8 August 2022
In Brief
The Government’s proposed multinational tax integrity and enhanced tax transparency measures, which were first announced as part of the Labor Government’s 2022 election commitment platform, are some of the most significant and wide-reaching tax integrity measures seen for many years.
On 5 August 2022, the Federal Treasury released a Discussion Paper to consult by 2 September 2022 on the implementation of proposals to:
- amend Australia’s existing thin capitalisation rules to limit net interest deductions for multinational enterprises (MNEs) to 30 per cent of Earnings Before Interest, Taxes, Depreciation, and Amortisation (EBITDA) (i.e. an earnings based ‘safe harbour’ test) in line with the Organisation for Economic Cooperation and Development (OECD)’s recommended approach under Action 4 of the Base Erosion and Profit Shifting (BEPS) Action Plan
- introduce a new rule limiting an MNEs ability to claim tax deductions for payments relating to intangibles and royalties that lead to insufficient tax paid outside of Australia, and
- ensure enhanced tax transparency by MNEs through measures such as public reporting of certain tax information on a country-by-country basis; mandatory reporting of material tax risks to shareholders; and requiring tenderers for Australian government contracts to disclose their country of tax “domicile”.
Although these measures were first announced by the Government as part of their election commitments to apply from as early as 1 July 2023, the Discussion Paper remains silent on the proposed commencement dates. There is still a long way to go before these measures are to be legislated and this consultation is the first opportunity taxpayers have to comment on the proposals and provide Treasury with feedback on the practical issues associated with these measures. The Discussion Paper does not include details of how these proposals would apply, but rather raises a series of questions relating to the manner and form in which the proposals could be implemented.
In Detail
Changing the thin capitalisation rules
The Government has committed to adapting Australia’s thin capitalisation rules to align with the OECD’s recommended approach under Action 4 of the BEPS Action Plan. Broadly, this approach limits net interest deductions to 30 percent of EBITDA in place of the existing safe harbour debt test. According to the Discussion Paper:
The policy intent of a fixed ratio rule based on earnings is to ensure that an entity’s interest deductions are directly linked to its economic activity and the entity’s taxable income, which can help protect against tax planning practices. Compared to the current assets-based safe harbour, the OECD recommended approach recognises that ‘thinly capitalised’ entities with high debt-to-asset ratios can still use various tax planning strategies to shift profits out of Australia (for example, by maximising debt-deductions via relatively high interest rate loans).
The Discussion Paper poses a question as to whether the EBITDA test should be based on a tax or accounting ratio. The OECD’s best practice approach adopts a tax basis for determining EBITDA (that is, a modified calculation based on taxable income), with a recommendation that countries set their benchmark fixed ratio within a range of 10 to 30 per cent. The good news for Australian taxpayers under this proposal is that the Government has opted for a fixed ratio at the top end of this range (i.e. 30 per cent).
The Government recognises that entities can be highly geared on commercial terms allowing them to claim higher levels of deductions. To accommodate this, and in a welcome move, the Government is proposing to retain the current arm’s length debt test (although it is open to modifying the existing test to address compliance and integrity issues) and some form of specific group ratio rule (the Discussion Paper notes that this could be the existing worldwide gearing test and/or a new earnings-based group ratio rule) to provide some flexibility for highly leveraged groups.
It is proposed that the fixed ratio rule will target ‘general entities’ as defined in the current thin capitalisation legislation. Financial entities and authorised deposit-taking institutions (ADIs) would, in the interim, continue to be subject to the existing thin capitalisation rules and are proposed to be excluded from the fixed ratio (namely EBITDA) rule. Although there is also a specific consultation question asking whether there should be any changes to the existing rules applicable to financial entities and ADIs.
While the Discussion Paper notes that the Government will draw on approaches adopted by comparable international jurisdictions (such as the United Kingdom, Canada, France, Germany and the United States) in implementing the fixed ratio rule, it is lacking in the detail that is needed to answer many questions that taxpayers are likely to have regarding these proposals.
