The Australian Taxation Office (ATO) has issued a taxpayer alert TA 2020/2 which signals the Commissioner’s intention to look closely at cross-border arrangements which he describes as “mischaracterising” the structure used by foreign investors to invest directly into Australian businesses.
What arrangements are being scrutinised
This Alert is relevant to arrangements which exhibit one or more of the following characteristics:
- The recipient of the funding is an Australian resident entity which is unable to obtain capital from traditional external debt finance sources on normal terms.
- A foreign investor that either:
- already participates in the management, control or capital of the Australian entity at the time of investment; or
- starts to participate in the management, control or capital as part of the investment.
- The arrangements between the recipient and the foreign investor:
- have features that are not consistent with vanilla debt or equity investments; or
- provide the foreign investor with direct exposure to the economic return from a particular business or assets (whether ongoing profit or a gain on disposal).
Τhe Alert suggests that the ATO will consider applying:
- the general anti-avoidance rules in Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) where arrangements divert profits (for significant global entities) or reduce the amount of taxable income or withholding tax payable by a taxpayer; and
- the transfer pricing provisions in Subdivision 815-B of the Income Tax Assessment Act 1997 (ITAA 1997) where parties are not dealing wholly independently in relation to the terms or conditions of the arrangements.
ATO examples and concerns
The Alert also examines two specific examples relating to "investments" made by foreign investors to Australian resident entities, though the Commissioner has not limited himself to these examples in seeking to apply Part IVA or the transfer pricing rules.
The first example relates to an arrangement where a foreign investor provides debt financing to an Australian resident entity.
Under the terms of the financing, the Australian resident entity will be charged with a higher interest rate (when compared to interest rates provided by traditional debt investors) and is required to make an additional contingent payment to the foreign investor in the event the Australian resident entity sells or divests its assets (which will be calculated as a share of the sale proceeds).
ATO concern: In this instance, the ATO is concerned that the additional contingent payment will not be subject to Australian withholding tax. Further, the contingent payment may not be otherwise subject to Australian income tax, as the Australian resident entity's taxable profit on divestment of the assets may be reduced based on the contingent amount payable to the foreign investor (either through the calculation of the capital gain or loss, or by deduction from the Australian resident entity's assessable income).
In the second example, the foreign investor (through a wholly owned US tax resident subsidiary which qualifies for benefits under the US / Australia double tax agreement (DTA)) provides capital funding to an Australian resident entity which holds a mining right. Under the terms of the funding, the foreign investor will have a right to receive payments based on the revenue from the sale of the resources.
ATO concern: In this instance, the ATO is concerned that the payments made to the foreign investor will not be subject to Australian income tax or withholding tax (by taking advantage of the US and Australia Double Tax Agreement).
Other ATO concerns
In addition to anti-avoidance and transfer pricing concerns, the Alert also identifies a number of other risk areas, including:
- the compliance with interest or dividend withholding tax obligations;
- capital gains arising from the grant of a right to income from mining or prospecting entitlements under CGT event D3;
- the characterisation of the investment as a debt interest or an equity interest (and the implications for thin capitalisation provisions and interest deductibility);
- the application of the relevant DTAs and entitlement to claim treaty benefits; and
- the requirement to disclose to the Foreign Investment Review Board under the Foreign Acquisitions and Takeovers Act 1975 and whether the arrangement seeks to avoid such an obligation by not characterising the arrangement as an ordinary equity interest or option to acquire such an interest.
The Alert provides an early warning to taxpayers in relation to alternative financing arrangements considered high risk by the ATO.
While it raises some important technical issues, we would be concerned if the application of the Alert in practice by the ATO lead to excessive scrutiny (including through the FIRB process) of genuine commercial arrangements with non-vanilla but low risk attributes. This is particularly crucial in the current economic climate, where vulnerable Australian companies need to have access to creative financing solutions which may be implemented quickly.
Prospective financiers, and recipients of finance, contemplating arrangements which exhibit one or more of the characteristics highlighted in the Alert should carefully consider the issues raised by the ATO. To the extent that financing arrangements do exhibit any of these characteristics a careful assessment of the arrangement is warranted.
In addition, we recommend that any assessment of arrangements be undertaken on a holistic basis, having regard to the various tax and non-tax outcomes for both the financier and the recipient of the finance. This exercise will form an important part of assessing the likelihood of the Commissioner applying general anti-avoidance rules.
If you would like any help in understanding the impact of the Alert on your existing or future financing arrangements, please contact us.