Denying deductions for payments relating to intangibles connected with low corporate tax jurisdictions

What you need to know

On 23 June 2023, Treasury released further exposure draft legislation in respect of the Government's previously foreshadowed October 2022-2023 budget announcement, denying deductions for payments in respect of intangibles made by Significant Global Entities (SGEs) to associate entities resident in low tax jurisdictions. In summary:

• The provisions will apply to payments made to jurisdictions with a headline corporate tax rate below 15% noting that clarification has been provided with respect to the income tax rate applicable to income derived in the ordinary course of carrying on a business and not any concessional rate that can be applicable to a particular taxpayer or industry;
• New rules have been introduced which provide consideration for amounts which have otherwise been subject to tax under Australia's CFC rules or a foreign income tax at a rate of at least 15%. Such amounts will not be subject to these provisions;
• A deduction denial will be reduced to the extent the payer has remitted Australian royalty withholding tax on that payment;
• Embedded royalties will be captured, i.e. where a payment is purported to be made solely for goods / services but also involves some use of an intangible asset;
• Concerns with respect to the definitions of "intangible asset", "exploit", "arrangement"; and the lack of purpose / substances based tests have not been addressed;
• Penalties will be quadrupled under this new measure. SGEs are already subject to double administrative penalties and under this new provision the potential penalties will be doubled again.

The new measure is not law yet, but is proposed to be effective for  payments from 1 July 2023. Once the law is passed (anticipated to be after 31 July when Parliament resumes) it will apply retrospectively. The Government has noted it is further considering interactions of this measure with global minimum taxes and domestic minimum taxes. Accordingly, the application of these provisions will need to reassessed at the introduction of Pillar 2 minimum taxes, particularly as applicable to embedded royalties and other integrity concerns.

What you need to do

Given the retrospective effect of these rules and that they apply to any existing as well as new structures, we recommend that multinationals review their arrangements to determine whether any restructure or intangible rationalisation may be necessary. This includes reviewing how the group's intangibles are being used in Australia, a subsequent analysis of the group's global supply chains and identification of valuable intangible assets with specificity within the global group.

It will also be critical to proactively document and ensure taxpayers have contemporaneous evidence to support the position to mitigate any potential challenges and/or penalties.

Introduction

On 31 March 2023, Treasury released the first exposure draft legislation (Treasury Laws Amendment (Measures for Consultation) Bill 2023: Deductions for payments relating to intangible assets connected with low corporate tax jurisdictions) in respect of this anti-avoidance measure, in the form of section 26-110 of the Income Tax Assessment Act 1997 (Cth) (ITAA1997), to deny an income tax deduction for payments relating to intangible assets connected with low corporate tax jurisdictions. The policy intent behind this measure aligns with the Government's agenda to limit deductibility for payments which it considers will erode the Australian tax base. 

Following a consultation process with industry and stakeholders, Treasury released a revised exposure draft on 23 June 2023 in the form of Treasury Laws Amendment (Measures for Future Bills) Bill 2023: Deductions for payments relating to intangible assets connected with low corporate tax jurisdictions (Revised ED).

Whilst there were some helpful amendments, many critical issues remain present and many key concepts within the Revised ED remain too broad in their application.

In summary, the rules provide that a taxpayer cannot deduct an amount for a payment it makes to an associate to the extent that the payment is attributable to a right to exploit an intangible asset, if:

1. the taxpayer is a SGE;  

2. as a result of the arrangement, or a related arrangement, the taxpayer or an associate of the taxpayer:

• acquires the intangible asset; or
• acquires a right to exploit the intangible asset; or
• exploits the intangible asset.

3. the above arrangement, or related arrangement, results in the payment being derived by the associate, (or another associate of the taxpayer), in a 'low corporate tax jurisdiction' directly or indirectly from exploiting the intangible asset (or a related intangible asset).

We set out below our observations on the key changes that have been addressed and elements which remain ambiguous.

What have Treasury addressed?

Low corporate tax jurisdiction

The Revised ED has resolved some uncertainties with respect to whether a particular jurisdiction will be considered a low corporate tax jurisdiction. In the initial exposure draft, a low tax jurisdiction was one with a corporate tax rate of 15% or less.  However, unlike its predecessor, the Revised ED clarifies that when determining whether a jurisdiction is a low corporate tax jurisdiction, regard is only to be had to the rate that applies to income derived in the ordinary course of carrying on a business, i.e., its headline corporate tax rate. This means that any concessional rate of income tax that could apply to particular taxpayers or industries are to be disregarded.

The effect of dividends, tax credits, tax losses, tax treaties, concessions for intra-group dividends, industry specific exemptions and exemptions for different types of income are also disregarded.

The updated explanatory memorandum also includes additional examples in identifying low corporate tax jurisdictions. Example 1.3 makes it clear even if a country taxes passive income at a higher rate, it will still be considered a low corporate tax jurisdiction to the extent that the tax rate for trading income is below 15%. Example 1.4 clarifies that reduced tax rates for income for a specific industry or the non-imposition of tax on capital gains will not alter the status of a country, if the corporate headline income tax rate is at least 15%.

This provides greater certainty that the unaffected headline corporate tax rate is the relevant measure.

Notwithstanding the above, the Revised ED maintains the position that jurisdictions with preferential patent box regimes without sufficient economic substance may (even if its headline corporate tax rate is at least 15%) be determined to be low tax jurisdictions if the Minister so determines under a legislative instrument.

