Denying deductions for payments relating to intangible assets connected with low tax jurisdictions

Introduction

In the October 2022-23 Federal Budget, the government announced its intention to introduce an anti‑avoidance measure to prevent large multinationals from claiming tax deductions for payments relating to intangibles connected with low corporate tax jurisdictions.

On 31 March 2023, Treasury released an exposure draft of the Treasury Laws Amendment (Measures for Consultation) Bill 2023: Deductions for payments relating to intangible assets connected with low corporate tax jurisdictions (Exposure Draft).  The Exposure Draft proposes to introduce an anti-avoidance provision in the form of section 26-110 of the Income Tax Assessment Act 1997 (Cth) (1997 Act).  The new rule is designed to deter significant global entities (entities with annual global revenue of at least $1 billion) (SGEs) from structuring their arrangements so that income from exploiting intangible assets is derived by an associate in a low or no corporate tax rate jurisdiction, while tax deductions for payments attributable to intangible assets made by the SGE to an associate are claimed in Australia. This rule will prevent the SGE from claiming tax deductions for such payments.

The proposed amendments will apply to amounts paid, liabilities incurred or amounts credited on or after 1 July 2023. 

Consultation on the Exposure Draft ends on 28 April 2023.  Please contact one of the authors or your KWM contact should you wish to discuss the Exposure Draft and its potential impact.

Background to the proposed measure

The EM identifies two issues that have necessitated the proposed measure and the breadth of it:

• Location of the taxation of income — A low or nil headline corporate income tax rate, or a regime that preferentially taxes income from intellectual property (i.e. a “preferential patent box regime”), may give rise to harmful tax practices if SGEs structure their business such that income from the exploitation of intangible assets is derived in a jurisdiction that provides the most favourable tax outcome, with nil or insufficient economic substance underlying the relevant tax concession.
• Mischaracterising payments — There may be circumstances where an SGE mischaracterises payments for intangible assets that are in substance, if not in legal form, made for the right or permission to exploit an intangible asset. This can occur if no value is assigned to the right to exploit an intangible asset under an arrangement, instead specifying that the consideration is paid for the provision of services from a related party.  In such circumstances, this may lead to royalty withholding tax not being paid.

Specifics of the proposed measure

Overview

Proposed section 26-110(2) provides that a taxpayer cannot deduct an amount for a payment it makes to an associate (the “recipient”), to the extent that the payment is attributable to a right to exploit an intangible asset, if:

• the taxpayer is an SGE for an income year;
• as a result of the arrangement under which the taxpayer makes the payment, or a related arrangement, the taxpayer or an associate of the taxpayer:
  • acquires the intangible asset; or
  • acquires a right to exploit the intangible asset; or
  • exploits the intangible asset.

The phrase ‘as a result of’, when read together with ‘arrangement’, has been drafted to ensure that it is not necessary that the payment and the acquisition of the right to exploit, or the exploitation of, an intangible asset, is provided for in the same contract; and

• the entering into of the arrangement under which the taxpayer makes the payment, or the related arrangement mentioned above, the acquisition of the intangible asset, the acquisition of the right to exploit the intangible asset or the exploitation of the intangible asset, results in:
  • the recipient; or
  • another associate of the taxpayer;

deriving income:

• • in a low corporate tax jurisdiction; and
  • directly or indirectly from exploiting the intangible asset, or from a related intangible asset.

The EM makes clear that where income is derived indirectly “strict tracing through the flow of funds is not required, in particular, it is not necessary to demonstrate that each payment in a series of payments funds the next payment or is made one after the other. Rather, it is sufficient if the payment exists between each entity”.  This view is consistent with the language used in the imported hybrid mismatch rule in Subdivision 832-H of the 1997 Act (in particular, section 832-625(3)(a)) and the broad interpretation adopted by the ATO in PCG 2021/5.

It is also not relevant where the recipient is located – there is no requirement that the recipient of the direct or indirect payment is located in a low corporate tax jurisdiction.

More generally, proposed section 26-110 will apply in relation to credits made by an SGE to an associate, or liabilities incurred by an SGE from an associate, in the same way as the proposed measure applies in relation to payments.

“Intangible assets”

Proposed section 26-110 applies to the specific items listed in section 26-110(5) in the same way as it does in relation to intangible assets (within the ordinary meaning of that term).  The matters identified include:

• certain things (whether property or not) referred to in paragraphs (a) or (c) to (e) of the definition of “royalty” in section 6(1) of the 1936 Act, including:
  • copyright, patent, design or model, plan, secret formula or process, trade mark, or other like property or right
  • scientific, technical, industrial or commercial knowledge or information
  • assistance that is ancillary and subsidiary to, and is furnished as a means of enabling the application or enjoyment of, any property or right, or any knowledge or information, as is set out above.

The proposed measure already applies to such “things” in the same way as it does an intangible asset given the inclusions set out above.  Therefore, it is unclear what this specific inclusion is designed to capture.  It is possible it will apply to payments for the supply of the ancillary and subsidiary assistance itself

• • visual images or sounds, or both, transmitted by various prescribed means
• a right in respect of, or an interest in, an intangible asset
• anything prescribed by the regulations.

Therefore, the intangible assets and other things to which the proposed measure will apply are exceptionally broad and, in some respects, unclear.  Clarification from Treasury and guidance from the ATO would be welcome in this respect.

Despite the breadth of the things to which the proposed measure can apply, there are limits.  For example, it will not apply to an intangible asset that is a right in these respects, or an interest in, a tangible asset, land, or a Division 230 financial arrangement.  As the EM provides, it is not intended to inappropriately apply to genuine supply and distribution arrangements between associates where there is no tax avoidance behaviour.  However, in the absence of a ‘purpose test’, it is difficult to see how the proposed measure would not apply other than in very specific circumstances where the prescriptive requirements are otherwise met.

