The ATO is pursuing more robust approaches to contemporaneous auditing, information-gathering and data-matching to close the tax gap. The ATO is also increasingly willing to strategically litigate disputes.
This section describes the ‘justified trust’ framework and developments in tax administration, which will lead to fewer opportunities for future tax planning.
i Justified trust
The ATO has adopted the OECD concept of ‘justified trust’ in its assurance approach. Under ‘justified trust’, the ATO seeks objective evidence from taxpayers that would lead a reasonable person to conclude that the taxpayer has paid the right amount of tax and met their tax obligations in a timely and transparent manner.
Justified trust focuses on obtaining assurance that:
- the taxpayer has a tax risk management and governance framework that is applied in practice;
- none of the specific tax risks communicated by the ATO to the market are present in the taxpayer’s circumstances;
- the tax outcomes of any significant, new or atypical transactions are appropriate; and
- any variance between accounting and tax results is explainable and appropriate.
The ATO applies its justified trust approach in its ‘Top 100’ and ‘Top 1,000’ programmes. Under both programmes, specialist tax performance teams are assigned to each taxpayer for intensive, tailored assurance reviews.
The justified trust approach is supported by ATO compliance activity (such as reviews, audits and litigation), active prevention activities across the market and the production of justified trust review documents, which are shared with the taxpayer’s board to encourage active tax risk management.
ii Litigation, information gathering and legal professional privilege
The ATO has been pursuing a strategic litigation approach for several years and is increasingly willing to litigate disputes with taxpayers to resolve conflicting interpretations of tax laws.
The ATO’s statutory information gathering powers include the ability to issue formal notices, colloquially referred to as a ‘Section 353-10 notice’. Such notices may require either the production of information, documents, the attendance of nominated persons for interview or a combination of the above. Section 353-10 notices are limited in scope to documents and personnel in Australia, however, the ATO may also issue ‘Section 264A’ offshore information notices to overseas entities.
Taxpayers failing to meet the requirements of Section 353-10 notices may be subject to a fine, and in extraordinary cases, imprisonment, though such enforcement is quite rare. No penalties or criminal sanctions are applicable for failure to comply with a Section 264A notice, however, refusing or failing to provide the requested information will mean that the same information is subsequently inadmissible in judicial proceedings challenging assessments, without the consent of the ATO.
The ATO’s information gathering powers are limited by legal professional privilege (LPP) under common law.
LPP does not apply to communications between accountants and their clients. However, as administrative concessions (which can be lifted), the ATO:
- accepts that certain documents between taxpayers and external professional accounting advisers should be treated as confidential; and
- will not, in practice, request access to advice that is provided by in-house counsel or external accountants and tax agents, where the advice is provided for the sole purpose of advising a corporate board on tax compliance risk.
The ATO has recently issued warnings regarding blanket unwarranted LPP claims being made over documents that do not contain independent legal advice or which contain aggressive tax planning arrangements disguised as privileged documents. The ATO is currently reviewing particular transactions and anticipates to conduct test litigation.
We expect these trends in information-gathering and strategic litigation to continue.
iii Cooperation with other government agencies
Increasingly, the ATO is coordinating with other government agencies, including the Foreign Investment Review Board (FIRB), to obtain advance warning of significant transactions that may impact revenues.
FIRB is the government agency responsible for examining proposals by foreign investors to acquire interests in Australian real estate (including agricultural land and water entitlements). FIRB makes a recommendation to the Australian Treasurer on whether to approve foreign investment and any conditions attached to the approval.
FIRB consults the ATO in the approval process to determine the potential tax impact of proposed foreign investment. The ATO provides a risk rating for the proposed transaction and may advise FIRB to impose tax conditions. This process gives the ATO considerable leverage to obtain information at the time of implementation.
A breach of tax conditions may lead to prosecution or a divestment order. FIRB may also impose other obligations on the investor, such as supplying certain information or requiring an ATO ruling be obtained.
iv Entity selection and business operations
Australia is a federation in which powers, including taxation powers, are divided between the federal government and the state and territory governments.
