Permanent Establishments 2.0

This article originally appeared in the September edition of The Taxpayer

https://www.taxandsuperaustralia.com.au/TSA/Products_Services/Publications/The_Taxpayer/TSA/Publications/The_Taxpayer.aspx

 

The 1997 Assessment Act states that, if you are a foreign resident, your assessable income includes the ordinary income you derive from Australian sources (e.g. from sales to Australian customers). In practice, however, it can be difficult for Australia to tax many non-residents on their Australian income. This is because it can be difficult for the ATO to detect business income which has a source in Australia and, where detected, challenging to collect the tax on that income.

In recognition of these difficulties, Australia will not tax the Australian-sourced income of our treaty partners, unless the non-resident has a sufficient presence in Australia. This sufficient presence is referred to as a ‘permanent establishment’ (PE). Practically, this means that a non-resident will likely need to lodge an Australian return if it has a PE in Australia.

What if the non-resident is not from a treaty country?

The bulk of Australia’s trade and investment involves countries with which Australia has entered into a Double Taxation Treaty (DTT). Furthermore, Treasury is frequently negotiating new treaties – for example a treaty was signed with Chile in April 2010. Nevertheless, there are still many countries, from Afghanistan to Zimbabwe, where no such agreement is in place. Where there is no DTT in place, Australia does not require non-residents to have Australia to have a PE before it will tax them on their Australian business profits.

Where a non-resident business has a PE in Australia, our DTTs only allow Australia to tax the profits that are attributable to that PE. When calculating which profits to attribute to a PE, the ‘functionally separate entity’ approach is applied. Broadly, this means that the PE will be taxed on the profits it might be expected to make if it were a separate and independent enterprise, dealing with other parts of the enterprise at arm’s length.

 

The OECD Model

Australia’s tax treaties generally closely match the OECD’s Model Tax Convention (model treaty) and therefore this article focuses upon the clauses of this model convention and its official commentary[2]. Under the model convention, there are broadly three types of PEs that can be construed:

  • A fixed place of business PE (Article 5(1)),
  • A construction or project PE (Article 5(3)), and
  • An agency PE (Article 5 (5-6)).

Each of these are discussed in detail below.

 

The BEPS Project

The permanent establishment concept has been around for many years – it dates back to the 1800s and the Austro-Hungarian empire. The OECD’s model treaty can trace its origins to the League of Nations. As you can imagine, international business has grown enormously, and undergone substantial changes during the intervening years.

The OECD’s BEPS (Base Erosion and Profit Shifting) project represents the most significant attempt to address the challenges of a modern, complex global economy in decades. The project is divided into 15 ‘actions’, with Action 7 focusing on permanent establishments. Broadly, the OECD is proposing to expand the definition of a permanent establishment to counter multinational enterprises that seek to avoid PE status via what it sees as artificial arrangements.

The OECD’s specific proposals, contained in the final report on Action 7, are discussed in detail below. It is expected that, over the coming 18 months or so, the countries involved (including Australia) will amend their bilateral tax treaties (via a multilateral instrument) to reflect the proposed changes.

 

The general definition

Paragraph 1 in Article 5 of the model treaty contains the general definition of the term “permanent establishment”. It states:

“For the purposes of this Convention, the term “permanent establishment” means a fixed place of business through which the business of an enterprise is wholly or partly carried on.”

A PE therefore has three elements:

  • There must be “a place of business”,
  • That place of business must be “fixed”, and
  • The business of the enterprise must be carried on “through” that fixed place

Place of business

The OECD commentary explains that the term place of business covers premises, facilities or installations, whether or not they are used exclusively in carrying on the business of the enterprise. Furthermore, a place of business may exist where an enterprise merely has a certain amount of space at its disposal (i.e. even if this space is not owned or rented by the enterprise).