For example, whilst the Discussion Paper contemplates a de minimis threshold to exclude low risk entities from the interest limitation rule (similar to the existing AUD 2 million de minimis threshold), it makes no comment on the potential to carry-forward or carry-back denied interest deductions or excess interest capacity, which is a common feature of similar rules in other jurisdictions.
The Discussion Paper also makes no mention of the proposed start date for these new thin capitalisation rules (which has been announced previously as applicable from 1 July 2023), and whether there would be any transitional measures for existing funding arrangements. This is important as taxpayers will need more information to prepare for any potential change in the after-tax cost of existing and proposed financing arrangements and to prepare for volatility in the after-tax outcome if there is no carry forward/back of any excess interest when the new rules take effect.
Denying deductions for certain payments relating to intangibles and royalties
The Government is proposing a specific new integrity rule to deny deductions for payments relating to intangibles and royalties paid to low or no-tax jurisdictions or that lead to insufficient tax being paid outside of Australia. Whilst the Discussion Paper acknowledges that Australia’s existing rules, including the transfer pricing rules, general anti-avoidance provisions, principal purpose tests (or similar rules) in Australia’s bilateral tax treaties and the controlled foreign company (CFC) rules, go some way in tackling the integrity concerns relating to intangibles and royalties, it argues that Australia’s tax framework needs a specific measure targeting these integrity issues.
The Discussion Paper sets out some policy design issues for consultation including:
- Taxpayers in scope: The Discussion Paper contemplates limiting the new integrity rule to Significant Global Entities (SGEs), and possibly even further to corporate tax entities that are SGEs.
- Payments in scope: This includes issues such as whether both royalties and ‘embedded royalties’ (i.e. which is not defined in tax law but apparently arises where there is bundled supply of tangible goods and/or services and no component is separately recognised as a royalty although it is asserted to have the characteristics of one) are within scope, and whether any other types of payments should be covered by this policy. It specifically discusses risks identified in Taxpayer Alerts TA 2018/2 relating to ‘embedded’ royalties, and TA 2020/1 relating to the migration or mischaracterisation of Australian activities connected with the DEMPE of intangible assets. The Discussion Paper also seeks views on whether the proposal should cover payments to both related and unrelated parties, noting that “[t]o ensure integrity risks are appropriately captured, it may be necessary to apply the measure to arrangements that involve both related and unrelated entities. This would also more effectively build upon, and be consistent with, other aspects of Australia’s tax law framework.” The impact on the cost of doing business in Australia will be just one of the many issues associated with any new policy approach and scope in this area.
- Low or no-tax jurisdictions, or insufficient tax: The Discussion Paper highlights a range of options - including existing concepts in the tax law - that could be used to identify “low or no-tax jurisdictions” (a concept that, historically, Treasurers have been reluctant to define), or situations where payments lead to insufficient tax, and seeks views on which option may be appropriate for this measure. These options include taking concepts from the existing hybrid mismatch targeted integrity rule (the so-called low-rate lender rule), the OECD’s Pillar Two Global Anti-Base Erosion Rules minimum tax rate, the existing sufficient foreign tax test in the Diverted Profits Tax, identifying intellectual property tax-preferred regimes, or developing a new bespoke list of low tax jurisdictions for this measure.
There is no mention of a “purpose test” for this measure, which has the potential to considerably increase the scope of payments caught. From as far back as 2019 the then opposition explained that any reforms in this area will be combined with a ‘dominant purpose’ test so that the measure is targeted for the integrity of the tax system. It will be important to understand whether this is a feature of the rules even though it does not appear in the Discussion Paper, given the potential scope becomes much broader without a purpose qualification.
The treatment of deductions relating to intangibles, software and royalties has been a focus area of the Australian Taxation Office (ATO) for some time, and this new proposal is the latest measure to specifically target profit shifting via these types of payments. The proposal is said to be consistent with actions taken by other jurisdictions, and the Discussion Paper provides an overview of some of these actions.