Income taxes are imposed by the federal government and collected by the ATO, led by the Commissioner of Taxation (Commissioner). No State or Territory government imposes income tax.
Income tax operates on residency and source bases. Residents of Australia are generally taxed on worldwide income. Non-residents are taxed on Australian-sourced income.
Australia operates a self-assessment income tax system. Companies are generally subject to a ‘full’ self-assessment system requiring companies to self-assess their tax liability and report this information to the ATO by lodging their taxation returns.
Indirect federal taxes, such as the broad-based value-added tax, called the Goods and Services Tax (GST) imposed at 10 per cent, are also self-assessed.
Returns may be audited by the ATO and amended generally within four years of assessment. An unlimited period of review applies in cases of ‘fraud or evasion’ by the taxpayer.
Businesses are required to register for pay-as-you-go (PAYG), a single integrated system for reporting and withholding amounts from certain types of payments including:
- business and investment income;
- wages and salaries paid to employees; and
- payments to other businesses that do not quote their Australian Business Number (ABN).
A new reporting framework called ‘Single Touch Payroll’ applies specifically to employers and operates by electronically transmitting payroll information in real time to the ATO when wages, salaries and other amounts are paid to employees.
A compulsory superannuation system operates in Australia. Generally, where an employee earns A$450 or more pre-tax income in a calendar month, employers are required to pay 9.5 per cent of an employee’s ordinary time earnings to a complying superannuation fund of the employee’s choice. Complex rules and concessions apply to superannuation contributions and income derived by funds.
Tax concessions are available to not-for-profit organisations, including an income tax exemption. These generally require satisfaction of purposive criteria and registration with relevant authorities.
Finally, state and territory governments impose their own taxes and equivalent imposts, including stamp duty, land tax, motor vehicle transfer duty and payroll tax.
Australian businesses are commonly structured as companies, partnerships or trusts (including ‘managed investment trusts’). All entities must register with the ATO and lodge annual income tax returns.
No check-the-box election is available. However, entity selection remains a choice for business owners, with taxation treatment generally following the nature of the entity. The ATO has scrutinised the use of multiple layers of entities, for example, establishing a head company and subsidiary to allow for tax consolidation in an acquisition scenario.
Partnerships and trusts
Partnerships (other than limited partnerships) are fiscally transparent, with partners being subject to tax on their allocation of income in accordance with a partnership agreement.
Trusts are generally fiscally transparent. Beneficiaries that are ‘presently entitled’ to trust income are usually subject to tax on their share of the trust’s taxable income. Trusts should annually distribute their income to beneficiaries as trustees failing to do so will be assessed on accumulated income.
Companies are not fiscally transparent and pay corporate tax.
An imputation system applies to distributions paid by Australian-resident companies. Under this system, refundable tax credits are available to Australian-resident shareholders for underlying Australian corporate tax paid on any ‘franked’ distribution received. This is intended to alleviate double taxation that occurs under a classical dividend system. Shareholders are taxed on ‘unfranked’ dividends at their marginal tax rate.
Draft legislation has been circulated for a proposed Corporate Collective Investment Vehicle (CCIV) regime, expected to be implemented around mid-2019.
CCIVs will be a new type of company intended to be readily marketable to foreign investors, including through the Asia Region Funds Passport.
Eligible CCIVs will be fiscally transparent with income and tax offsets retaining their character and subject to tax in the hands of members.
Australia’s foreign hybrid rules operate to treat foreign companies and foreign limited partnerships (LPs) controlled by Australians as partnerships for Australian income tax purposes. This impacts the nature of distributions received by Australian members in the foreign hybrid entity.
Choice of entity
Entity choice is generally linked with the character of the investors and the underlying assets. The default vehicle for trading businesses is a company, as it can retain cash without penalty and pay franked distributions.
