Treasury Consultation Paper on Government election commitments

Treasury has released a consultation paper which outlines three main areas of tax reform for the new Government, including:

• Changes to the thin capitalisation regime, including changing the safe harbour debt amount from an asset-based calculation to an earnings-based test (among other changes);
• Denying deductions for royalty payments to no or low tax jurisdictions;
• Greater transparency (including public disclosure) of multinational tax affairs.

The proposed changes to the thin capitalisation rules have the potential to significantly affect the deductibility of interest for taxpayers that are subject to those rules.  Affected taxpayers should review the potential impact of the proposed rules and consider making a submission on key issues and impacts around the design of these rules. The consultation paper is open for submissions until 2 September 2022 and Ashurst is preparing a submission to Treasury.

Treasury Consultation Paper

Following the Labor Party's victory at the federal election, the new Government has commenced consultation on their tax-related election commitments.  We discussed those election commitments, and some of the associated tax issues, in our last bulletin (May in Australian Tax: Post-Election Special Bulletin).

The consultation paper (the Paper) is made up of three core parts, summarised below.

Thin Capitalisation Changes

Australia's current thin capitalisation regime determines the safe harbour debt amount by reference to an asset-based calculation rather than utilising the OECD's recommended approach, which is an earnings-based calculation.

To elaborate, the current limit for what are referred to as "general" entities (which excludes certain financial entities and authorised deposit-taking institutions), or "maximum allowable debt", is the greatest of:

1. The safe-harbour debt amount, which is (broadly) 60% of the average value of the entity's Australian assets less its non-debt liabilities;
2. The arm's-length debt amount, which is the amount that would and could have been borrowed by and lent to an independent third party in the same or similar situation; and
3. The worldwide gearing debt amount, which allows an entity's Australian operations to be geared up to 100% of the gearing of the worldwide group to which it belongs.  Note that the worldwide gearing debt amount is not available as an alternative to all general entities.

The Paper notes that the current rules act to limit debt deductions "indirectly" by controlling the quantum of debt which gives rise to allowable debt deductions, rather than the OECD's recommended approach of directly limiting the quantum of debt deductions as a proportion of earnings.

The Paper proposes a fixed ratio rule that will replace the safe harbour debt amount and will limit debt deductions for general entities where they exceed 30% of Earnings before Interest, Taxes, Depreciation, and Amortisation (EBITDA); financial entities and ADIs would be excluded from the fixed ratio rule.  The Paper does not propose that there will be grandfathering for existing projects from the operation of the new rules.  Consultation is also invited regarding the continued operation of the current tests that determine  the arm's length debt amount and worldwide gearing debt amount (discussed below).

One rationale advanced in the Paper for moving to an earnings-based approach is to prevent entities which satisfy the safe harbour debt amount shifting profits out of Australia by maximising debt deductions by way of high interest loans.  It is worth noting that such profit shifting arrangements would be expected to be subject to the transfer pricing regime which may apply to reduce the deductible part of the interest expense. 

With respect to the arm's length debt amount, the Paper also notes the high ongoing compliance costs for both taxpayers and the ATO in complying with the requirements associated with the arm's length debt amount.  It further questions whether the existing legislative architecture for the arm's length debt test is appropriate given the test is not a bright-line test and there are difficulties in establishing the genuine commercial quantum of debt allowable.  It is possible (and, to some extent, may be expected) that entities that have debt deduction denials under the revised safe harbour may look to ascertain whether the arm's length debt amount would support a higher quantum of debt deductions.  The Paper considers that would potentially undermine the policy intent of introducing the fixed ratio rule.

The Paper also notes that the OECD's preferred approach contains a group ratio rule, which considers the net interest expense of the worldwide group.  The Paper notes that Australia's current thin capitalisation rules include a variant of the group ratio rule in the form of the worldwide gearing debt amount.  Consultation is sought regarding the role of that test if a group ratio rule is introduced, including whether it is appropriate for the worldwide gearing test to be repealed.  In addition, and this is not noted in the Paper, certain general entities are prohibited from using the worldwide gearing debt amount, such as inward investing general entities where the audited consolidated financial statements for the entity do not exist, or where the average value of Australian assets exceeds 50% of the value of the worldwide assets of the entity. 

