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26 June 2023
In brief
On 23 June 2023, the Treasury released updated exposure draft law and explanatory materials (proposed new law) which significantly amends the scope of the Federal Government’s proposal to deny deductions for payments made by Significant Global Entities (SGEs) relating to intangible assets connected with low corporate tax jurisdictions.
The commencement date for the proposed new law is unchanged and is anticipated to apply for in-scope payments made or credited, or liabilities incurred on or after 1 July 2023.
Of particular note is a new two-step process outlined below:
Step one
Consider whether income is derived in a low corporate tax jurisdiction.
A low corporate tax jurisdiction continues to include foreign countries with a headline (as opposed to effective) corporate income tax rate of less than 15 per cent (or nil) or foreign countries with a preferential patent box regime.
However, the proposed new law will now have regard to a rate of tax in that country that applies to income derived in the ordinary course of carrying on a business with that rate not overridden where there are exemptions or concessions for particular industries or particular types of income.
Step two
There is now an additional provision (proposed subsection 26-110(4)(b)) to apply in relation to income derived in a low corporate tax jurisdiction, which takes into account the actual tax paid on the income received.
A deduction for a payment should not be denied where the corresponding income is:
- assessed as attributable income under Australia’s controlled foreign company (CFC) regime; or
- ‘subject to foreign income tax’ at a rate of 15 per cent or more.
Subject to foreign income tax is a defined term in Australian tax law and, due to a modification in the exposure draft law, it enables consideration to be given to combining the actual rates of tax suffered including:
- federal income tax;
- taxation under foreign CFC regimes which correspond to Australia’s CFC regime;
- taxation under the hybrid mismatch rules of a foreign country (or rules with substantially the same effect);
- State and municipal taxes; and
- potentially, income taxed under a domestic minimum top-up tax regime (DMTT). However, this aspect is not certain given the current drafting which may depend on how DMTTs are legislated in foreign countries.
Other key aspects to note are summarised below:
- A deduction denial will be reduced to the extent the payer has remitted (Australian) royalty withholding tax on the payment.
- The operative provisions of the proposed rules have been updated but appear broadly similar in their effect. Definitions of other key concepts including ‘intangible asset’, ‘exploit’ and ‘arrangement’ are intended to remain broad in their scope.
- There remains uncertainty around ‘mischaracterisation’ and of certain payments that are in substance, but not legal form, made for the right to exploit an intangible asset.
- There remains no guidance on apportionment methodology. This is expected to be relevant in determining the proportion of a payment that may be denied including in scenarios where a payment is considered to be mischaracterised.
- Existing base penalties for SGEs will be doubled in respect of tax shortfall amounts resulting from the application of the proposed rule.
- The accompanying ‘Summary of Consultation Process Outcomes’ notes that “The Government is further considering interactions of the intangibles measure with global minimum taxes and domestic minimum taxes.”
The proposed new law has not been introduced as a bill in Parliament, will not be enacted before 30 June 2023 and therefore will apply retrospectively to in-scope payments from 1 July 2023.
All multinational enterprises operating in Australia should consider the impact of these changes as a matter of priority.
In detail
The Australian Treasury released three tranches of exposure draft law in March and April 2023, covering several of the key components of the Government’s multinational tax package including an intangible assets integrity measure to deny deductions for payments relating to intangible assets connected with low corporate tax jurisdictions.
The intangible assets integrity measure was not included in the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share - Integrity and Transparency) Bill 2023 which was introduced into the House of Representatives on 22 June 2023 and covered thin capitalisation and Australian public company disclosures as summarised in PwC’s Tax Alert.
However, on 23 June 2023, the Treasury released updated exposure draft law and draft explanatory materials in relation to the intangible assets integrity measure.
Payments in scope
Broadly, and subject to the additional provisions discussed below, under the proposed new law, a deduction denial will apply:
- to a payer that is an SGE (multinational groups with consolidated annual global income of A$1 billion or more);
- in respect of a payment it makes directly or indirectly to an associate;
- to the extent that the payment is attributable to a right to exploit an intangible asset;
- if, the arrangement under which the payer makes the payment (either alone or together with any other related arrangement) results in the payer (or an associate of the payer):
- acquiring the intangible asset; or
- acquiring a right to exploit the intangible asset; or
- exploiting the intangible asset; and
- the payment results in an associate deriving income in a low corporate tax jurisdiction directly or indirectly from exploiting the intangible asset or from a related intangible asset.