Outbound investments from Australia are typically structured through companies as they have access to participation exemptions for non-portfolio dividend income and capital gains on disposal of shares in foreign companies carrying on active foreign businesses.
Unit trusts are routinely used in the property sector as they have the following advantages: trusts can pay ‘tax deferred’ distributions to members; and widely held property trusts can qualify as managed investment trusts (MIT).
Discretionary trusts are generally used in private groups to assist in income-splitting between family members.
Domestic income tax
Australian-resident companies are taxed on worldwide income at the flat rate of 30 per cent, however, those qualifying as ‘base rate entities’ are eligible for a reduced rate of 27.5 per cent. Companies do not benefit from the ‘tax-free threshold’ applying to Australian-resident individuals.
Foreign companies are taxed on Australian-sourced income at a flat rate of 30 per cent.
Subject to integrity rules, individuals are entitled to a 50 per cent discount on capital gains made on assets held for at least 12 months, including where the gain flows through a trust. Companies and non-residents are not entitled to this discount.
Australian residents are taxed on foreign-sourced income. Double taxation is addressed through an extensive treaty network (currently being updated under the MLI) and credits for foreign tax paid.
Offshore profits may be repatriated to an Australian company by payment of exempt non-portfolio dividends, however, subsequent dividends paid by the Australian company will be subject to tax at marginal rates in Australia, unless franking credits are otherwise available. This effectively means that these participation exemptions merely defer Australian tax for Australian-resident shareholders in respect of interests in foreign companies.
Non-residents who receive an unfranked dividend sourced from offshore exempt dividends do not pay any Australian dividend withholding tax under the conduit foreign income regime. This is intended to promote Australia as a holding company jurisdiction, although the success of this policy is unclear.
Australian branches of foreign subsidiaries are generally subject to tax at the corporate rate on income connected with the permanent establishment (PE). These profits can then be repatriated offshore free of further Australian tax.
Taxation of foreign income has been an area of significant legislative change, including new integrity rules targeting profit-shifting and avoidance within multinational groups or ‘significant global entities’ (SGEs).
SGEs are subject to additional reporting, integrity measures including the Diverted Profits Tax (DPT) and the Multinational Anti-Avoidance Law (MAAL) and increased penalties.
An SGE is an entity that is:
- a ‘global parent entity’ with annual global income of A$1 billion or more; or
- a member of a group of entities consolidated for accounting purposes in which another group member is a global parent entity with annual global income of A$1 billion or more.
From 1 July 2017, the DPT aims to ensure SGEs pay tax that reflects the economic substance of their activities in Australia’.
The DPT applies only to SGEs earning more than A$25 million revenue in Australia and requires that the SGE, or a foreign entity associated with the SGE, entered into or carried out a scheme for which a principal purpose was to obtain an Australian tax benefit or a foreign tax benefit.
If applied, the DPT will result in a 40 per cent penalty rate of tax being levied on the affected entity, which must be paid upfront. The DPT is intended to minimise the information asymmetry present in transfer pricing cases by shifting the onus to taxpayers to provide transfer pricing analysis before the ATO pursues litigation.
The MAAL was Australia’s unilateral legislative response to PE avoidance schemes.
The MAAL applies to schemes entered into from 1 January 2016 if under, or in connection with, the scheme:
- a foreign SGE supplies goods or services to an Australian customer;
- an Australian associate or commercially dependent entity undertakes activities directly in connection with the supply;
- some or all of the income derived by the foreign entity is not attributable to an Australian PE; and
- a principal purpose of the scheme is to obtain an Australian tax benefit or foreign tax benefit.
Where the Commissioner determines that the MAAL applies, any tax benefits arising under the scheme can be cancelled and penalties imposed.
The MAAL has largely achieved its intended effect of onshoring profits from sales to Australian customers. We expect that there will continue to be a shift away from complex structures that seek to avoid PEs in Australia as a result of the MAAL.
Activities and tax concessions
Australia does not have income tax rate differentials for industry sectors, other than a specialised offshore banking unit regime.
