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26 May 2023
In brief
The Australian Taxation Office (ATO) has released a draft Practical Compliance Guideline, PCG 2023/D2 (the draft PCG), on intangibles arrangements involving international related parties. This draft PCG replaces PCG 2021/D4 which was released in May 2021 and as summarised in PwCs Tax Alert here.
The draft PCG sets out the ATO’s compliance approach to cross border intangibles arrangements with related parties. More specifically, it addresses the key risks considered for arrangements that involve:
- the ‘migration’ of intangible assets; and/or
- the development, enhancement, maintenance, protection and exploitation (DEMPE) of intangible assets.
In assessing risk, there is a significant focus on the potential application of transfer pricing rules and the general anti-avoidance rules (GAAR) to these intangibles arrangements, although it is noted that the ATO will take into account other Australian tax provisions that may be relevant such as capital gains tax and capital allowance provisions.
The draft PCG introduces a quantitative framework to assess whether the ATO will consider certain intangibles arrangements to be high, medium or low compliance risk. The rating assigned will then determine the likely level of action or engagement that the ATO will take. Taxpayers with high risk ratings will be prioritised and can expect further reviews or audits.
The risk assessment framework requires a number of particular features of the arrangements to be considered with points assigned for features that are regarded as indicative of risk. Evidence and documentation expectations are set out to inform taxpayers of the nature and extent of information and analysis that the ATO may expect to see to support and substantiate intangibles arrangements.
The draft PCG does not address the ATO’s future compliance approach for the new intangibles integrity measure (under which Exposure Draft Law and Explanatory Materials were released on 31 March 2023) which seeks to deny deductions relating to payments for intangible assets connected with low corporate tax jurisdictions.
Taxpayers that have, or are contemplating, international related party transactions involving intangible assets will need to consider the draft PCG including self-assessing risk under the framework included in the draft PCG and potentially disclosing those outcomes in future annual Reportable Tax Position (RTP) Schedules. Taxpayers may also be required to substantiate their self assessments in ATO compliance activity or as part of applying for or compliance with an Advance Pricing Arrangement (APA).
Comments can be made to the ATO on the draft PCG until 16 June 2023.
In detail
Scope of the guidance
Practical Compliance Guidelines (PCGs) provide guidance to taxpayers as to how the ATO will administer the law. They are intended to assist taxpayers in complying with tax laws and are non-binding on the ATO. The ATO has issued several PCGs since 2017 including in respect of tax issues associated with cross-border financing arrangements, transfer pricing issues related to inbound distribution arrangements, the diverted profits tax (DPT) and the imported hybrid mismatch rule.
The draft PCG applies to cross border intangibles arrangements with related parties. The scope is broad and can potentially include a wide range of operating models where intangible assets are developed or used in cross border settings.
Intangibles arrangements covered in the draft PCG are arrangements relating to the DEMPE associated with intangible assets and/or the ‘migration’ of intangible assets. The former might include, for example, intangible assets which are held offshore where development activities occur in Australia under a R&D services arrangement or where exploitation occurs through manufacturing or marketing activities. Regarding the latter, the draft PCG states that migration means a “restructure or change associated with your intangible assets”.
There is to be a particular focus on the risks relating to potential application of transfer pricing rules and the GAAR (including DPT) to intangibles arrangements. However, other Australian tax provisions may also be considered relevant to particular arrangements, for example capital gains tax and capital allowances provisions.
Noting that the ATO may apply different evidence expectations to different taxpayers (considered below), there are no materiality thresholds in the draft guidance, so it applies equally regardless of the size or value of the arrangement or taxpayer.
Risk rating outcomes under the draft PCG will be considered by the ATO in relation to taxpayers seeking entry to the APA program. The ATO will expect evidence of the nature set out in the draft PCG for taxpayers seeking entry to APA and during the APA period.
Once finalised, the PCG will apply before and after its date of issue.
Risk assessment framework
The draft PCG introduces a quantitative framework to assess and provide a single outcome as to whether each intangibles arrangement is high, medium or low risk.
It is first necessary to identify all intangibles arrangements. This is broadly based on considering each individual intangible asset and treating all agreements that relate to that intangible asset as a single intangibles arrangement. It is recognised that intangible assets may be naturally grouped (for example by a particular product) and in such circumstances grouping is permitted.
The risk assessment framework is based on a flowchart which is applied to each intangibles arrangement. If two ‘threshold’ questions are passed, further questions determine whether Risk Assessment Framework Table 1 or 2 or both should be applied in assessing the risk rating for that intangibles arrangement.