Similar to the interest limitation rule discussed above, there is still much detail to come. The Discussion Paper has no mention of the proposed start date (previously announced as from 1 July 2023) or any transitional measures that might be appropriate for existing arrangements.
Multinational tax transparency
Tax transparency is high on the Government’s agenda, and the election commitments which address new transparency measures are just one part of an overall transparency agenda. The Discussion Paper notes the existing tax transparency measures that are embedded into Australia’s tax law, as well as the Voluntary Tax Transparency Code and the Global Reporting Initiative (GRI). Before considering the specific election commitment transparency initiatives, the Discussion Paper poses a general question as to whether any specific features could be introduced to improve how multinationals publicly report tax information.
In relation to the commitment to require large multinationals to publicly report tax information on a country-by-country (CbC) basis (such as high level data on the amounts of tax paid in the jurisdictions they operate, and the number of employees in these jurisdictions), a wide range of matters are raised. A general question is posed as to whether the SGE definition is the appropriate threshold at which any form of enhanced public reporting of tax information would apply and whether it should apply to a broader range of entities.
When it comes to the information that would be publicly reported, the Discussion Paper seeks views around the approaches adopted by the European Union, the GRI’s new tax Standard – GRI 207: Tax 2019 or by legislating the Voluntary Tax Transparency Code as a basis for mandating public CbC reporting in Australia. It also seeks views on the form and administrative aspects of any public reporting which is an important consideration for affected taxpayers when it comes to considering the compliance aspects of the obligation.
Another aspect of the Government’s increased tax transparency initiative is that it will require companies to disclose to shareholders “material tax risk” to assist shareholders to better understand their investments and any tax structuring arrangements of the company. The Discussion Paper seeks stakeholder views on how this disclosure could be made and what sort of “risk” such disclosure should address. For example, it flags the potential for high-risk arrangements that are identified in the ATO’s key Practical Compliance Guidelines or where taxpayers invest in low tax jurisdictions as the sort of arrangements that listed companies should disclose to shareholders.
The final aspect of the transparency initiatives raised in the Discussion Paper is to require that tenderers for Commonwealth Government contracts worth more than AUD 200,000 (inclusive of GST) disclose their country of tax domicile. This would supplement the existing requirement for tenderers with contracts that have an estimated total value of over AUD 4 million (including GST) to obtain a Statement of Tax Record from the ATO to evidence satisfactory engagement with the tax system in respect of their tax registration, payment and lodgment obligations. It remains to be seen whether the concept of tax domicile introduces a new definition and test that differs from tax residency, noting that clarification of Australian tax residency definitions remains subject to legislative reform.
It is worth noting that legislation has already been passed by the new Parliament which has extended public transparency of corporate taxpayers with amendments made to increase the number of companies for which the Commissioner of Taxation reports annually in a Corporate Tax Transparency report taxpayer details on total income, taxable income and tax payable. Specifically, with effect from the 2022-23 income year, all companies (whether public or private or domestic or foreign owned) will be subject to this reporting where they have total income of at least AUD 100 million.
More yet to come
The Government’s other multinational tax initiatives, including Australia’s implementation of the OECD two-pillar solution to address the tax challenges of the digitalisation of the economy and creating a public registry of beneficial ownership to improve transparency on corporate structures to show who ultimately owns (or controls) a company or legal vehicle are yet to come.
The Takeaway
With a potential start date as early as 1 July 2023, there is not much time for the details for these measures to be developed and legislated and also for affected taxpayers to plan ahead for their upcoming application. The time frame to respond to the Discussion Paper is limited with comments due to be made in response to the Discussion Paper by 2 September 2022. PwC will be making a submission. Accordingly, now is the time for affected taxpayers to raise concerns and respond to the issues on which clarity is needed, particularly when it comes to the practical application of the proposed measures.
The Government will issue and consult further on exposure draft legislation prior to introducing any legislation into Parliament, following consideration of responses to this Discussion Paper.
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Contact us
Michael Bona
Partner, International Tax & Trade Leader, PwC Australia
Tel: +61 405 136 010