Tax concessions are available for start-ups and certain R&D activities, including:
- refundable tax offsets, currently at a rate of 43.5 per cent for ‘eligible entities’ with an aggregated turnover of less than A$20 million, and non-refundable tax offsets at a rate of 38.5 per cent for all other ‘eligible entities’;
- an early-stage innovation company (ESIC) tax incentive, which gives investors a 20 per cent refundable tax offset for their investment and a 10-year capital gains tax (CGT) exemption where the investment in an eligible entity is held for more than 12 months; and
- the start-up employee share scheme rules, which exempt the provision of shares or options to employees of start-up companies under compliant schemes.
Australia does not have corporate minimum capitalisation requirements. Thin capitalisation rules exist that prevent base erosion by disallowing debt deductions where the debt-to-asset ratio of Australian operations exceed prescribed debt limits. Higher limits apply to banks and financial entities.
A ‘general entity’ calculates its ‘maximum allowable debt’ under one of three elective methods.
The predominant method is the ‘safe harbour debt amount’ (SHDA). This method allows an entity to be funded by debt up to an amount equalling 60 per cent of the average value of the entity’s Australian assets calculated based on the accounting balance sheet, subject to certain adjustments.
Since the reduction of the allowable gearing ratio, taxpayers have increasingly relied on recognising and revaluing assets specifically for thin capitalisation purposes, resulting in increasing ATO review activity.
To eliminate this planning opportunity, draft legislation has been proposed that will require entities from 1 July 2019 to align the value of their assets and liabilities for thin capitalisation purposes with financial statements.
Entities geared above the SHDA may apply the arm’s-length debt test (ALDT) or worldwide gearing debt test (WWGT).
To rely on the WWGT, foreign-controlled entities must have audited accounts demonstrating that less than 50 per cent of the group’s assets are in Australia.
The ALDT sets the debt limit based on a hypothetical amount that could be borrowed given certain assumptions, including that the entity does not have any explicit or implicit credit support. In practice, the ALDT is highly subjective and requires significant work to document.
In contrast, the WWGT permits gearing of Australian operations up to the level of the worldwide group. It is based on audited accounting values and is more objective than the ALDT.
v Common ownership: group structures and intercompany transactions
A consolidation regime allows wholly owned groups of companies, eligible trusts and partnerships to consolidate for income tax purposes.
Consolidation requires the head company and subsidiary entities to be Australian tax residents. Australian-resident wholly owned subsidiaries of a common foreign holding company may form a multiple-entry consolidated group.
A consolidated group is treated as a single entity for income tax purposes. Tax attributes are pooled and transactions between members are disregarded, permitting the transfer of assets between wholly owned entities with no income tax implications. For this reason, group restructures generally make extensive use of the consolidation regime.
Assets can also be transferred tax-free between an Australian entity and a foreign resident free from CGT, provided the transferor and transferee are members of the same wholly owned group.
Ownership structure of related partiesTax grouping and loss sharing
Consolidation is necessary to pool tax losses in a group.
On joining, all of the entity’s carry-forward losses that could have been used outside the group at the joining time are transferred to the head company. Integrity rules operate to prevent losses being used at a greater rate than they would have without consolidation.
Australia has robust and broad-based CFC rules, which capture passive and ‘tainted’ service and sales income. The CFC rules are considered to meet the ‘best practice’ BEPS criteria.
Planning opportunities are limited and mostly involve ensuring that Australian entities do not control the CFC or that ‘active income’ makes up 95 per cent or more of the CFC’s income, although this is difficult in light of an associate inclusive in-substance control test.
Australia has repealed its foreign investor fund (FIF) rules. The FIF rules formerly taxed accrued gains on ‘portfolio’ interests.
Domestic intercompany transactionsGeneral deductibility
Although there are no general domestic transfer pricing rules, limitations exist on deductibility of related party expenses. Excessive payments may be characterised as distributions of profit and are consequently not deductible.
