The Australian Tax Office (ATO) guidance issued in relation to the Diverted Profits Tax (DPT) will be a useful practical tool for taxpayers and it comes nearly a year after the DPT was introduced.
The DPT is an additional anti-avoidance provision affecting significant global entities (where global turnover is A$1 billion or more) where certain criteria are satisfied (outlined in more detail below). When DPT is found to apply, the penalty tax rate of 40 per cent plus interest, will be imposed with no access to Australia’s double tax treaties.
Draft Practical Compliance Guideline (PCG 2018/D2) issued on 7 February 2018 will have a useful practical application. It will be of particular use to taxpayers’ in self-assessing their level of DPT risk and what, if any further work is required to support their position and avoid the application of the DPT.
Among other aspects, PCG 2018/D2 provides example scenarios in relation to ‘high risk’ and ‘low risk’ cases in determining whether sufficient economic substance exists to support the allocation of profit or prices set between international related parties. These scenarios highlight the far reaching nature of the DPT legislation and the extent of analysis and evidence expected to prove that the DPT provisions do not apply in the taxpayer’s circumstances.
Although still in draft, recent experience suggests changes to the final PCG are unlikely to be material. Given the potentially significant impact of DPT legislation on affected taxpayer’s companies are encouraged to act early.
More information about other ATO guidance, Draft Law Companion Guideline LCG 2017/D7 and Law Administration Practice Statement PSLA 2017/2 issued in December 2017 is available in this Transfer Pricing Alert from December 2017 and Transfer Pricing Alert from January 2018.
The DPT law is an anti-avoidance measure that was introduced in the 2016/17 Budget and came into effect on 1 July 2017. It was designed to ensure that Significant Global Entities (SGEs) do not reduce the amount of Australian tax by diverting profits offshore (to low tax jurisdictions) through arrangements with related parties.
In general terms, the DPT law applies if, under a scheme or in connection with a scheme:
- A taxpayer has obtained a tax benefit in connection with the scheme in an income year
- A foreign entity, that is an associate of the taxpayer in question, entered into or carried out the scheme or is otherwise connected with the scheme
- The principal purpose, or one of the principal purposes of the scheme, is to obtain an Australian tax benefit or to obtain both an Australian and foreign tax benefit (i.e., the so-called ‘principal purpose test’), and
- None of the following exceptions apply:
- The A$25 million income test
- The sufficient foreign tax test, and
- The sufficient economic substance test.
The DPT law is applicable to income years starting on or after 1 July 2017. However, it can apply to schemes entered into before 1 July 2017. A detailed analysis of the DPT law can be found in our previous Transfer Pricing Alert from December 2016.
Given DPT is part of Australia’s anti-avoidance legislation (i.e. within Part IVA), it will over-ride Australia’s double taxation treaties and effectively will leave affected taxpayers open to double taxation.
PCG 2018/D2 – DPT engagement and compliance framework
The draft PCG 2018/D2 provides guidance on the ATO’s compliance approach to the DPT. In addition, it outlines the client engagement framework, framing questions to aid in risk assessment as well as suggested documentation and information requirements. Also included are 10 high and low risks scenarios to test the extent of sufficient economic substance (SES).
Any DPT risk will generally be identified in the normal course of the ATO’s compliance activity. If identified, the ATO will decide whether to conduct a review at that time or continue monitoring the perceived risk.
The ATO expects taxpayers to self-assess their DPT risk and then engage with the ATO under their client engagement framework (summarised in Appendix one attached at the end of this Alert). The main avenues of engagement include:
- Applying for an APA
- Applying for a private ruling, or
- Contacting the DPT specialist team to discuss specific arrangements.
Any of these avenues are likely to involve comprehensive review of information, documentation and evidence to support the company’s position and, undoubtedly, a quasi-audit.
If your company is already in the APA program, no assurance will be provided unless the APA application was submitted and/or finalised after 4 April 2017.
The PCG includes a guide as to the framing questions the ATO might ask. The nature of the questions highlights the transactions the ATO believes will be of higher risk for the DPT to apply.
The initial questions will cover whether DPT applies in principle.
If the answer to the initial questions is yes AND international related party dealings are with an entity with an effective tax rate of 24 per cent or lower, the arrangement may be within the scope of DPT.
Framing questions – transaction specific
The ATO has identified the following transaction specific areas to assess DPT risk:
- The transfer or effective transfer of valuable intangible assets offshore
- The transfer or effective transfer and/or centralisation of functions and/or risks offshore
- A significant transfer of value relative to overall profitability
- The mischaracterisation of payments (for example, service fees rather than royalties)
- The use of hybrid entities and/or instruments
- Back-to-back or flow-through arrangements
- The booking of profit offshore in a manner disproportionate to staff headcount and/or capability, or
- Any other features that are unusual having regard to the nature of the relevant business operations.