The proposed new law continues to apply to payments, the incurring of a liability or the crediting of an amount (collectively referred to as “payments”) on or after 1 July 2023.
Payments made directly to unrelated third parties remain out of the scope of the proposed new law, unless they are also indirect payments to an associate.
Low Corporate Tax Jurisdiction
A key gateway of the proposed new law is that the income is derived in a “low corporate tax jurisdiction”. This includes foreign countries with a corporate tax rate of less than 15 per cent (or nil).
Whilst there remains some complexity in determining whether a country is a low corporate tax jurisdiction, several uncertainties from the previous exposure draft appear to have been clarified, including:
- the removal of the requirement to treat a country as a low corporate tax jurisdiction where, under the laws of the foreign country, there is no income tax on a particular amount of income; and
- clarification that the headline tax rate is not overridden where there are exemptions or concessions for particular industries or particular types of income.
In working out the corporate tax rate of a foreign country under the proposed new law, the following broadly applies:
- Have regard only to tax that applies to income derived in the ordinary course of carrying on a business;
- Disregard:
- the effect of deductions, offsets, tax credits, tax losses, tax treaties, concessions for intra-group dividends, exemptions for particular industries and exemptions for particular types of income; and
- rates of income tax that apply only to non-residents;
- The highest possible corporate tax rate is used if the application or rate of income tax in a foreign country depends on the taxpayer’s amount of income;
- The lowest tax rate is used where there are different rates of tax for different types of income in a foreign country (albeit noting the aspects disregarded above, such as exemptions for industries or other concessions); and
- Have regard only to the rate of corporate income tax in respect of the income of an entity that is a SGE.
The Explanatory Materials also include two new examples to illustrate the assessment as to whether a country is a low corporate tax jurisdiction. Example 1.3 clarifies that the taxation of passive income at a rate of 22 per cent will not alter the status of a country as a low corporate tax jurisdiction where the tax rate applying to trading income, ordinarily derived from the carrying on of a business, is 10 per cent. Example 1.4 clarifies that the non-imposition of tax on capital gains and a reduced tax rate for income for a specific industry will not alter the status of a country.
A Government Minister can also determine a foreign country to be a low corporate tax jurisdiction if the foreign country has a preferential patent box regime without sufficient economic substance in that jurisdiction. This provision is not intended to capture all patent box regimes, only those that provide concessional tax treatment without requiring any economic activity to develop the relevant intellectual property in the country that provides the patent box concession.
The proposed new law states that, in making a determination, the Minister may “have regard to any relevant findings, determinations, advice, reports or other publications” of the Organisation for Economic Co-operation and Development (OECD).
Disregarding income - Subsection 26-110(4)(b)
An additional provision in the proposed new law has been included in proposed subsection 26-110(4)(b). This subsection applies to test the actual payments from Australia in relation to income derived (directly or indirectly) in a low corporate tax jurisdiction and in essence gives consideration to the particular tax paid on the income derived.
Income will be treated as not having arisen in a low corporate tax jurisdiction, and a deduction for the corresponding payment will not be denied, where the income is assessed as attributable income under Australia’s CFC rules or where the income is ‘subject to foreign income tax’ at a rate of 15 per cent or more.
‘Subject to foreign income tax’ is a term defined in Australia’s hybrid mismatch rules (in section 832-130 of the Income Tax Assessment Act 1997) and requires:
- an amount of income or profits;
- in a foreign country in a foreign tax period;
- foreign income tax (with exceptions including for State and municipal taxes excluded in the proposed new law) payable under a law of the foreign country in respect of the amount; and
- payable because the amount is included in the tax base of that law for the foreign tax period.
Proposed subsection 26-110(4)(b) allows for consideration of the rate at which the income is ‘subject to foreign income tax’ as defined in the hybrid mismatch rules or a modification of the term which excludes the exceptions for State and municipal taxes (i.e. the modification allows them to be included in assessing whether the income was subject to foreign income tax at 15 per cent or more).
The effect of this provision is to enable consideration to be given to combining the actual rates of tax suffered including the following:
- Federal income tax applied to the income (which might not be at the same headline rate as considered in the definition of a low corporate tax jurisdiction);
- Taxation under foreign CFC regimes which correspond to Australia’s CFC regime;
It is noteworthy that in Taxation Determination 2022/9, the Australian Taxation Office considers the US Global Intangible Low-Taxed Income (GILTI) regime under Section 951A of the Internal Revenue Code of 1986 does not correspond to Australia’s CFC regime.