Statutory rules also exist in relation to the deductibility of related party expenditure. For example, deductions for related party expenditure are not generally available until the period in which the recipient treats the receipt as assessable. A full list of similar integrity rules is beyond the scope of this chapter.
MIT non-arm’s length income
The MIT rules uniquely contain specific non-arm’s length income (NALI) rules. If the Commissioner determines an amount to be NALI, the trustee is taxed at the corporate rate on the excess of the NALI amount over the hypothetical arm’s-length amount, minus deductions that are referable only to the amount of the excess. The NALI rule is an integrity rule aimed at preventing the abuse of the 15 per cent withholding tax rate. It will generally apply to businesses that derive rental or similar passive income such as property funds or infrastructure assets.
International intercompany transactionsTransfer pricing
Supported by the application of the DPT to SGEs, Australia has a robust international transfer pricing regime that the ATO considers is ‘broadly consistent with the updated OECD TP Guidelines’. The regime is supported by country-by-country reporting obligations effective from 1 January 2016. The transfer pricing regime operates on an arm’s-length principle and now permits the ATO to adopt a reconstruction approach to determining the impermissible transfer pricing benefit.
Chevron Australia Holdings Pty Ltd v. Commissioner of Taxation provided judicial guidance on applying the transfer pricing provisions to cross-border related-party financing. The Court held that an arm’s-length rate of interest should not be determined as if the subsidiary were a company separate from the rest of the group. This will have significant implications for pricing cross-border debt in multinational groups, as the subsidiary will need to account for the group’s creditworthiness.
Australia also participates in information exchange under both the Foreign Account Tax Compliance Act (FATCA) and Common Reporting Standard (CRS) regimes.
Australia’s CGT regime applies to related party transactions.
Australian residents are subject to CGT on a worldwide basis.
Foreign residents are only subject to CGT on assets that are ‘taxable Australian property’, including real estate in Australia or CGT assets used in an Australian PE.
Integrity rules exist to deem a transfer to be at market value if the transaction is not at arm’s length.
Tax is payable on net capital gains, while a capital loss may be offset against capital gains or carried forward to later income years. Companies are entitled to carry forward capital losses provided they have either substantially maintained the same ownership and control or carried on the same business.
The operation of the CGT rules means that cross-border related party transactions may have Australian tax implications where the vendor is an Australian entity or where the asset is land or an interest in a land rich entity. No CGT implications arise for foreign entities where the assets is not land or an interest in a land-rich entity.
vi Third-party transactions
The taxation implications of third-party transactions depend on whether the transaction is on revenue or on capital account, which is a question of fact. This subsection addresses third-party transactions on capital account, generally including divestment of investments and like transactions.
Sales of shares or assets for cash
Australian companies may reduce their capital gains from disposals of shares in a foreign company under a participation exemption.
The exemption requires the Australian company to have held a ‘direct voting percentage’ of 10 per cent or more in the foreign company throughout a 12-month period that began no earlier than 24 months before the time of disposal. Under the exemption, the gain is reduced by a percentage reflecting the foreign company’s ‘active business’ asset use. The relevant percentage reduction is calculated by a market value or book value method at the taxpayer’s election. If that percentage is greater than 90 per cent, the gain is reduced by 100 per cent.
There is no other relief on a cash sale of assets.
Tax-free or tax-deferred transactionsScrip for scrip
In the case of a takeover involving the issue of some shares, a vendor may be able to defer paying CGT until a later CGT event to the extent of the scrip consideration. The exchange should be carefully structured so the same arrangement is offered to all shareholders of the same class. This rollover does not permit an exchange of shares for units or vice versa, however, it does permit a rollover of redeemable preference shares (RPS) even if they are treated as debt for income tax purposes. Importantly, if RPS are ‘voting shares’ for the purposes of the Corporations Act 2001, they must be able to participate in the exchange.
There is no specific rollover available for the exchange of tangible or intangible assets other than in specific circumstances (e.g., when the asset is damaged).
