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How can the tax obligations of companies change from responses to COVID-19?

15 December 2020

With international travel restrictions one of the first measures implemented to limit the spread of COVID-19 both in Australia and globally, this can create specific tax issues for individuals or businesses needing to relocate their work activities.  Of particular relevance is the practical approach taken by the Australian Taxation Office (ATO)  in relation to:

  • corporate tax residency, and

  • permanent establishments.

Businesses are also impacted by impairment of assets due to the economic slowdown and/or seeking additional debt or equity, all of which can give rise to additional tax implications including with respect to transfer pricing and thin capitalisation.

Furthermore, new ways of working and responding to employee’s health and well-being also create additional tax considerations for employers.

Travel restrictions should not impact corporate tax residency

Consistent with recent Australian Taxation Office (ATO) guidance in PCG 2018/9, there is now an expectation that Australians travel to attend foreign board meetings when they are Board members of an overseas incorporated affiliate. 

This becomes an issue for employees and directors that are based in Australia who need to observe the Government’s and/or their group’s travel restrictions which have been put in place to limit the spread of COVID-19. 

If the travel doesn’t take place to attend foreign board meetings then it could risk bringing the foreign entity into the Australian tax net due to Australia’s concept of ‘central management and control’ for our corporate residency test.

The ATO has released guidance that states if the only reason for holding board meetings in Australia, or directors attending board meetings from Australia, is because of impacts of COVID-19, then the Commissioner will not apply compliance resources to determine if the entity’s central management and control is in Australia.

In the 2020-21 Federal Budget, the Government announced it would make technical amendments to the corporate tax residency test to provide that a foreign incorporated company will be treated as an Australian tax resident if it has a ‘significant economic connection to Australia’. This test will be satisfied where both the company’s core commercial activities are undertaken in Australia and its central management and control is in Australia. This measure will have effect from the first income year after the date of Royal Assent of the enabling legislation, however, taxpayers will have the option of applying the new law from 15 March 2017. This should alleviate many of the concerns arising from travel restrictions due to COVID-19.

Relocation of group employees back to Australia

For foreign companies, the simple act of assisting expatriate employees to return back to Australia to look out for their health and wellbeing could trigger a branch (i.e. permanent establishment) in Australia that has compliance and tax filing obligations.

Consider a scenario where an Australian national has been employed by a group company overseas for the past two years, but they return to Australia and continue their work for the overseas entity from their place of accommodation. These steps are consistent with the group’s disaster recovery and business continuity protocols.

Similar to above, the ATO’s helpful and practical guidance states that the impacts of COVID-19 will not, in itself, result in the foreign company having an Australian permanent establishment. 

The Commissioner will not apply compliance resources to determine if the foreign company has a permanent establishment in Australia if the following conditions are satisfied:

  • the foreign company did not otherwise have a permanent establishment in Australia before the effects of COVID-19
  • the temporary presence of employees in Australia is solely be as a result of COVID-19 related travel restrictions
  • those employees temporarily in Australia will relocate overseas as soon as practicable following the relaxation of international travel restrictions, and
  • the company has not recognised those employees as creating a permanent establishment or generating Australian source income in Australia for the purpose of the tax laws of another jurisdiction.

This approach will apply until 31 January 2021, and foreign companies are encouraged to engage with the ATO in relation to their specific circumstances, particularly if employees are likely to be in Australia beyond 31 January 2021.

Thin capitalisation considerations 

The COVID-19 crisis is likely to result in the impairment of assets in the balance sheet for many businesses and/or additional debt or equity raisings, which can give rise to additional tax implications including with respect to transfer pricing and thin capitalisation.

For thin capitalisation purposes, to the extent that a reduction in asset values is reported in financial statements in accordance with accounting standards, this will lead to a reduction in maximum allowable debt calculated using the safe harbour method (which is broadly 60 per cent of adjusted assets). 

It is worth noting that affected taxpayers can consider using alternative averaging valuation methods to reduce the impact on their thin capitalisation calculations for the current income year (e.g. switch from opening-closing method to frequent measurement method). The particular method chosen may have an important bearing on the quantum of debt deductions denied deductibility as the methods will usually arrive at different average values for the various items to be valued. This will be especially relevant for June balancers where the impact of COVID-19 will be apparent in the last few months of the 2019-20 income year. In these circumstances, using the frequent measurement method may assist in smoothing out the impacts of asset impairments due to COVID-19. The ATO has also indicated that this approach would be available to affected taxpayers to consider when assessing their thin capitalisation position under the safe harbour method.

However, for many taxpayers, changing the method in which to determine the relevant average values will not significantly alter their thin capitalisation position, and they may need to look to the arm’s length debt test to maintain their current level of deductions for debt. 