Determining when a facility is at the disposal of an enterprise can be a difficult and contentious issue. Clearly the mere presence of a representative of an enterprise at a location does not necessarily mean that the location is at the disposal of that enterprise. However, where an employee of a company is permitted to use an office at the premises of another company (e.g. a subsidiary) for an extended period of time, that office can be said to be at the disposal of the former company. It appears that the extent of the presence at a location, the activities performed at a location and the effective power to use a location may be relevant.

 

Fixed

The commentary explains that there must be a stable link between the place of business and a specific geographic point. Furthermore, the business must have a certain degree of temporal permanency. The ATO has ruled[1], and the OECD has suggested, that, as a guide, six months or more is sufficiently ‘permanent’. However, this is not a hard and fast rule – each case is a question of fact and degree. A place of business may constitute a PE even though it exists for a very short period of time, due to the nature of the business.

Through

The commentary advises that the word ‘through which’ must be given a wide meaning “so as to apply to any situation where business activities are carried on at a particular location that is at the disposal of the enterprise for that purpose”.

 

The listed examples

Paragraph 2 provides specific examples of a PE. It states that the term includes especially:

“a) a place of management;

  1. b) a branch;
  2. c) an office;
  3. d) a factory;
  4. e) a workshop, and
  5. f) a mine, an oil or gas well, a quarry or any other place of extraction of natural

resources.”

These examples are by no means exhaustive and are to be seen against the background of the general definition.

 

Building sites etc

Paragraph 3 of the model treaty states:

“A building site or construction or installation project constitutes a permanent establishment only if it lasts more than twelve months.”

 

The term ‘building site or construction or installation project’ includes not only the construction of buildings but also the construction or renovations of roads, bridges or canals, the laying of pipelines and excavating and dredging.

 

The twelve-month requirement applies to each individual site or project. The commentary explains that the period commences when the contractor begins work, including preparatory work, in the country where the construction is to be established. Seasonal or other temporary interruptions should be included.

 

The BEPS project identified that some multinational enterprises have split-up contracts between closely related parties in order to abuse the twelve-month requirement and artificially avoid permanent establishment status. To address these concerns, a principal purpose test will be added to the model treaty. The commentary will be updated to explain that, where it would be reasonable to conclude that one of the principal purposes for the conclusion of separate contracts was to obtain the benefit of the exclusion in paragraph 3, it would not be appropriate to grant that benefit. Some states may wish to expressly provide for the time periods of separate contracts between closely related enterprises to be combined.

 

Specific activity exemptions

 

Article 5(4) lists a number of business activities that are not permanent establishments, even if they satisfy a definition contained in one of the earlier paragraph (e.g. even if they are carried on through a fixed place of business). The common feature of these activities is that they are, in general, preparatory or auxiliary activities.

 

The exemptions listed in paragraph 4 are:

  • The use of facilities solely[2] for the purpose of storage, display or delivery of goods

or merchandise belonging to the enterprise;

  • The maintenance of a stock of goods or merchandise belonging to the enterprise solely for:
    • The purpose of storage, display or delivery; or
    • The purpose of processing by another enterprise;
  • The maintenance of a fixed place of business solely for the purpose of;
    • Purchasing goods or merchandise or of collecting information, for the enterprise;
    • Carrying on, for the enterprise, any other activity of a preparatory or auxiliary character;

 

An exemption is also available for any combination of activities mentioned above, provided that the overall activity is of a preparatory or auxiliary character.  While not defined in the model treaty, a preparatory activity can be understood as one that is carried on in contemplation of carrying on the essential and significant part of the activity of the enterprise as a whole. An auxiliary activity is one that is carried to support or supplement, without being part of, the essential and significant part of the activity of the enterprise as a whole.

 

The key criterion, therefore, is whether the activity forms an essential and significant part of the enterprise as a whole. In practice, it is often difficult to distinguish between activities which have a preparatory or auxiliary character and those which are the core or main activities of the business. As a guide, an activity that requires a significant proportion of the assets or employees of the enterprise is less likely to be preparatory or auxiliary.

