With 2023 now well and truly behind us, our Tax team has reflected on the most significant developments in corporate tax over the past 12 months. We have also highlighted some developments to watch out for in 2024 here.
Changes to Transfer Pricing Rules
As part of the suite of changes announced by the Federal Government to increase the tax burden of multinationals operating in Australia, proposed changes to the thin capitalisation rules will broaden the application of Australia’s transfer pricing regime. Further details will be announced in 2024.
Generally, the transfer pricing regime applies to negate tax advantages known as ‘transfer pricing benefits’ for multinational groups entering inbound or outbound cross-border transactions with related Australian entities. Typically, transfer pricing benefits arise when the prices agreed to by the related parties in the transaction do not reflect the price independent parties would agree to, resulting in more/less income being recognised in the country of one party, and more/less cost being recognised (and likely claimed as a deduction) in the other country of the other party. Broadly, the regime addresses these tax advantages by reconstructing the arrangement as if the parties were transacting at arm’s length.
The current thin capitalisation rules amend the transfer pricing rules so that relevant entities, in working out their taxable income, are only required to determine what the arm’s length interest rate is to be applied to the actual debt issued between the relevant parties. However, the proposed amendments in Treasury Laws Amendment (Making Multinationals Pay Their Fair Share — Integrity and Transparency) Bill 2023 introduce an arm’s length requirement for determining both the relevant interest rate to be applied to the debt, and the quantum of debt that the interest rate can be applied to. In other words, if the Commissioner determines the amount of related party debt held by a taxpayer is excessive and not an arm’s length amount, then he may seek to disallow a portion of the relevant interest deduction by reconstructing the debt amount that interest can be applied to.
The changes will allow the Australian Taxation Office (ATO) to notionally reconstruct both the debt amount and interest rate of a cross-border loan that does not satisfy ‘arm’s length’ conditions. The ‘arm’s length’ conditions require that both the amount of debt and interest charged are equivalent to what would occur if the parties to the loan were dealing at arm’s length.
The transfer pricing rules currently do not require taxpayers to demonstrate that their actual levels of debt are arm’s length provided they are subject to the thin capitalisation rules, and it can be demonstrated there is an amount of debt. The proposed amendments in Treasury Laws Amendment (Making Multinationals Pay Their Fair Share — Integrity and Transparency) Bill 2023 will remove this restriction. Practically this means the transfer pricing regime can now reconstruct both the interest rate on debts and the amount of the debt to reflect arm’s length terms.
Changes to Thin Capitalisation Rules
On 29 November 2023, the Senate moved further changes to the controversial Treasury Laws Amendment (Making Multinationals Pay Their Fair Share – Integrity and Transparency) Bill 2023 (Bill) which sets out the Federal Government announced changes to the Australian thin capitalisation rules in the 2022-23 October Budget. The Bill has been referred to the Senate Economics Legislation Committee (Committee) for the second time with the Committee due to provide its second report by 5 February 2024.
The Bill is designed to address ‘risks to the domestic tax base arising from the excessive use of debt deductions, which amount to base erosion or profit shifting arrangements’. The proposed amendments seek to align Australia's thin capitalisation rules more closely with OECD recommendations and draw parallels with analogous regimes in the UK and the US. The proposed amendments will come into effect retroactively from 1 July 2023.
The proposed measures will introduce new earnings-based thresholds, and a new arm’s length debt test, targeted at ‘general class investors’ – a singular concept referring to each of the following entities under the existing regime: an ‘outward investor (general)’, ‘inward investment vehicle (general)’ and ‘inward investor (general)’. These new rules will disallow an entity’s debt deductions based on the entity’s earnings or profits for the income year, rather than the historical approach which centred on debt-equity gearing ratios.
Key modifications include the replacement of the widely used safe-harbour test with the 'fixed-ratio test,' imposing a cap of 30% of tax EBITDA on an entity's debt deductions. Denied debt deductions under this test can be carried forward for up to 15 years to smooth the effect of temporary volatility in earnings and limit distortions on investment decisions where high up-front capital investment is required before earnings are generated. Additionally, the global gearing ratio will be replaced by the 'group-ratio test,' allowing entities within a group to claim debt-related deductions proportional to the worldwide group's debt divided by earnings. The 'arm’s-length debt test' is set to be substituted with the ‘third-party debt test,' restricting deductions to genuine third-party debt costs.
The Bill remains in a draft phase after extensive consultation and numerous concerns expressed by industry experts. This significant overhaul is poised to impact a range of businesses, with particular ramifications for those in the Real Estate and Construction sector, where high capitalisation and low EBITDA are commonplace. Taxpayers and their advisors should proactively engage with the proposed laws given their retroactive effect and seek advice to ensure they won’t be in breach.