Given the proposed amendments to the operation of the safe harbour may result in reliance on the alternative means to determine the maximum allowable debt,  it would be worth the Government reconsidering some of these exclusions to the worldwide gearing debt amount. The current exclusions may be particularly inequitable for entities controlled by foreign investment entities which do not prepare consolidated financial statements.  This includes foreign investment entities, such as pension funds, which generally consolidate on an equity basis (with the consequence that debt, and associated interest expense, sitting in downstream entities is not recognised on the balance sheet of the foreign entity). 

Furthermore, in our last bulletin, we questioned whether any debt deductions (or excess thin capitalisation capacity) will be able to be carried forward into future periods or carried back to earlier periods.  Despite the UK (and other countries) allowing a  carry forward and carry back in certain circumstances, and the OECD indicating that countries may allow for the carrying forward (and back) of denied interest deductions, there is no specific mention in the Paper of this topic.  The Paper does note that the Government will draw on approaches adopted in comparable international jurisdictions in implementing the fixed ratio rule (and a number of jurisdictions are specifically mentioned including the UK, Canada, France, Germany and the US).  It would be hoped that rules dealing with the carry forward and carry back of denied interest deductions (and excess thin capitalisation capacity) will be included in the new rules but this will be a matter for consultation.

One issue that is not expressly discussed in the Paper is how the proposed changes will impact the associate entity rules, which (very broadly) allow upstream entities to pick up excess thin capitalisation capacity arising from the downstream entities.  These rules generally apply by disregarding the value of the associate entity equity that the upstream entity holds in the downstream entity, and then including the excess thin capitalisation capacity of the downstream entity (along with the premium excess amount).  Moving to an earnings-based test will materially alter the way these rules will need to work.  Similarly, where an entity borrows from an external party and on-lends the amount to an associate entity, the first entity is treated (in effect) as not having any debt and the debt is in effect tested in the thin capitalisation position of the associate entity.  Again, changes will be required as a result of moving to an earnings based test to ensure on-lending arrangements are appropriately dealt with.

There are a range of specific questions included in the Paper that relate materially to the design of any earnings-based debt deduction limitation, as well as potential changes to the existing arm's length debt amount and worldwide gearing debt amount concepts, including:

1. Whether EBITDA should be determined by reference to tax or accounting concepts;
2. Whether there are specific entities currently using the safe harbour debt amount that would be affected by an earnings-based debt deduction limitation, and further whether there are specific sectors which experience earnings volatility which may cause these entities to explore utilising the arm's length debt amount or the worldwide gearing debt amount;
3. Whether there should be any changes to the existing thin capitalisation rules applicable to financial entities and authorised deposit-taking institutions;
4. If a group earnings-based rule is included as part of introducing the measures, whether the worldwide gearing debt amount should be repealed; and
5. Whether any changes should be made to the arm's length debt amount, whether to strengthen or clarify its operation, or to introduce differentiating factors between external (third party) debt and related party debt.

Denying MNEs deductions for intangible and royalty related payments to low or no tax jurisdictions

The Paper considers that taxpayers can use arrangements involving intangibles and royalties (I&R) to shift profits out of Australia to low or no tax jurisdictions, and that the growth of the digital economy has exacerbated these practices.  The Government has announced that it will introduce new rules to limit the ability to claim deductions for payments relating to I&Rs where the payments are made to these low or no tax jurisdictions.

Over the last few years, and as noted in the Paper, the ATO has raised integrity issues regarding different elements of arrangements involving I&R, including in TA 2018/2 and TA 2020/1 (and, not mentioned in the Paper, more recently in TA 2022/2).  Specifically, the Paper notes concerns have been raised where intangibles and/or associated rights are migrated to international related parties as part of non-arm's length arrangements in a manner intended to avoid Australian tax.  Concerns have also been raised about arrangements where the royalty element of a payment may be recharacterised/embedded into the price of tangible goods and/or services and is not separately recognised as a royalty. 

Notwithstanding the concerns raised in the Paper in this regard, it is worth noting that such arrangements may be subject to other tax regimes such as the transfer pricing regime, general anti-avoidance regime, the principal purpose test under relevant Double Tax Agreements, the CFC regime, and (further) that payments may be required to be apportioned to determine royalty elements.