 

The changing nature of international business means that activities which were previously considered to be merely preparatory or auxiliary may nowadays constitute core business activities. Therefore, some enterprises have been able to artificially avoid PE status via the specific activity exemptions, beyond the intend application of paragraph 4.

 

 

 

Accordingly, most of the countries involved in the BEPS project have agreed to amend the paragraph, so that it explicitly provides that an activity will only excluded where the overall activity of the fixed place of business is of a preparatory or auxiliary character. Therefore, the listed activities will become simply common examples of activities that are covered by the paragraph, not those that automatically qualify for an exemption.

 

Dependent agents

 

In some circumstances, an entity will be treated as having a permanent establishment if it has a dependant agent (e.g. an employee) acting on its behalf in a contracting state, even if it does not have a fixed place of business in that state. As it currently stands, paragraph 5 states that a permanent establishment exists where a dependent agent “has, and habitually exercises, an authority to conclude contracts in the name of the enterprise”.

 

The commentary explains the importance of looking beyond legal formalities.

“Lack of active involvement by an enterprise in a transactions may be indicative of a grant of authority to an agent. For example, an agent may be considered to possess actual authority to conclude contracts where he solicits and receives (but does not formally finalise) orders which are sent directly to a warehouse from which goods are delivered and where a foreign enterprise routinely approves the transactions.”

 

The OECD has expressed concern that it has sometimes been possible to artificially avoid having a PE under article 5(5) through commissionaire arrangements. Broadly, a commissionaire is a person who acts in his or her own name for the account of a principal. Under a typical arrangement the commissionaire sells products in a State in its own name but on behalf of a principal. That principal is contractually bound to deliver (through the commissionaire) the goods sold to the customer, while the commissionaire is contractually bound to collect the proceeds and remit it to the principal (in exchange for a commission). Importantly, no relationship is created between the customer and the principal. Under civil law jurisdictions, the activities of a commissionaire are not attributed to the principal and therefore, through such an arrangement a foreign enterprise is able to sell its products in another state without creating a taxable presence.

 

Similar strategies that seek to avoid the application of article 5(5) involve situations where contracts are substantially negotiated in a State, but finalised abroad.

 

To address these concerns, paragraph 5 will be amended to state that a permanent establishment will exist where a dependent agent is acting in a contracting state on behalf of an enterprise and:

 

“in doing so, habitually concludes contracts, or habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification by the enterprise, and these contracts are:

  1. in the name of the enterprise, or
  2. for the transfer of ownership of, or for the granting of the right to use, property owned by that enterprise or that the enterprise has the right to use, or
  3. for the provision of services by the enterprise”

 

 

 

The principal role leading to the conclusion of a contract will typically be played by the person who convinced the third party to enter into a contract with the enterprise (e.g. where the conclusion of a contract directly results from the actions of that person). The phrase would not apply where a person merely promotes and markets the goods or services of an enterprise in a way that does not directly result in the conclusion of contracts.

 

Independent agents

 

Paragraph 5 will not apply where the agent is performing their activities in the course of an independent business.

 

As it presently stands, paragraph 6 states that:

“an enterprise shall not be deemed to have a permanent establishment in a Contracting State merely because it carries on business in that State through a broker, general commission agent or any other agent of an independent status, provided that such persons are acting in the ordinary course of their business”

 

An independent agent will typically be responsible to the principal for the results of their work, will not be not subject to significant control with respect to the manner in which that work is carried out and will often represent numerous principals. The distinction between dependent and independent agents is therefore akin to the distinction between employees and contractors for PAYG withholding purposes.

 

There is concern among OECD countries that some agents are being inappropriately being classified as independent, despite being closely related to the foreign enterprise on behalf of which they are acting. To address these concerns, paragraph 6 will be amended to include the proviso that:

“Where, however, a person acts exclusively or almost exclusively on behalf of one or more enterprises to which it is closely related, that person shall not be considered to be an independent agent”.