One of the threshold questions provides that intangibles arrangements which exhibit features or characteristics of Taxpayer Alert TA 2020/1 (TA 2020/1) will automatically be classified as high risk. TA 2020/1 was issued to provide examples of concerns that the ATO had in relation to the mischaracterisation of Australian DEMPE activities connected to intangible assets. It specifically includes, but is not limited to, arrangements involving the bifurcation of intangible assets and mischaracterisation of Australian DEMPE activities, and non-recognition of DEMPE activities. In this regard, there is a degree of overlap with the draft PCG.
The framework then requires taxpayers to consider and complete a risk table, for each of their intangibles arrangements.
Migration of intangible assets
For arrangements where there has been a migration of intangible assets during the year, Table 1 will need to be considered. A migration of intangible assets is broadly defined as any restructure or change associated with the intangible assets that allows another entity to access, hold, use, transfer, or benefit from the intangible assets.
Table 1 is broadly focussed on assessing the risks by reference to the degree of change that has taken place and the level of substance in respect of DEMPE activities to support the change. It also considers particular tax features or consequences both in Australia and outside Australia that might be seen as indicating higher compliance risk.
Table 1- Migration of intangible assets*
| Risk factors | Features | Points assigned |
|---|---|---|
| A. Restructure or change | Question 1
|
5 points |
Question 2 If, in connection with the change or restructure identified in Question 1, the arrangement involves your continued use or benefit of the intangible assets or you continue to be involved in the DEMPE functions. |
5 points | |
| B. Substance of the relevant entity | For the relevant entity (that is, the international related party, or parties identified in the restructure or change), identify which of the following three categories best describes the relevant entity: Category 1
Category 2
Category 3
|
Category 1 - 15 points Category 2 - 9 points Category 3 - 0 points If the relevant entity is resident in the jurisdiction which is also the jurisdiction in which the products or services related to the relevant intangible assets are predominantly sold - deduct 5 points. |
| C. Tax Outcomes | If one or more of the following applies:
|
Add 10 points |
If as a result of the restructure or change to the intangible assets:
|
Add 10 points |
* Please note Table 1 has been simplified for this publication and so reference should be made to the actual wording in PCG 2023/D4.
Mischaracterisation of DEMPE activities
Where a migration of intangible assets has not occurred, taxpayers will need to consider Table 2. The focus of the risk assessment in Table 2 is on understanding and assessing the degree of substance of the DEMPE related activities currently being performed in Australia and by the owner of the intangible assets as well as examining the overall tax outcomes of the arrangements.
Where a migration of intangible assets from Australia has occurred in the previous year, Table 1 will also need to be considered for the year the migration occurred as well as Table 2 for the current year.
Table 2 - Mischaracterisation of DEMPE activities#
| Risk factors | Features | Points assigned |
|---|---|---|
| A. Overall characterisation | If
Then consider how many of the following factors apply:
|
If one factor applies - 10 points If two factors apply - 15 points If three factors apply - 20 points |
| B. Substance of the relevant entity | Which category best describes the relevant entity (that is, the international related party counterpart): Category 1
Category 2
Category 3
|
Category 1 - 15 points Category 2 - 9 points Category 3 - 0 points |
| C. Tax outcome | If:
|
5 points |
# Please note Table 2 has been simplified for this publication and so reference should be made to the actual wording in PCG 2023/D4.
Determining the risk rating
For both Risk Assessment Framework Tables, a score of 25 points or more will result in a high risk rating, a score of 19-24 points will result in a medium risk rating and a score of less than 19 points will result in a low risk rating. There is no ‘white zone’, as included in other PCGs, to cover scenarios where an intangibles arrangement is subject to an existing APA or settlement outcome and has not materially changed.
The risk rating assigned to the intangibles arrangement then determines the level of engagement to expect from the ATO. Low risk arrangements will mean the ATO is unlikely to prioritise compliance resources to further examine or audit the arrangements, particularly where the ATO has verified the assessment. High risk arrangements will likely involve a further review or audit.
Taxpayers will need to form a number of qualitative views on factual questions in order to complete and evidence their own risk assessments. Whilst the framework uses a points system based on particular criteria and features relating to the intangibles arrangements, a number of those criteria will require subjective and qualitative assessments. The level of detail to answer the questions and provide evidentiary support to complete the assessment will likely go beyond the level of detail in the transfer pricing documentation prepared for some taxpayers.
Importantly, the assessment will require a high degree of detailed information in relation to the functions performed by personnel in the international related party that owns the intangible assets, as well as the Australian entity.
A further effect may be to bring into scope all past migrations of intangible assets where there remains any ongoing arrangement to exploit those intangible assets. For example, the past transfer of an intangible asset (such as a trademark) by a taxpayer may be subject to the Risk Assessment Framework in both Table 1 and Table 2 where there is ongoing exploitation of that intangible asset by that taxpayer (such as ongoing marketing activities in respect of that trademark).