Off-market share buy-backs
Changes to the tax treatment of off-market share buy-backs offered by listed companies announced by the Federal Government in the 2023 October Budget are now law. The changes are designed to align the tax treatment of off-market buy-backs with on-market share buy-backs. This alignment ensures listed public companies can no longer use off-market purchases and selective reductions of capital to take advantage of the concessional tax status of shareholders as part of their capital management activities.
The measures prevent part of the purchase price for an off-market buy-back from being taken to be a dividend where the buy-back is undertaken by a listed public company. The result is that shareholders who participate in such an off-market buy-back are only assessed on the gain or loss from the sale of the share, rather than a deemed dividend.
Though no part of the purchase price is taken to be a dividend, listed public companies that undertake an off-market buy-back must debit their franking account to the extent the buy-back price is not debited to the company’s share capital account. To prevent companies from using selective share capital reductions in place of off-market share buy-backs, the measures also make distributions by listed public companies which are consideration for the cancellation of a membership interest in the company unfrankable. This makes share buy-backs less attractive for shareholders who could otherwise sell their shares on-market, particularly low-rate taxpayers such as superannuation funds, charities and certain individuals.
These measures will apply to buy-backs and selective share cancellations undertaken by listed public companies that are first announced to the market after 7:30 pm on 25 October 2022.
Franking Credits and Dividends Funded by Equity Raisings
On 16 November 2023, the Federal Government passed legislation that denies franking credits otherwise attached to distributions to the extent the distributions are funded directly or indirectly by capital raising activities that result in the issue of new equity securities.
The changes are intended to discourage artificial or contrived arrangements where capital is raised to fund the early release of franking credits on dividends, with the overall outcome not resulting in any significant change to the financial position of the entity. The legislation contains a number of changes from the Bill resulting from the public consultation process, which include:
- the denial of franking credits applies to a distribution if the capital raising funds at least a substantial part of the distribution (rather than any part of the distribution); and
- if the provision applies, only the portion of the distribution that is funded by the capital raising will be unfrankable.
Critically, a requirement of the provision is that there is an issue of equity interests in the entity making the distribution or any other entity (whether before, at or after the time the relevant distribution was made). It will then be necessary to decide whether it is reasonable to conclude based on the circumstances of the distribution that the principal effect and the purpose of issuing the equity interests was the direct or indirect funding of a substantial part of the distribution. The new section sets out the matters to be taken into consideration when assessing whether the entity has a practice of making distributions of a certain kind, and when a distribution has the effect or purpose of funding all or part of the distribution.
Entities that have an established practice of making distributions of a kind on a regular basis will not be impacted by these rules to the extent that distributions are made in accordance with that practice.
The measure was initially slated to have retrospective effect but will now only apply to distributions made on or after 28 November 2023. Corporate entities, especially those without a long and established history of making distributions, will be at risk of having franking credits denied where there has been any issue of equity in relative proximity to the distribution.
Central Management and Control – Corporate Residency – Finalisation of PCG 2018/9
In November, the ATO finalised its guidance on the central management and control corporate residency test in Practical Compliance Guideline PCG 2018/9. PCG 2018/9 provides practical guidance to help foreign-incorporated companies apply the principles set out in in the ATO’s accompanying taxation ruling, TR 2018/5.
PCG 2018/9 includes a risk assessment framework that outlines the ATO’s compliance approach and is designed to help foreign-incorporated companies understand the risk factors that will make it more likely that the ATO will review a company’s residency position. The three risk zones are:
- Low – the ATO will not normally allocate resources to review the company’s residency position.
- Medium – the ATO may conduct further analysis to understand a company’s residency position and tax outcomes through ordinary engagement and assurance activities.
- High – a company will likely be subject to compliance activity.
PCG 2018/9 reaffirms the position that the minutes of board meetings are the starting point for evidencing who and where the central management and control of a foreign-incorporated company is located. Only when a company has not kept board minutes, it makes high-level decisions outside of board meetings, the board minutes do not disclose where directors are making a company's high-level decision or the board minutes are false (including where they record the rubber stamping of decisions made elsewhere), will it be necessary to look at other evidence of who makes and where they make the company's high-level decisions.
The transitional compliance approach introduced in 2017, which gave some companies time to review and adjust their governance arrangements to maintain their non-resident status, ended on 30 June 2023. In line with the ATO’s continued focus on international tax matters and compliance, we expect the Commissioner to pay continued attention to the residence status of foreign incorporated companies with ties to Australia.
Diverted Profits Tax Decision
The reasons for decision in PepsiCo, Inc. v Commissioner of Taxation  FCA 1490 (PepsiCo) were handed down by Justice Moshinsky on 30 November 2023. This is the first court decision to consider the diverted profits tax (DPT) in Part IVA of the Income Tax Assessment Act 1936 (Cth) after its introduction in 2017. Although the decision did not apply the diverted profits tax directly (instead holding that a royalty withholding tax applied) the Court still considered the application of the diverted profits tax in detail. This consideration provides guidance on the potential application of this tax going forward.