Additionally, the proposed new law does not provide any reference to the anticipated adoption of new laws by foreign countries under the OECD’s Pillar Two reforms including the anticipated legislation of Income Inclusion Rules (IIRs). Further consideration will need to be given to how IIRs are legislated in foreign countries (for example, whether IIRs will represent foreign CFC regimes which correspond to Australia’s CFC regime); - Taxation under the hybrid mismatch rules of a foreign country (or rules with substantially the same effect);
- State and municipal taxes;
This is illustrated in Example 1.5 of the draft explanatory materials and may result in different outcomes for payments made to the same country due to different rates of State or municipal taxes.
Consideration should also be given as to whether an entity is entitled to a deduction for State and municipal taxes in the calculation of its liability to Federal income tax, State or municipal taxes; and - Income taxed under a DMTT regime (potentially);
To the extent income subject to a DMTT satisfies the requirements to be ‘subject to foreign income tax’, they should be eligible to be taken into consideration in proposed subsection 26-110(4)(b). However, this aspect is not certain and may depend on how DMTTs are legislated in foreign countries.
Remittance of (Australian) royalty withholding tax
A further additional provision has been included in the proposed new law with the effect that a deduction denial will be reduced to the extent the payer has remitted (Australian) royalty withholding tax on the payment. Importantly, the way this is achieved is by grossing up the withholding tax actually paid by 30 per cent to arrive at the deductible proportion or amount. Example 1.6 of the draft explanatory materials illustrates the effect of this additional provision.
Other key concepts - intangible asset, exploit and arrangement
Definitions of other key concepts including ‘intangible asset’, ‘exploit’ and ‘arrangement’ are largely unchanged from the previous exposure draft and remain broad.
Intangible assets
The proposed new law will apply to payments attributable to a right to exploit an intangible asset. The term “intangible asset” is undefined and is intended to take its ordinary meaning (with limited examples such as information or data, including a database of customers and an algorithm specifically set out in the proposed new law).
Noting a substantial degree of overlap, the proposed new law also applies to a list of specific inclusions in the same way as it applies to intangible assets. The specific inclusions are those subject to the definition of a royalty under Australian domestic law (excluding industrial, commercial or scientific equipment), a right in respect of, or an interest in, an intangible asset; and anything prescribed by the regulations for the purposes of this paragraph.
The proposed new law also contains a list of intangible assets which are excluded from the application of the law:
- Rights in respect of, or interests in, tangible assets (such as a right to use a piece of industrial equipment under a hire agreement or a right to extract minerals from the earth),
- An estate, interest or right in or over land or a right in respect of such an estate, interest or right (such as a lease over real property),
- Financial arrangements to which the Taxation of Financial Arrangements (TOFA) regime under Division 230 of the Income Tax Assessment Act 1997 applies (such as a derivative where the gains and losses are brought to account under the TOFA regime),
- A financial arrangement being an equity interest or right or obligation in relation to an equity interest for which the gains and losses are not brought to account under the TOFA regime (this ensures such equity interests are carved out regardless of the TOFA election a taxpayer has made),
- A right in respect of, or an interest in, an intangible asset that is already covered by any of the above, and
- Anything already prescribed by the regulations.
The explanatory materials at Paragraph 1.53 state that the proposed new law is not intended to apply to the extent that a “genuine supply and distribution arrangement between associates” is attributable to any of the excluded items (such as rights in respect of, or interests in, tangible assets). A short example is then provided that considers the proposed new law will not apply where trademarks are printed on finished goods that are marketed and sold by an SGE to customers, to the extent that the payment made is genuinely attributed to the good and not the trademark.
This wording represents a subtle change from the wording in the previous draft explanatory materials which did not reference the excluded items but simply stated “it is not intended for this anti-avoidance rule to inappropriately apply to genuine supply and distribution arrangements between associates where there is no tax avoidance behaviour”.
Exploit
The proposed new law prescribes a broad definition of the term ‘exploit’ where ‘exploit an intangible asset’ includes:
- use the intangible asset;
- market, sell, licence or distribute the intangible asset;
- supply, receive or forbear in respect of the intangible asset where paragraph (c), (d), (da) or (f) of the definition of a royalty in subsection 6(1) of the Income Tax Assessment Act 1936 applies to the supply, reception or forbearance;
- exploit another intangible asset that is a right in respect of, or an interest in, the intangible asset; and
- do anything else in respect of the intangible asset.