Framing questions – sufficient economic substance (SES) test
The ATO has identified the following areas to assess whether an arrangement satisfies the SES test. This is the most critical and comprehensive area and, depending on the quality of existing transfer pricing analysis and documentation, could result in considerable additional work for SGEs with potential DPT risk:
- Commercial rationale and whether objectives were achieved
- Legal form v substance
- Evidence of market conduct and industry experience
- Where a business restructure has occurred, assess the competencies of overseas parties to manage assets, carry out functions and manage, control and fund risks
- A heavy focus on risks including commercial and financial capacity to bear risk.
Framing questions – principal purpose test (PPT)
Additional questions the ATO may consider in determining whether or not the principal purpose test has been satisfied may cover:
- Commercial assessment of the arrangements
- Alternatives/options available
- Commercial v tax reasons for the arrangement
- Quantifiable non-tax financial benefits of the arrangement.
What is most concerning with this line of questioning is the implied commercial assessment of the arrangements by the ATO. Time will tell how the ATO accepts a taxpayers own commercial assessment/objectives versus imposing their own assessment.
Risk assessment scenarios
The ATO has outlined a number of scenarios to illustrate some of the matters they will consider in assessing risk in relation to satisfying the test of SES. There are ten scenarios and in most cases, both high and low risk scenarios for each. Notably there is only a ‘high risk’ scenario for marketing hubs. Examples cover:
- Lease in and lease out arrangement (foreign head-lessor)
- Intangibles migration overseas in pharmaceutical group
- Australian limited risk distributor
- Intangibles migration (run up run down scenario, i.e. IP transfer from Australia overseas where new IP is created overseas and Australian IP value is wound down)
- A marketing hub, which is only high risk
- An insurance arrangement, which is only low risk.
The threshold on moving from high risk to low risk appears narrow, subjective and is based on the facts and circumstances (rather than legal agreements). This highlights the need for multinationals to maintain robust, comprehensive and sophisticated transfer pricing analysis to support arrangements with related parties in low tax jurisdictions if there is any possibility that the transactions are within the scope of DPT.
The guidance provided by the ATO in PCG 2018/ D2, LCG 2017/D7 and PSLA 2017/2 is welcome, although the guidance does not resolve all of the uncertainty in relation to the application of the DPT law. One of the areas requiring more clarity is when the ATO would seek to apply DPT rather than ordinary transfer pricing provisions. Effectively this places all companies within the scope of DPT where any arrangements with related parties in low tax jurisdictions fall within the higher risk scenarios. This is unfortunate because, for example, transactions with UK and US related parties can also be subject to DPT and one would not normally expect such transactions to fall within the scope of an anti-avoidance provision. In an environment where many countries have reduced or are planning to reduce their corporate tax rates, the DPT may trigger unintended consequences, which means all or most transactions may require an increased level of analysis/evidence to reject a potential DPT application!
Despite the final set of guidance material issued by the ATO, DPT assessment remains a complex matter that requires comprehensive and thoughtful case-by-case analysis by SGEs. In most cases, the level of analysis already undertaken is likely to fall short of what is needed to dis-prove a DPT assessment therefore this legislation and guidance imposes a heavy compliance burden. If a taxpayer has transactions that fall within the framing questions or structures that look like ATO identified scenarios, we recommend advice is sought to determine how best to manage and respond to the risk of DPT.
The ATO expects taxpayers to self-assess the risk of a DPT assessment however this is not required under the law. This expectation is part of a suite of ‘behavioural expectations’ continually expanded by the ATO to influence how they will deal with taxpayers.
Much of what is outlined by the ATO’s guidance is open to interpretation – or one might say miss-interpretation. Conclusions must be drawn based on commercial assessments and the extent of any non-tax financial benefits (which are undefined). Even if a taxpayer believes it has demonstrated its commercial reasons for a particular business structure there is no guarantee the ATO will agree. One might expect a taxpayer to be in a better position to assess the commercial drivers for its own business operations however the last word will be with the ATO.
Like other anti-avoidance legislation, the DPT and guidance issued by the ATO is intended to change behaviour. It is not expected the ATO wants to spend significant resources in disputing an SGE’s business operations, but rather, encourage SGEs to (re)structure their operations into more conservative arrangements which arguably favours the Australian tax net. Any decisions by SGEs to restructure should be approached with caution as there is always more than one side to global business arrangements and adopting transfer pricing models in favour of Australia may expose the group to challenge elsewhere.
The DPT is an anti-avoidance provision however with very broad potential application. SGEs with Australian turnover exceeding A$25m and related party dealings with low tax jurisdictions will need to assess whether or not the DPT and more technical aspects of the law apply (such as the principle purpose test and foreign tax test). In cases where the DPT could apply, a more detailed analysis of existing transfer pricing documentation, including substantial economic substance, will need to be assessed in relation to each transaction and compared against the ATO’s suggested evidence set out in the draft PCG.
BDO is able to provide assistance with:
- Understanding the ATO’s multi-step process in formulating a DPT assessment
- Assessing DPT risk levels for both current and future transactions
- Appropriately evidencing a transfer pricing position both before and after a DPT assessment issues, and
- Engaging with the ATO to most effectively navigate the DPT review and GAAR panel processes. Any engagement with the ATO should be approached with caution and only after a detailed review of the group’s circumstances.