The ATO has outlined a simplified approach to the arm’s length debt test for those that need to rely on it as a direct consequence of COVID-19. It has specifically stated that it will not dedicate compliance resources to reviewing the application of the arm’s length debt test in the following circumstances, other than to verify that the taxpayer’s use of the test was directly due to COVID-19:

  • The taxpayer would have satisfied the safe-harbour test but for the COVID-19 related balance sheet effects and has used its best endeavours to apply all criteria of the arm’s length debt test.
  • For entities that are classified as inward investing entities (and not also outward investing entities) no additional related party funding is received, other than short-term (less than 12 months) debt facilities. The ATO expects any new capital to be equity.
  • For inward investing entities, the use of the arm’s length debt test was not because dividends were paid, thereby weakening the Australian balance sheet.

The ATO also state that taxpayers should attempt to prepare documents supporting the application of the arm’s length debt test, even though it will not apply compliance resources to determine if the documents satisfy the standards set out in draft Practical Compliance Guideline PCG 2019/D3 ATO compliance approach to the arm's length debt test.

The administrative concessions outlined above are stated to apply for tax years encompassing the February/March 2020 period, and it is understood the ATO has no current plans to extend these concessions.

Transfer pricing

The economic impact of the pandemic on multinational businesses may have implications for a range of transfer pricing arrangements, including financing and cash management, and impacts of changes in global supply chains and profitability on transfer pricing policies for goods, services and intangibles. 

As multinational businesses focus on financing and repatriation options to maintain sufficient levels of liquidity, transfer pricing becomes critical. As a starting point, any intercompany financing policy should be aligned with the group’s external approach to financing and commercial conditions facing the overall group. Refer to our Global Tax Insights for further information. 

Businesses experiencing severe economic impacts, such as reduced revenues, increased costs, disrupted supply chains, or other impacts on profitability, may need to reconsider whether their current transfer pricing policies are sustainable during the pandemic period. In some cases, groups may consider modifying their transfer pricing arrangements, and in others it may be necessary to prepare documentation to explain variations in profit or loss outcomes triggered by the pandemic. The ATO has released guidance on the types of analysis that it would expect to be performed to assess the impact of COVID-19 on a multinational group and its Australian operations, and the evidence it may seek to review when evaluating a taxpayer’s approach to managing its transfer pricing during this period. Any taxpayers considering changes to their transfer pricing policies as a result of the pandemic will need to ensure they have robust analysis demonstrating that the changes are arm’s length, and it will be important to maintain contemporaneous documentation to be able to respond to ATO enquiries in the future.

The ATO has also released guidance on interactions between transfer pricing and the JobKeeper program. Broadly, the ATO notes that it has concerns where the benefits of JobKeeper payments are effectively passed through to a non-resident related entity via a change in transfer pricing arrangements. An example is provided of an Australian entity providing services to a related party, but the ATO views may also be relevant for taxpayers with other types of transfer pricing arrangements (eg manufacturing or distribution transactions) where the Australian party involved is receiving JobKeeper payments.

Failure to prepare transfer pricing documentation by the time an income tax return is lodged means that an entity will not have a reasonably arguable position which may result in the imposition of penalties. However, the ATO has also indicated that as interim relief it will work with affected taxpayers who plan to lodge their income tax returns before the due date but are not able to get their transfer pricing documentation in place by the time the return is lodged. Specifically, the ATO may remit any penalties that would otherwise arise from the lack of a reasonably arguable position due to the failure to have relevant transfer pricing documentation in place at the time the return is lodged. This is only available where, among other things, the tax return which was lodged early was due to be lodged between 1 March and 15 July 2020 and the applicable transfer pricing documentation is put in place on or before the lodgment due date.

Other employment tax matters

Situations may arise where employers incur expenditure in order to assist employees that are at risk of becoming subjected to an emergency (including a serious illness or any similar matter). This may be, for example, by way of accommodation, transport, first aid or emergency health care. Such expenditure can generally attract Fringe Benefits Tax (FBT), however there are exemptions which may relieve any such liability where the assistance provided to the employee can be classified as ‘emergency assistance’ for the purpose of the FBT laws.

Furthermore, employers may consider offering employees greater flexibility in their working arrangements, to cater to those who wish to work from home during this time.

Items such as laptops and certain other work related devices, when used by an employee primarily for work purposes, may be provided by an employer without attracting FBT under certain circumstances. Similarly, if an employee wishes to salary package a device of this nature, provided the salary packaging arrangement is effective and the device meets the eligibility criteria, employers may be able to facilitate such an arrangement without attracting FBT.

Conclusion

With the assistance of support and practical statements from revenue authorities, businesses can focus on their operations and doing the right thing for their employees. For further information please refer to the ATO’s COVID-19 Frequently Asked Questions.

 

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Michael Bona

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