What is treaty shopping?
“Treaty shopping” is commonly understood as being “the attempt by a person to indirectly access the benefits of a tax treaty between two jurisdictions without being a resident of one of those jurisdictions”.
The concept of treaty shopping is not new and has been directly addressed by the OECD through the implementation of the Multilateral Instrument giving effect to Action 6 of the BEPS Report. The ATO has also developed PS LA 2020/2 which provides guidance on the process of applying the principle or main purpose test included in Australia’s tax treaties and in the Multilateral Instrument.
Overview of TA 2022/2
The Alert targets arrangements being adopted by taxpayers for the principal or main purpose of obtaining a reduced withholding tax rate on royalty and unfranked dividend payments from Australia to which they would not otherwise be entitled.
What transactions are attracting the ATO’s attention?
The Alert identifies that international transactions displaying the following features are likely to be scrutinised by the ATO:
- Structures and restructures involving the interposition of an existing or newly incorporated entity between Australia and the ultimate recipient of royalties or unfranked dividends.
- Circumstances where the interposed entity may have significant existing operations and employees and the taxpayer may contend the commercial benefits and/or synergies flow to the Australian operations or the interposed entity.
- Royalty or unfranked dividend payments to the interposed entity that are, or would be, subject to reduced withholding tax rates under the relevant double tax agreement, compared with Australian domestic law or the applicable withholding tax rate under the double tax agreement between Australia and the country of residence of the ultimate recipient.
How will the ATO determine if a treaty benefit has been obtained in a manner consistent with the objects and purpose of a double tax agreement?
In reviewing these arrangements, the ATO will consider the taxpayer’s assertions and context behind why certain structures were adopted. The Alert also indicates that the ATO will seek to follow PS LA 2020/2 before concluding whether a treaty benefit should be denied.
PS LA 2020/2 provides instructions to ATO staff on how to apply:
- the principal purpose test contained in certain tax treaties or in Article 7(1) of the Multilateral Instrument, and
- the main purpose test contained under the relevant royalty and dividend articles in the tax treaties,
in assessing whether a treaty benefit has been obtained.
When considering the principal or main purpose threshold, the relevant question the ATO will consider is whether obtaining the treaty benefit was at least one of the principal or main purposes (it need not be the sole or dominant purpose as is the case for Part IVA matters).
If an arrangement has two purposes – to obtain a treaty benefit and to achieve a particular commercial objective – the test may be met without determining which purpose is dominant.
ATO example: Where a treaty benefit may be denied
In the Alert, the ATO provides two higher risk examples of concern that will be subject to increased scrutiny by the ATO, and where a treaty benefit may subsequently be denied. We have summarised the ATO’s first example below. As always, the onus is on the taxpayer to discharge its burden of proof. The lack of contemporaneous evidence supporting the principal or main purpose for why a particular structure was adopted may result in an adverse finding being made against the taxpayer.
The ATO sets out the following fact pattern:
- Aus Co had an exclusive licence arrangement with For Co which granted Aus Co the rights to use For Co’s intellectual property to facilitate their sales and marketing activities in Australia.
- In exchange, Aus Co paid a licence fee to For Co. Under the tax treaty between For Co and Aus Co, the licence fee constituted a ‘royalty’. A reduced WHT rate of 10% was therefore accessible to the parties (rather than 30% under Australia’s domestic laws).
- As part of a restructure of its Australian operations, For Co undertook the following steps:
- It terminated the exclusive licencing arrangement with Aus Co.
- Treaty Co (a tax resident in Treaty Country B) was interposed between For Co and Aus Co, and was granted rights to sub-licence For Co’s intellectual property in certain regions, including Australia.
- Aus Co entered into a new licencing agreement with Treaty Co (but the rights were similar in substance to the rights under the original agreement with For Co).
- Treaty Co's activities mainly consisted of the receipt and on-payment of royalties to For Co, reporting on its investment in Aus Co to For Co and complying with its corporate obligations.
The ATO notes that this restructure enabled:
- The WHT rate to reduce from 10% to 5% under the tax treaty between Australia and Treaty Country B.
- A lesser amount of tax to be payable in Treaty Country B upon receipt of the royalty from Aus Co (compared to the level of taxation imposed on For Co in Treaty Country A).
- A lesser amount of tax to be payable in Treaty Country A upon receipt of subsequent payments made by Treaty Co.
The ATO concludes that in the absence of contemporaneous documentation, these circumstances suggest that accessing the reduced withholding tax rates was one of the principal or main purposes for the restructure.
What action will the ATO take?
If the ATO determines that the principal or main purpose of implementing the structure is to obtain reduced withholding tax rates under the relevant double tax agreement, that reduced rate will be denied and the taxpayer’s position will revert to the position under Australian domestic tax law. This could occur either under the relevant double tax agreement or through other provisions of domestic tax laws, such as Part IVA (as noted in TD 2010/20).
Depending on the Commissioner’s concerns on the cross-border structural issues, the Commissioner may also separately seek to consider the application of other provisions of Australian tax legislation (not covered by this Alert), such as the transfer pricing in Subdivision 815-B, and the debt and equity rules in Division 974 of the Income Tax Assessment Act 1997 (Cth).
The ATO has indicated it will scrutinise arrangements displaying the above features. It will likely make detailed enquiries and request evidence in relation to the relevant facts and circumstances of the arrangement to test the veracity of the commercial benefits that taxpayers contend.
In following the principles of PS LA 2020/2, some of the questions the ATO may pose to taxpayers to understand the principle or main purpose of a particular structure may include:
- What are the objective effects of the arrangement? That is, what are the results which it produces or is capable of producing?
- Is the arrangement more complex or does it contain more steps than is necessary to achieve the non-tax objectives? For example, is there a more convenient, commercial or cost-effective way of achieving the same non-tax objectives?
- Is the role of any entity in the arrangement explicable solely or principally by tax reasons or for obtaining the relevant benefit?
Where an arrangement is put in place merely to attract the operation of a particular tax treaty in the context of a broader structuring arrangement, the ATO may seek to deny the benefit gained. This is consistent with the Multilateral Instrument and past ATO practices (such as in PS LA 2020/2 and TD 2010/20).
Taxpayers should ensure they have contemporaneous documentation and substantial objective evidence on file to support the principal purpose for structuring their arrangement(s) in a particular way. Superficial or overarching statements or assertions will not be sufficient.
Any treaty benefits should be obtained in a manner consistent with the object and purpose of the relevant double tax agreement and not which may be subject to the general anti-avoidance rules and/or diverted profits tax regulations.
Contact our team
If you or any of your clients have entered into arrangements or are contemplating entering into arrangements similar to those described in the Alert, we encourage you to contact one of our experts below.