 

A person is closely related to an enterprise if, based on all the relevant facts and circumstances, one has control of the other or both are under the control of the same person or enterprises. The new paragraph 6 will expressly provide that a person will also be closely related to an enterprise where:

  • Either one possesses, directly or indirectly, more than 50% of the beneficial interests in the other; or
  • A third person possesses, directly or indirectly, more than 50% of the beneficial interests in both the person and the enterprise

 

 

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Small Business Restructure Rollover

The following article originally appeared on the WTS Australia website in March 2016.

 

Introduction

Roll-over relief was previously available for transfers of a CGT asset, or all the assets of a business, from a sole trader or partnership, to a wholly-owned company. The small business restructure roll-over supplements these existing roll-overs by also allowing small business owners to defer gains or losses that they would otherwise make from transfers of business assets from one entity to another as part of a genuine restructure.

It is intended that the roll-over will facilitate flexibility for owners of small business entities by allowing them to restructure their businesses via a change of legal structure. This is in recognition of the fact that the most appropriate structure for a small business may change over time and that restructuring may lead to benefits, both for the small business itself and for the economy as a whole.

The roll-over will apply to transfers of CGT assets, depreciating assets, trading stock or revenue assets on or after 1 July 2016.

 

Availability of the roll-over

The roll-over is available if an asset is transferred to one or more entities and;

  1. The transaction is, or is part of, a genuine restructure of an ongoing business; and
  2. Each party to the transfer is a small business entity (SBE) or alternatively an affiliate of, connected to, or a partner in, an SBE; and
  3. The transaction does not have the effect of materially changing the ultimate economic ownership of the asset; and
  4. The asset is a CGT asset and is, at the time of the transfer, an active asset of the relevant SBE; and
  5. The transferor and transferee(s) are Australian residents; and
  6. The transferor and transferee(s) choose to apply the roll-over.

 

Genuine restructure – safe harbour

The requirement that the transaction be part of a ‘genuine’ restructure is intended to deny the roll-over to artificial or inappropriately tax-driven schemes. Whether a restructure is ‘genuine’ is a question of fact, to be determined having regard to all of the facts and circumstances surrounding the restructure.

To provide certainty, a small business will be taken to satisfy the requirement of a genuine restructure where, for three years following the roll-over;

  • There is no change in the ultimate economic ownership of any of the significant assets of the business (other than trading stock) that were transferred under the transaction;
  • Those significant assets continue to be active assets; and
  • There is no significant or material use of those significant assets for private purposes.

If a business does not meet the requirements of the safe harbour, it can still access the roll-over by satisfying the general principle that the transaction is, or is part of a genuine restructure.

 

Small business entity

An entity is a small business entity if it meets the requirements under Subdivision 328-C ITAA 1997. Broadly, this requires the entity to carry on a business and have a turnover, when combined with affiliates and connected entities, of less than $2m. Previously the bill also required the taxpayer to satisfy the maximum net asset value test. This requirement has been removed.

 

Ultimate economic ownership and discretionary trusts

Ultimate economic owners are individuals who, directly or indirectly, beneficially own an asset. Where a non-fixed (e.g. discretionary) trust is involved in the transfer, the requirement will be satisfied where the trust has made a family trust election (FTE) and, the ultimate economic owners of the asset, just before and just after the transfer, are members the trust’s family group.  Before making an FTE consideration should be given to the fact that it effectively limits the beneficiaries eligible to receive distributions to those within the family group.

 

Active asset

The meaning of active asset is given in Subdivision 152-A ITAA 1997. Broadly, an asset is active if it is used, or held ready for use, in the course of carrying on a business or if it is an intangible asset inherently connected with a business. Loans to shareholders of a company are not active assets and therefore the roll-over cannot be used to circumvent the operation of Division 7A.