Arrangement
The term “arrangement” is already defined very broadly in the Australian tax law to include any arrangement, agreement, understanding, promise or undertaking whether express or implied and whether or not enforceable (or intended to be enforceable by legal proceedings). The draft explanatory materials confirms this and suggest that the legal agreements may not be determinative and non-legal undertakings may be relevant. This could potentially create uncertainty in terms of attempting to identify the arrangement(s) in question.
Mischaracterisation
There remains uncertainty as to the circumstances where a deduction will be denied due to the mischaracterisation of a payment.
Exploitation of an intangible asset by the payer under the arrangement
The proposed new law is intended to apply in circumstances outlined (primarily for the purposes of withholding tax) in Taxpayer Alert TA 2018/2 Mischaracterisation of activities or payments in connection with intangible assets, broadly being where a payment is made under an arrangement for tangible goods or services but the arrangement (or related arrangement) also results in the payer being provided with a right to exploit, permission to exploit or otherwise exploitation of intangible assets.
This scenario is illustrated in Example 1.1 which remains unchanged from the previous exposure draft.
Exploitation of an intangible asset by an associate under the arrangement (or related arrangement)
It is still unclear whether, under an arrangement, there is an exploitation of an intangible asset by an associate in delivering a service or a good to a taxpayer which may result in a denial of part of the payment made to acquire that service / good (for example the exploitation of a patent by an associate in manufacturing a good).
Apportionment
No guidance has been included on apportionment methodology.
The use of the words ‘to the extent’ in the proposed new law contemplates a scenario where the payment represents an undissected amount for a bundle of rights or benefits such that an apportionment exercise is required to separate and allocate parts of the payment to those rights. There is also reference in the draft explanatory materials to a deduction being “proportionately denied where the payment is genuinely made as consideration for other things…”.
There are a number of transfer pricing methodologies that could be used to apportion payments, however the draft explanatory materials do not provide guidance on how such an apportionment exercise should be undertaken. This appears similar to the potential for uncertainty on apportionment in the context of draft Taxation Ruling TR 2021/D4 Income tax: royalties - character of receipts in respect of software (albeit relevant to withholding tax).
Penalties
Treasury previously sought stakeholder views regarding a shortfall penalty provision, as a punitive measure, to penalise SGEs which mischaracterise payments in an attempt to avoid income tax, including withholding tax.
Under the proposed new law, existing base penalties for SGEs will be doubled in respect of tax shortfall amounts resulting from the application of the proposed rule. This may represent a penalty of 100 per cent of the tax shortfall amount where there is no reasonably arguable position.
What happens next?
There does not appear to be any scope to make submissions on the proposed new exposure draft.
The proposed new law was not introduced into Parliament in the most recent sitting which ended on 22 June 2023 and will therefore not be enacted before 30 June 2023. The next opportunity to do so will be following resumption for the Spring sittings, which commence from 31 July 2023.
The Impact Statement included as part of the explanatory memorandum for Treasury Laws Amendment (Making Multinationals Pay Their Fair Share - Integrity and Transparency) Bill 2023 also included a confirmation that the ATO intends to issue guidance materials to assist taxpayers after the intangibles integrity measure has passed parliament.
The Takeaway
The new exposure draft seeks to clarify some uncertainties from the previous exposure draft, particularly regarding the definition of a low corporate tax jurisdiction. The additional provisions in proposed subsection 26-110(4)(b) relating to income assessed as attributable under the Australian CFC rules and amounts subject to foreign income tax at a rate of 15 per cent or more should remove many payments from the scope of the proposed new law. The ability to reduce the deduction denial to the extent the payer has remitted (Australian) royalty withholding tax on the payment will also reduce the impact of the proposed new law for some taxpayers.
A critical component of outcomes for taxpayers will be whether anticipated and enacted DMTTs under Pillar Two reforms will satisfy the requirements of the definition of 'subject to foreign income tax'.
Additionally, there remains uncertainty as to when an amount will be considered to be mischaracterised under the proposed new law and the extent to which it will be denied.
As the commencement date for the proposed rules is unchanged and will apply to in-scope payments made on or after 1 July 2023, taxpayers should consider the potential application of the proposed rules to their arrangements in anticipation of final legislation after 1 July 2023.
Jonathan Malone
Chris Hogger
Angela Danieletto
Greg Weickhardt
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