The Paper contends that Australia's tax framework needs a specific measure for targeting these issues.  It references the UK's 'Offshore Receipts in respect of Intangible Property' program, the US's Global Intangible Low Tax Income (GILTI) and Base Erosion Anti-abuse tax (BEAT), the Dutch changes to withholding tax rates and the German royalty barrier deductibility rule as potential methods of curbing I&R facilitated tax avoidance.

Broadly, the proposed measure may seek to deny deductions for royalties (including embedded royalties) paid to low or no tax jurisdictions, including jurisdictions where insufficient tax is being paid (e.g., even if the jurisdiction is not per se a low or no tax jurisdiction, but where the payment is not subject to sufficient foreign tax such as where there is a patent box or similar regime).   Again, there are a number of consultation items that would materially impact the design of this regime, including (for example):

1. Whether the regime should only apply to large multinational groups (such as those that qualify as Significant Global Entities as presently defined in the Income Tax Assessment Act 1997), or whether the regime should have broader application;
2. Whether the regime should cover embedded royalties (and how the concept of an embedded royalty may be defined);
3. Whether the regime should cover payments only to related parties or should also cover payments to unrelated parties;
4. Whether the regime should also target the migration of functions associated with intellectual property (although, as noted above, it is unclear how the regime would target these arrangements and no proposal is provided in this regard); and
5. How the concept of a low or no tax jurisdiction, or the concept of a receipt in a foreign jurisdiction not being subject to sufficient tax, should be defined for these purposes.

Multinational Tax Transparency

The Government intends to introduce tax transparency initiatives (including public reporting) aimed at multinational enterprises (MNEs) in order to increase public knowledge and scrutiny of those entities.

Measures have been announced which require the public release of data on the amounts of tax that large MNEs pay in their operating jurisdictions and their employee headcount.  This information is included in Country-by-Country (CbC) reports, which is a measure adopted from OECD BEPS Action 13.

Under current law, CbC reporting entities currently lodge CbC reports with the ATO, and these reports are subject to the ordinary taxpayer confidentiality requirements.  The Paper notes that the EU has recently introduced the obligation that MNEs produce an annual public CbC report.  This new obligation applies to MNEs with more than €750 million in consolidated revenue that are active in more than one EU member state, which could include Australian headquartered MNEs.  The Paper seeks consultation on whether a similar requirement should be adopted in Australia.

The Paper also canvasses the Global Reporting Initiative tax standard (GRI) which is a similar obligation to the EU CbC reporting obligations, although it is a voluntary transparency regime.  The data from the GRI tax standard is considered more readable and accessible than the EU CbC data.  Another potential option canvassed by the Paper is to mandate the application of the (currently voluntary) Tax Transparency Code developed by the Board of Taxation.

The Paper notes that ensuring a consistent standard of voluntarily disclosed tax information is crucial to achieving the Government's policy intent.  It appears that at this stage, the Government is interested in hearing from key stakeholders and industry as to how this should be achieved, and does not have any preferred methods.

The Paper also indicates the Government's intention to require companies to disclose material tax risks to shareholders in order to assist shareholders in understanding their investments and the tax structuring arrangements of the company in which they invest.  The Paper provides an example of a material tax risk as exposure to a tax haven, although it notes that the definition of tax haven is unsettled and may cause problems of its own.

The Paper suggests an alternative approach to ensuring that companies make their shareholders aware of high-risk tax practices, by requiring listed entities to disclose to the market if they self-identify as a high-risk taxpayer under the terms of particular Practical Compliance Guidelines (such as under PCG 2017/4, related to related party debt arrangements).

The Government is also resurrecting a transparency measure from a lapsed bill of Senator Rex Patrick (Public Governance, Performance and Accountability Amendment (Tax Transparency in Procurement and Grants) Bill 2019 (Cth)).  The Government has announced that it will require all firms that tender for Federal Government contracts worth more than $200,000 to state their country of domicile for tax purposes.  No further detail is provided but it can be assumed that an adverse inference may be made against the tenderer where they are domiciled in a tax haven or in a jurisdiction which does not have an effective exchange of information agreement with Australia.

The Paper is open for consultation until 2 September 2022.