Amounts subject to tax

An additional provision (subsection 26-110(4)(b)) has been added to apply in relation to income derived in a low corporate tax jurisdiction, which addresses the actual tax paid on the income received. Even if, income has been derived in a low corporate tax jurisdiction, this provision will apply not to deny a deduction to the extent that income is assessed as:

• Attributable income under Australia's CFC regime; or
• Subject to foreign income tax of at least 15% having regard to:

Inclusion under a foreign CFC regime;

State and municipal income taxes;

Amounts subject to foreign income tax as a result of the application of foreign hybrid mismatch rules.

As noted in the EM, this will require taxpayers to identify the income that is being subject to a particular tax rate or tax treatment in that foreign jurisdiction. As provided in Example 1.5, the taxpayer will need to provide evidence and substantiate the position that an amount of income was subject to at least 15% foreign income tax, i.e. tax returns, working papers and other relevant information.   

Royalty Withholding Tax 

The original exposure draft presented a material risk of double taxation on royalty payments, where royalty withholding tax was already remitted and paid to the ATO. The Revised ED has been amended so that a deduction denial will be reduced to the extent the payer has remitted Australian royalty withholding tax on that payment. This is achieved by grossing up the withholding tax that was actually paid by 30% (SGE corporate tax rate) to determine the deductible portion. A key practical implication is that to the extent withholding tax of less than 30% applies (by virtue of a treaty rate of withholding tax) there remains a portion of the payment that will be denied.

If only part of the payment made is in respect of a royalty, the amount of the denied deduction is reduced proportionally.   

Penalties

The Revised ED contained an unwelcome surprise amendment to the penalty provisions. Under this amendment, base penalties in respect of a shortfall amount which arises as a result of the proposed measure will be doubled. Moreover, this punitive measure will operate having already doubled a base penalty amount for a shortfall for SGEs under the Taxation Administration Act 1953 (Cth). The practical effect of these measures is that penalties imposed in respect of shortfall amounts under these provisions may be quadrupled. This means that a taxpayer may be liable up to 100% of the shortfall amount arising from a lack of reasonable care or not having a reasonably arguable position. This highlights the importance of having evidence in place to substantiate the positions adopted, particularly with respect to mischaracterisation of payments and any subsequent apportionment exercises. 

What haven’t Treasury addressed?

Lack of purpose and substance based tests  

Despite stakeholder recommendation for a purpose / substance based test to ensure consistency with Australia's other anti-avoidance measures, this was not implemented.

The revised explanatory memorandum maintains that these provisions are not intended to "inappropriately apply to the extent that a genuine supply and distribution arrangement".  However, when considering "arrangement" captures any legally enforceable or unenforceable understandings, and the fact "exploit" may be taken to mean "…anything else in respect of [an] intangible asset", the ambit of transactions to which these provisions could conceivably apply remains alarmingly broad. 

Lack of clarity – intangible asset, exploit and arrangements

Key terms in the Revised ED have remained largely unchanged and extremely broad such as:

• Intangible assets  – remains broadly defined. The only additional guidance provided was in the revised explanatory memorandum, in that intangible assets only captures things that are assets, and it is not intended to adopt definitions for accounting and transfer pricing purposes (such as workforce synergies). 
• Exploit – includes almost any act done in respect of an intangible asset. It also includes simply having permission (in addition to a right), including implicit permission or an understanding between parties to exploit the intangible asset. There has been a slight change in wording with respect to "genuine supply and distribution arrangement between associates," the explanatory memorandum notes where trademarks are printed on finished goods that are marketed and sold by an Australian taxpayer to customers, there will be no denial of a deduction to the extent that the payment is genuinely attributed to the good and not the trademark. This should be contrasted with Taxpayer Alert TA 2018/2 Mischaracterisation of activities or payments in connection with intangible assets, which preceded the current proposed measures, and included an exception such that TA 2018/2 should not apply to "resellers of finished tangible goods where the activity or reselling the goods involves an incidental use of a brand name that appears on the goods and related packaging."     
• Arrangement – the explanatory memorandum notes that an objective test is required to examine the whole of the arrangement, including collateral contracts and legally unenforceable understandings between the parties. Legal agreements will not be determinative. Therefore, it is possible that non-legal understandings outside of traditional legal contracts and agreements are required to be taken into account. 
• Indirect payments – for the purposes of determining whether a payment is made indirectly through one or more interposed entities, and where income is derived indirectly through one or more interposed entities, the Revised ED provides that it is sufficient if amounts are paid or transferred between each entity. That is, it is not necessary to demonstrate that each payment or transfer in a series of payments funds the next payment or transfer, or is made after the previous payment or transfer.   

Mischaracterisation and apportionment

There remains great uncertainty in respect of 'mischaracterisation' i.e. certain payments that may be in substance but not in legal form made for the right to exploit an intangible. In turn, there was a lack of guidance provided with respect to apportionment of those mischaracterised payments. This illustrates the Government's focus on embedded royalties, being an issue that the ATO has attempted to address with TA 2018/2. 

Further guidance materials on this issue will likely be required. For example, there are a number of transfer pricing methodologies that could be used to apportion payments. Indeed, some of the existing transfer pricing methodologies may be more appropriate to address the pricing of royalties and their use, rather than seeking to design a prescriptive bright line test that requires taxpayers to determine the attributable value of intangible assets in a transaction.

It will also be imperative to consider Australia's transfer pricing reconstruction provisions in conjunction with this measure, as it may enliven this new measure through the recharacterisation of existing arrangements.

Author: Vanja Podinic, Partner.