 

Consequences of the roll-over

 

Consequences for the transferor

The small business restructure roll-over is intended to be tax-neutral with no direct income tax consequences to the transferor. For example, the transfer of an asset by a company to a shareholder will not trigger a capital gains tax liability nor an assessable dividend under section 44 or Division 7A ITAA 1936.

 

Consequences for the transferee

Broadly, the transferee is taken to have acquired each asset for an amount equal to the transferor’s roll-over cost just before the transfer. This is the transferor’s cost such that the transfer would result in no gain or loss for the transferor.

CGT assets are deemed to have been acquired for an amount equal to the cost base of the asset. Pre-CGT assets will retain their pre-CGT status in the hands of the transferee. However, the time period for eligibility for the CGT discount will recommence from the time of the transfer. For the purposes of determining eligibility for the small business 15-year exemption, the transferee will be taken as having acquired the asset when the transferor acquired it.

The transferee of trading stock will inherit the transferor’s cost and other attributes just before the transfer. Therefore, the asset’s roll-over cost will be an amount equal to the cost of the item for the transferor, or, if the transferor held the item as trading stock at the start of the income year, the value of the item for the transferor.

The roll-over cost of revenue assets is the amount that would result in the transferor not making a profit or loss on the transfer.

Where deprecating assets are transferred the transferee can deduct the decline in value of the depreciating asset using the same method and effective life (or remaining effective life) as the transferor was using.

 

New membership interests issued as consideration for the transfer

Where membership interests (e.g. shares or units) are issued in consideration for the transfer of a roll-over asset or assets, the cost base of those new membership interests is worked out as follows:

The sum of the roll-over costs, less any liabilities that the transferee undertakes to discharge in respect of those assets  

/

 

 

The number or membership interests

 

 

Membership interests affected by transfers

Where an asset transfer is made at other than market value, decreases and increases in the market value of any interests that are held in the transferor and transferee can result. An integrity concern can arise where the transfer of value from an entity could result in the creation of tax losses on later disposal of the membership interests. A ‘loss denial’ rule is intended to address these concerns. This rule states that a capital loss on any direct or indirect membership interest in the transferor or transferee that is made subsequent to the roll-over will be disregarded, except to the extent that the taxpayer can demonstrate that the loss is reasonably attributed to something other than the roll-over transaction.

 

Comment

The small business restructure roll-over is a generous addition to Australia’s income tax laws. It presents opportunities for small business owners to tax-effectively restructure their affairs.

However, taxpayers should bear in mind the limitations of the roll-over. Specifically, the roll-over;

  • Will not affect a tax liability arising under another Commonwealth tax (for example fringe benefits tax or goods and services tax) or a liability for stamp duty under State legislation
  • Does not prevent the general anti-avoidance provisions of Part IVA from applying
  • Does not extend to exempt entities or a complying superannuation entity.
  • Does not extend non-active assets such as investment assets or Division 7A loans.

Small business owners should contact us to discuss the costs and benefits of a restructure in light of these new amendments.

 

Australia’s Diverted Profits Tax now Law

The following article originally appeared on the FTI Tax website in April 2017.

http://fti.tax/wp/wp-content/uploads/2017/04/AA_2017_DPT_20170434_v_final.pdf

 

