A stream of changes to international tax laws including the Australian Government’s tough new measures for multinationals has seen global tax fill the business press over the last 12 months.
Amid the furore, it’s tempting to think that the ATO, Inland Revenue (and other revenue offices) are interested only in large multinationals (those with A$1bn of turnover). The reality is that in this new environment, any business with international dealings faces a much higher risk of scrutiny.
Here are my five key areas that middle-market businesses with international dealings need to focus on:
1. Transfer pricing documentation
All businesses with international related party dealings need to revise their transfer pricing documentation. There are three factors that are driving this:
- Australia has amended its transfer pricing laws multiple times over recent years. You need to ensure that you comply with the laws as they currently stand.
- Australia has adopted the master file/local file format for transfer pricing documentation, moving away from the 4-step approach. The principles are largely consistent, but the form and content of the documentation that ATO expects has changed significantly.
- The documentation needs to be in place before the income tax return is lodged, otherwise the company and its public officer are exposed to potential penalties.
For smaller businesses or those with low risk transactions, simplified transfer pricing record keeping options may be available. These will both reduce compliance costs and all but remove your transfer pricing risk. For all other businesses, a “full scope” transfer pricing document is likely to be required.
2. Controlled Foreign Corporations
Australia has strong Controlled Foreign Corporations (CFC) rules which are relatively old and don’t always reflect modern business practices.
Under the rules, certain profits of overseas companies may be attributed to their Australian shareholders. These shareholders will then be taxed on the profits, even though the profits may be retained by the overseas company.
Holding a 40% interest (including related parties) in a foreign company can be enough to make it a CFC. Examples of transactions which can trigger application of the CFC rules include; investment income, the provision of services to Australians and the sale of goods to Australians.
We expect much greater emphasis from the ATO on compliance with the CFC rules, given their importance as a “anti-avoidance” measure for multinational businesses.
Australian businesses should review any overseas related parties to assess whether the CFC rules may be triggered. This could significantly impact your international tax planning.
3. Permanent Establishments
For countries where Australia has a tax treaty, the concept of a permanent establishment determines whether Australia or the overseas country can tax the profits of the business operations.
The definition of permanent establishment is changing. It has already changed in the Australia-Germany tax treaty and the new definition will be included in any new or revised treaties Australia enters into.
The new definition emphasises the substance of arrangements. For example, historically an overseas sales team could negotiate a sale right up to the point of signing the contract, but as long as the contract was signed overseas no permanent establishment would arise. In the future, where a contract is substantially negotiated in an overseas country, a permanent establishment (and hence tax obligations) is likely to arise.
These developments will impact how multinationals structure their business operations and how they manage their international tax position. Such changes take time to implement, however understanding the likely future impact now is critical.
4. Debt strategies
Structuring your debt arrangements is one of the key strategies used to manage international tax positions. Interest on debt attracts withholding tax (in Australia, at 10%) and the interest is deductible against profits, saving corporate tax (in Australia, at 30%).
Thin capitalisation rules are intended to minimise the extent to which debt can be “loaded” into particular entities by limiting the amount of debt deductions available to that entity. In Australia, at least $2M of interest (debt deductions) is needed before the thin capitalisation rules apply. The threshold in other countries can be quite different.
Around the world we are seeing Governments act to limit interest deductions through:
- Tighter thin capitalisation laws. Most countries have tightened, or are expected to tighten these laws.
- Applying transfer pricing rules to financing arrangements. For any high value or complex financing arrangements, the risk of a transfer pricing focused review is high.
- Anti-hybrid laws. Hybrids are arrangements where, for example, an instrument is treated as debt in one country (so the interest distribution is deductible) but equity in another (so the distribution is treated as a dividend and not taxed). Tackling this mismatch is one of the OECD BEPS actions items, and it something Australia has announced it will implement.
As a result of these changes any international related party debt arrangements will need to be revisited.
5. Tax treaties
Revision of the Permanent Establishment definition is not the only change happening to Australia’s tax treaties. Anti “treaty shopping” measures are also being introduced.
It is not uncommon for a “sub holding company” in one region or country to be used as an intermediary to an investment in another region or country. The jurisdiction for that sub holding company is chosen for various reasons, including the tax implications arising under a treaty.
For example, an Australian company that wants to invest in an ASEAN region country will often do so via a Singapore resident sub holding company as this can produce a lower tax impost than a direct investment. Other than holding the investment, there may or may not be any significant substance to that sub holding company.
In other instances, transactions will be structured to fall within (or out of) specific definitions in treaties. This may be through splitting up contracts to fall under a 12 month test or locating employees in particular locations to trigger permanent establishments.
Tax treaties override domestic laws in most cases, but not in relation to Australia’s general anti-avoidance laws. Australia, and other countries, will increasingly use domestic anti-avoidance laws to deny treaty benefits in situations where it is considered that the treaty is being abused.
Over time tax treaties will also be amended to include strong limitations of benefits clauses and other measures to ensure that the treaty achieves the purpose of avoiding double taxation, but is not being used as a tax planning tool.
In light of these changes, global corporate structures will need to be reviewed and potentially updated to reflect what will increasingly be the global view on the role of tax treaties.
For middle-market businesses without the regulatory teams and experience in dealing with cross-border taxation, complying with changing legislation can pose a real challenge. I would highly recommend any businesses with a reasonable level of international dealings seek expert advice.