team.

 

Only transactions covered by APAs entered into on or after 4 April 2017 (being the date of enactment of the DPT) or where the application for the APA was received on or after that date will be given a low risk rating.

 

The ATO states that, if taxpayers wish to obtain further comfort on the protection afforded by an APA, the ATO may agree to insert a standard DPT clause in the APA to the effect that the ATO will not seek to apply the DPT to the transactions and income years covered by the APA, if requested at an early stage in the engagement process by the taxpayer.

 

High and low risk scenarios in sufficient economic substance test

 

The second key aspect of the guideline is that it provides 10 scenarios of the ATO's application of the sufficient economic substance test and the ATO's assessment of whether variations in the scenarios results in a high or low risk outcome.

 

Broadly, the scenarios deal with the following types of arrangements:

 

• lease in lease out arrangements;
• migration of valuable intangible assets offshore;
• limited risk distributor arrangements;
• marketing hub arrangements; and
• insurance arrangements.

 

Whilst it is stated in the guideline that the scenarios are provided to illustrate some of the matters the ATO will consider in assessing risk in relation to the test, the ATO's risk assessment in the scenarios are based on the specific factual circumstances of the scenarios.  

 

Therefore, the scenarios may not provide a clear indication of the ATO's likely conclusion on a taxpayer's arrangement, to the extent the taxpayer's arrangement deviates from the scenario.  

Further, even if a taxpayer were able to assess that their arrangement is comparable to a "low risk" scenario, the ATO states that a low risk assessment of the scenario does not necessarily preclude the application of other tax provisions to the arrangement, such as the transfer pricing or other anti-avoidance rules to the arrangement. 

 

For further information, please contact:

Vivian Chang, Partner, Ashurst
vivian.chang@ashurst.com