On 4 April 2017, the Diverted Profits Tax Bills received Royal Assent and became Australian Acts No. 21 and 27 of 2017. The new law applies to income years commencing 1 July 2017 (whether or not a relevant transaction entered into before that date) and targets ‘significant global entities’ that have a global income of more than A$1 billion and an Australian income of more than A$25 million and provides for 40% tax on diverted profits; 30% franking; payment of tax to object; 12 months to supply documents in defence; and with limited rights of appeal.
Background
The Diverted Profits Tax (DPT), first announced in the 2016-17 Federal Budget, is the latest in a raft of measures (including the Multinational Anti-Avoidance Law (MAAL)) designed to combat multinational tax avoidance.
The Australian Treasury indicates there are approximately 1,600 taxpayers with income sufficiently large to potentially fall within the scope of the new law, though it is expected that the DPT will apply in only very limited circumstances. Treasury estimates that the tax will raise A$100 miilion in each of the 2018-19 and 2019-20 financial years.
When will DPT apply
The DPT will apply to an entity if, broadly:
• It is reasonable to conclude that a scheme (or any part of a scheme) was carried out for a principal purpose of, or for more than one principal purpose that includes, enabling a taxpayer (the relevant taxpayer) to obtain a tax benefit. This ‘principal purpose’ threshold is lower than the ‘sole or dominant purpose’ threshold that applies for Part IVA anti-avoidance purposes (Australia’s GAAR). Taxpayers may however provide evidence to support the non-tax financial benefits of the scheme;
• The relevant taxpayer is a ‘significant global entity’ (i.e. it has annual global income of A$1 billion or more being either a global parent entity or member of a group of entities consolidated for accounting purposes) for theincome year in which it would obtain the tax benefit;
• A foreign entity that is an associate of the relevant taxpayer entered into, carried out or is otherwise connected to the scheme or part of it. Therefore, the DPT will not apply to a scheme with which only Australian entities are connected; and
• The relevant taxpayer obtains a tax benefit (as defined for Part IVA purposes) in connection with the scheme.
When will DPT not apply
The DPT will only apply if it is reasonable to conclude that none of the following tests are satisfied:
The $25 million turnover test
The DPT does not apply where it is reasonable to conclude that the Australian turnover of the relevant taxpayer and other entities that are members of the same global group does not exceed A$25 million. This test has been broadened to take into account the Australian assessable income of foreign entities (not just Australian entities) that are part of the same global group.
The sufficient foreign tax test
The DPT does not apply where it is reasonable to conclude that, in relation to the scheme, the increase in foreign tax liability is equal to or exceeds 80% of the corresponding reduction in the Australian tax liability. To work out the amount of the increased foreign tax liability, it is necessary to consider any specific tax relief provided by a foreign country to relation to the scheme. Where the tax benefit is an allowable deduction and the taxpayer must withhold an amount in respect of withholding tax, the Australian tax liability is reduced by the amount withheld.
We note that many countries currently have a corporate tax rate that is equal to or less than 24% (i.e. 80% of Australia’s 30% rate). These include the United Kingdom, Russia, Croatia, Sweden, Hungary, the Czech Republic, Singapore and Hong Kong. The United States will be added to this list if President Trump’s tax policies are enacted.
The sufficient economic substance test
The DPT does not apply where it is reasonable to conclude that the profits derived, received or made as a result of the scheme reasonably reflects the economic substance of the entity’s activities in connection with the scheme, having regard to the functions, assets used and risks assumed by the entity. For the purposes of applying this test, consideration should be given to the OECD transfer pricing guidelines.
A carve-out has also been created for managed investment trusts, foreign collective vehicles with a wide membership, foreign entities owned by a foreign government, complying superannuation entities and foreign person funds.
Interaction with the thin capitalisation and CFC provisions
The DPT’s interaction with the thin capitalisation and controlled foreign company (CFC) provisions have been clarified. In particular;
•If a taxpayer is subject to the thin capitalisation provisions and the DPT tax benefit includes a debt deduction, when calculating the DPT tax benefit, the rate is to be applied to the debt interest actually issued (rather than to the debt interest that would have existed if the scheme had not been carried out).
• In relation to the CFC provisions, where an amount of attributable income is included in the assessable income of the relevant taxpayer or their associate, it should be excluded from the taxpayer’s DPT tax benefit.
If DPT applies