Rollover relief may apply to the interposition of a new holding company between a company and its shareholders. Under this rollover, interests in a newly incorporated holding company are issued to all of the shareholders in exchange for all of their interests in the original company (and nothing else).
An entity may choose to rollover a capital gain or loss arising from a demerger of entities from a group provided a number of eligibility conditions are satisfied.
Observations have been made by industry that the ATO is narrowing the scope of the demerger tax relief provisions.
One criterion is that shareholders of the head entity must acquire shares in the demerged entity, and nothing else (of value). The ATO previously accepted that demerger tax relief would apply where the shareholders of the demerged entity sold their shares after the demerger (e.g., under a takeover), provided the demerger was not conditional on the subsequent share sale occurring.
The ATO has recently released a draft Taxation Determination (TD 2019/D1) in which the ATO gives the following examples:
- demerger tax relief will be available where a head entity is sold after a subsidiary is demerged pursuant to a takeover bid that is legally and commercially independent of the demerger; and
- where a subsidiary is demerged with the intention of preparing the head entity for sale, the ‘nothing else’ requirement will not be satisfied (where it is shown that the demerger was unlikely to have occurred except to prepare for the head entity’s sale).
The ATO has only recently expressed the view that relief is not available where a demerger is followed by a share sale as the ‘nothing else’ requirement is not met, in some cases even absent conditionality between the two. This view in the draft determination is controversial as it had not been previously announced and no public guidance or explanation has been provided.
Rollover relief will be available where an individual, partner or trustee disposes of the assets of a business to a wholly owned company. This is commonly done as part of an exit from a business operated as a sole trader or through a discretionary trust.
The balance sheet of the business must be managed to ensure that the liabilities assumed by the company do not exceed the sum of the market value of precluded assets and the cost base of the non-precluded assets. There is frequently difficulty in satisfying this requirement where the value of the business is largely internally generated goodwill.
There is no specific rollover for intangible assets.
Liquidation dividends sourced in profits are assessable as dividends. Liquidation proceeds not attributable to profits are treated as capital proceeds of liquidation and may trigger a capital gain. No specific relief is available.
Two noteworthy issues arise in relation to third-party cross-border transactions.
First, key integrity rules around interest withholding tax-free financing only apply where the counterparty is an unrelated non-resident financier. For example, the public offer test is deemed to have been failed if the financier is a related third party.
Secondly, claw-back rules can apply to the sale of shares. CGT event J1 applies where there was previously a rollover of a capital gain on transfer of an asset between members of a wholly owned group. The tax liability is triggered if the transferor and transferee cease to be wholly owned. Any share sale structuring should take account of this possibility.
vii Indirect taxes
The GST is a broad-based (value added) tax of 10 per cent applying to most goods, services and other items sold or consumed in Australia. A number of goods and services are exempt from GST, in particular, many medical goods and services, most ‘basic’ food, and exports.
Registration for GST is mandatory for Australian businesses with a GST turnover exceeding A$75,000, increasing to A$150,000 for non-profit organisations.
Non-resident entities are required to register if they are carrying on an enterprise and have a GST turnover from sales connected with Australia exceeding A$75,000.
The ‘Netflix Tax’, applicable from 1 July 2017, imposes GST on sales of imported services and digital products to purchasers that are ‘Australian consumers’.
A purchaser is an ‘Australian consumer’ if it is an Australian resident and either:
- is not a business registered for GST; or
- purchases the product for non-business use.
Several other indirect taxes in Australia are limited to specific industries or products. For example, luxury car tax of 33 per cent is imposed on vehicles over the relevant inflation indexed threshold; and wine equalisation tax is imposed at 29 per cent of the wholesale value of wine, payable by entities making, wholesaling or importing wine into Australia.
Fuel tax credits provide businesses with a credit for excises or customs duty that was included in the price of fuel used in machinery, plant, equipment and vehicles travelling off public roads.