Evidence expectations
PCG 2023/D4 sets out examples of the type of evidence that the ATO is likely to want to examine when reviewing intangibles arrangements. The draft PCG notes that the list is intended as a general guide and is not exhaustive. It is also noted that some of the examples of evidence may not be relevant in certain facts and circumstances.
Importantly, the evidence expectations are not intended as a substitute for the transfer pricing documentation requirements under Australian tax law.
Examples of the evidence required to substantiate intangibles arrangements include:
- Evidencing the commercial reasons and your decision-making process (in circumstances where there has been a change or restructure in relation to the intangibles arrangement)
- Analysis of the commercial objectives and anticipated outcomes, whether prepared internally or by independent advisors, such as cost-benefit analyses, modelling/projections, etc.
- Documents considering the tax implications (Australian and foreign) of the arrangement (especially prior to a restructure)
- Minutes of board and other meetings where the options were discussed and considered
- Evidencing the legal form and substance of your Intangibles Arrangements
- Legal agreements
- Policies, manuals, and guidelines
- Transfer pricing documentation
- Identifying and evidencing the intangible assets and connected DEMPE activities
- Intangible asset registers
- IP registration documents
- Accounting records
- Organisation charts and role descriptions of personnel involved in DEMPE activities
- Correspondence about DEMPE activities
- Evidence about approvals and decision making on DEMPE activities and intangibles
- Evidencing the tax and profit outcomes of your Intangibles Arrangements
- Comparability studies, projections, modelling, tax profile of relevant entities
The draft PCG is clear that evidence is key to substantiating the self-assessed risk rating. For inbound groups in particular it is likely that a significant level of support will be required from offshore affiliates in obtaining the relevant evidence needed to support the intangible arrangements.
The evidentiary burden may be challenging for some taxpayers, and particularly smaller taxpayers to manage, although there is acknowledgement in the draft PCG that the type and level of evidence expected will be influenced by the complexity of the business and the extent to which the relevant intangibles arrangements contribute to that business.
Examples
The draft PCG includes 13 examples which are intended to illustrate the kind of matters that the ATO will consider when assessing compliance risks in different fact patterns. Each example sets out the facts of the arrangement and then applies the risk assessment framework to arrive at an overall risk rating score. The particular tax provisions likely to be most relevant are identified as part of the risk assessment.
The examples include fact patterns involving:
- The migration of Australian owned intangible assets to a central entity in circumstances where the Australian entity then pays royalties for access to the previously owned and future intangible assets (examples 1, 7 and 10);
- The sale by an Australian entity to a new international related party of the rights to offshore intangibles that previously resulted in royalty income in Australia (example 2);
- An international related party being granted access to intangibles assets that are owned and developed and exploited in Australia by an Australian entity without an agreement or compensation (example 3);
- An Australian company developing pre-commercialised intangible assets that are then transferred to an international related party for further development and commercialisation (example 4, 5 and 8);
- The transfer of intangible assets to a foreign hybrid entity (example 6);
- Contract R&D services being provided by an Australian company to an international related party (example 9 and 11);
- The entry into a cost contribution arrangement (CCA) to pool intangible assets and share risks and costs of development between related party owners of intangible assets (example 12); and
- Contract R&D services being provided to an Australian company by an international related party service provider (example 13).
The examples will be helpful as a practical guide to how the ATO envisages the risk framework to be applied. However, taxpayers will need to consider their own specific facts and circumstances in undertaking their own risk assessments.
The ATO notes that any references to particular intangible assets, industries or commercial activities in the examples are anecdotal and does not limit the particulars of the example arrangements to any one industry.
The Takeaway
The core issues of ATO concern are clear (such as arrangements that lack commercial rationale, misalignment of form and substance, and/or inappropriate transfer pricing), the draft PCG will have broad application and many taxpayers are likely to need to consider the risk assessment framework and self assess risk ratings in completing RTP Schedules in future years.
For taxpayers who have related party arrangements involving intangible assets, or are considering potential new intangibles arrangements, it remains important to ensure documentation and evidence is collated to support the commercial rationale and expected benefits for the arrangement implemented (including the reasons why it is preferred over other alternatives).
It is also important to ensure that the evidence adequately supports the legal form and economic substance of each intangibles arrangement, and the arm’s length nature of transfer pricing policies and valuations applied.
There is still scope for further changes to the draft PCG through the feedback process. However, once finalised, the PCG and its risk assessment framework will need to be considered by all taxpayers as part of their annual RTP schedule and in considering the level of expected engagement with the ATO in relation to intangible arrangements.
Nick Houseman
Chris Hogger
Helen Fazzino
Michael Bona
Angela Danieletto
Edin Mahir
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