Broadly, the DPT applies to qualifying ‘significant global entities’ (SGEs) that enter into transactions that aim to divert Australian profits offshore, and to that extent imposes an addition 40% tax on the profits from these arrangements. The policy intent of the DPT is to ensure that the tax paid by SGEs properly reflects the economic substance of their activities in Australia.
PepsiCo concerned an exclusive bottling agreement for soft drinks between an intellectual property holder in the United States and an Australian bottler and distributor. These agreements included a requirement for the Australian company to purchase soft drink concentrate at specified prices, however payment was expressed to be for this concentrate alone, and not for intellectual property rights granted under the same agreement. Despite this description, the court found that a portion of this concentrate purchase price was consideration for the intellectual property rights. The amount of the royalty was determined by considering comparable licence agreements. Ultimately an estimated royalty was arrived at by the Court, expressed as a percentage of net revenue for relevant products.
The DPT was only considered for ‘sake of completeness’. Broadly, the DPT requires that:
- an SGE taxpayer obtain an DPT tax benefit in connection with a ‘scheme’;
- an SGE taxpayer has total Australian turnover of more than $25 million;
- the scheme has a principal purpose of avoiding Australian tax;
- the scheme involves one or more foreign associates of the taxpayer in a lower tax jurisdiction or a jurisdiction in which they receive tax concessions;
- the foreign associate does not pass the ‘sufficient foreign tax test’ or the ‘sufficient economic substance test’; and
- the taxpayer is not an excluded entity.
The Court considered the DPT question on the hypothetical assumption that the royalty withholding tax would not apply. On that basis, the Court decided that the relevant DPT tax benefit obtained under the ‘scheme’ would have been the failure to include a specific royalty payment for intellectual property rights. The accepted counterfactual would have been payment of the same amount by the Australian company for all of the rights under the contract, rather than just the soft drink concentrate. This counterfactual was accepted as representative of the commercial substance of the agreement, as the amount paid by the Australian company, and the rights it would receive would be the same. Avoiding royalty withholding tax was therefore considered a principal purpose of the scheme, despite suggestions by the taxpayer that payments historically were made only for concentrate, and this was done for simplicity. Ultimately, but for the royalty withholding tax, DPT would have been applied in this case.
This case is currently subject to an appeal, and the ultimate outcome is expected to set the stage for the application of the diverted profits tax in the future. We note that a second case considering the DPT is expected to be heard in 2024. See our comments in our preview of corporate tax developments to watch out for in 2024 here.
Debt Deduction Creation Rules
As part of the suite of changes the Federal Government has introduced aimed at reducing the ability of multinational entities to reduce their Australian taxation liabilities, the new Debt Deduction Creation (DDC) rules will come into effect in 2024. The rules are included in the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share—Integrity and Transparency) Bill 2023 together with the Government’s proposed changes to Australia’s thin capitalisation rules (see above, and here).
The DDC rules will be hosted under the newly created Subdivision 820 EAA of Income Tax Assessment Act 1997 (Cth) and will enable the Commissioner to disallow deductions when they are related to a debt creation scheme. These schemes lack genuine commercial justification, and operate to create artificial interest-bearing debt to shift profits out of Australia through tax-deductible interest payments. Generally, the DDC rules will only apply to entities already subject to the revamped thin capitalisation rules (and who have not been granted an exemption), which will be most multinational enterprises reporting total debt deductions exceeding $2 million in the given fiscal year.
The DDC Rules will be limited to two specific scenarios, being:
- Acquisitions: Entity A obtains a capital gains tax (CGT) asset, or a legal or equitable obligation (such as debt) either directly or indirectly from one or more entities (the disposers), and at least one disposer forms an associate pair with Entity A. The following transactions may be captured under this scenario:
- Entity A creates debt to buy shares in a foreign subsidiary from a foreign associate.
- Entity A uses debt to acquire business assets from domestic and foreign associates after a global merger.
- Payments: Entity A borrows from its associate to make payments (which can include dividends, repayment of loans or returns of capital) to that associate or another associated entity. This includes payments made to one or more interposed entities, regardless of whether the payment occurred before or after the debt interest was created. There is also no need for the Commissioner to prove that the debt funded the specific payments made through each of the interposed entities.
The new subdivision includes its own set of anti-avoidance provisions. Those provisions apply if the Commissioner is satisfied that a principal purpose of a scheme was to avoid the application of the DDC rules. If so, then the Commissioner may determine that the DDC rules apply to that debt deduction.
The Bill was introduced in June this year and was referred back to the Senate Economics Legislation Committee for a report due on 5 February 2024. The DDC rules are expected to commence to income years commencing on or after 1 July 2024.