“Exploit”

The concept of ‘exploiting’ an intangible asset includes a range of activities beyond the use of the intangible asset.  As the proposed measure provides, doing “anything … in respect of the intangible asset” constitutes the exploitation of the intangible asset.  The EM makes clear that the term is to be afforded a broad meaning “to capture the variety of ways in which intangible assets can be exploited in the businesses of an SGE group”.

Proposed section 26-110 will also apply in relation to any permission to exploit an intangible assets in the same way as it applies in relation to a right to exploit.  That is, mere access to the intangible assets by an associate will be sufficient to meet the definition.

The EM provides examples of activities that fall within the meaning of exploiting an intangible asset.  These include:

• the copying of an item of copyright or software
• the issuance of a licence key or other piece of information that allows access to a piece of software or a database
• accessing information contained on a database
• the deploying of or accessing the output of an algorithm
• a brand, trademark or other intangible asset that is a source of goodwill that can be used by an entity holding themselves out as a representative of that brand or group
• a right or obligation to distribute or sell products on behalf of an associate in return for consideration from either the associate or third party customers that involves marketing, selling or distributing the intangible asset even when that intangible asset, such as a software licence, is distributed directly from the offshore associate to the customer.

This may be relevant for taxpayers who, following the introduction of the multinational anti-avoidance legislation in 2015, restructured to bring certain foreign activities onshore.

“Low corporate tax jurisdictions”

A foreign country will be a “low corporate tax jurisdiction” if:

• the rate of corporate income tax under the laws of that foreign country is less than 15%, or nil

For this purpose, there are certain modifications to the headline corporate tax rate of a foreign country.  For example:

• • only income tax applicable to income of an SGE is relevant. For example, an income tax rate applicable to an SME would be disregarded
  • if the foreign country effects a progressive corporate income tax rate, then the highest possible rate is the relevant rate
  • if no income tax applies on a particular amount of income, then the rate of income tax on that amount is treated as being nil
  • if different rates of tax apply to different types of income, then the rate of income tax is the lowest of those rates.

We discuss the implications of some of these modifications below.

• the Minister makes a determination by legislative instrument that a foreign country is a low corporate tax jurisdiction. This determination requires the Minister to be satisfied that “the income tax laws of the foreign country provide for a preferential patent box regime without sufficient economic substance”.

Concerns with the proposed measure

Interpretation of ‘low corporate tax jurisdiction’

Given the breadth of the proposed measure – and, in particular, the concept of ‘exploit’ - it would be reasonable to look to the low corporate tax jurisdiction requirement as a reason for why the proposed measure will not apply.

However, given the definition of ‘low corporate tax jurisdiction’, there is a question as to how many foreign countries would not be low corporate tax jurisdictions.  In particular, the combination of:

• the rate of tax being treated as nil where no income tax applies on a particular amount of income, and
• only the lowest tax rate being relevant for the purpose of the proposed measure where different income tax rates apply,

might mean that many countries are low corporate tax jurisdictions.  For example, a country with an investment incentive for a particular type of income might come within the scope of a low corporate tax jurisdiction even when its headline corporate tax rate is 15% or greater. 

Further, if an amount of income is exempt from income tax (or, using an Australian concept, is non-assessable non-exempt income), it would appear that there is no income tax on a particular amount of income.  If so, then it necessarily means that the rate of corporate income tax under the laws of that foreign country will be nil, and thus that it is a low corporate tax jurisdiction.  This would be the case even when the income that is not subject to tax is unrelated to the income to which the proposed measure applies.

If that is correct then the scope of an already broad measure would be even broader.

A lack of examples in the EM

The EM only contains one detailed example regarding the application of proposed section 26-110.  For such a measure – and having regard to the other concerns addressed above and below - we would expect to see further examples.  The explanatory memorandum to the final Act should include additional examples to assist taxpayers to navigate the broad proposed measure. 

Since late last year, the ATO’s National Tax Liaison Group has been reviewing the process for supporting new tax laws with both extrinsic materials and ATO guidance, with a focus on maintaining regular and effective discussions between the ATO and Treasury to support the issuance of public advice and guidance.  We would encourage the ATO and Treasury to apply the recommended new consultation methodology to this measure to assist taxpayers in understanding the breadth and limits of the proposed measure.

Lack of a purposive element

Unlike other anti-avoidance rules (e.g. Part IVA and the proposed “distributions funded by capital raisings” measure), section 26-110 does not contain a purposive requirement (sole, dominant, principal or otherwise).  The result is that an already extremely broad measure is even broader.

Consistent with other anti-avoidance rules, we consider that a purpose-based requirement be introduced to the rules.  For example, this could be modelled off the diverted profits test ‘principal purpose’ test, coupled with exclusions such as a sufficient economic substance test, given both measures are, broadly, targeting the diversion of certain profits to lower taxing jurisdictions.

Apportionment

Proposed section 26-110 provides that a deduction will be denied “to the extent that the payment is attributable to a right to exploit an intangible asset”.  The EM notes that this text contemplates some degree of apportionment to occur, regardless of what is stated in the written contract between the relevant associated parties. 

A similar issue was addressed in the ATO’s draft royalties and software ruling (TR 2021/D4), and it is unclear how such apportionment is expected to occur.

Penalties

The EM notes that a shortfall penalty provision is being considered as “a punitive measure to penalise SGEs who mischaracterise such payments in an attempt to avoid income tax, including withholding tax”.  Stakeholder views are being sought as to how any proposed penalty provision is appropriately targeted. 

We consider that a loss of deductibility of a payment is sufficient penalty and that the imposition of a further penalty should not be introduced.