If the DPT applies to a taxpayer, the Commissioner may make a DPT assessment and issue it to the relevant taxpayer. The ATO will establish a DPT panel (similar to the existing General Anti-Avoidance Rule (GAAR) panel) and will generally seek
endorsement from this panel before issuing an assessment.
Tax is payable on the amount of diverted profits at a penalty rate of 40% . Furthermore, the DPT due and payable will not be reduced by the amount of foreign tax paid on the diverted profits. The DPT assessment will also include an interest charge.
The DPT will only give rise to franking credits at 30% and not the 40% penalty rate.
The assessment and review process
If the Commissioner considers that a taxpayer is in scope of the DPT, he may make a DPT assessment at any time within 7 years of first serving a notice of assessment on the taxpayer for an income year. In practice, the Commissioner would only do this after communication with the relevant taxpayer had failed to reach an agreement about the correct amount of tax that should be paid.
The relevant taxpayer must then pay the amount set out in the DPT assessment no later than 21 days after the Commissioner gives the notice of assessment.If the Commissioner gives an entity a notice of a DPT assessment, a period of review will generally apply. This
review period gives the taxpayer the opportunity to provide additional documents and information relating to the DPT assessment to the Commissioner.
This review period will typically end 12 months after the DPT assessment is given but can be shortened (for example if the taxpayer considers that it has provided the Commissioner with all relevant information and documents) or extended (for example where the entity provides information close to the end of the 12 month period and the Commissioner needs additional time to properly examine the material).
As a result of receiving additional information, the Commissioner may conclude that the DPT assessment is excessive or that the liability should be increased. He may then make an amended DPT assessment. Where an amended DPT assessment is made, interest will be payable (by the Commissioner on the refund where the liability is reduced or by the taxpayer on the additional amount payable where the liability is increased).
Objections to DPT assessments
The relevant taxpayer may object to the DPT assessment by appealing to the Federal Court within 60 days of the end of the period of review. Previously under the draft legislation this period was 30 days. However, any information or documents that were not provided to the Commissioner during the period of review, or that the Commissioner did not already have prior to the period of review, will not be admissible without either
the Commissioner’s consent or the leave of the court.
What should businesses be considering with regards to potential DPT exposure?
Businesses should first review existing and proposed arrangements, having regard to the the following DPT threshold questions:
1. Is the Australian company (or permanent establishment) a significant global entity (being a member of a group with annual global income of AU$1 billion or more)?
2. Is it reasonable to conclude that annual Australian income is less than AU$25 million (though this includes any DPT benefit)?
3. Is it reasonable to conclude that sufficient foreign tax (effectively over a 24% rate) has not been paid/imposed in all jurisdictions directly or indirectly relevant to the
supply chain into Australia?
4. Is it is reasonable to conclude that the sufficient economic substance test is not satisfied? The taxpayer must prove the arrangement reasonably reflects the economic substance of the entity’s activities. In most cases, this will require a ‘two-sided analysis’, applying an Australian transfer pricing examination to the functions, assets and risks of the activities carried out in Australia and those activities carried out in one or more other overseas jurisdictions; and/or
5. Was obtaining a tax benefit a principal purpose (or one of the principal purposes) behind the taxpayer carrying out the scheme? This is a lower threshold than the existing
Part IVA/GAAR, which requires a ‘dominant purpose’ of obtaining a tax benefit.
We expect that ATO transfer pricing reviews and compulsory Country By Country Reporting may signal to the ATO the existence of potential DPT arrangements. Therefore it is incumbent upon affected taxpayers to review and understand their positions and have in place robust documentation.
Further, the DPT may also encourage multinational taxpayers to engage in a dialog with the ATO in relation to their cross-border activities such that they may consider Advance Pricing Agreements (APAs) to provide greater certainty with respect to their international arrangements and transfer pricing.
The ATO has significant power to raise DPT assessments and taxpayers should be prepared.

Low Value Goods and Digital Products: the New Black

The following article appeared in the February edition of ‘The Taxpayer’ by Tax & Superannuation Australia. Unfortunately I cannot upload a PDF or link to the article so the unformated text below will have to suffice. Please contact me if you would like to discuss anything in this article.

Simon Dorevitch reviews important changes to GST and cross-border transactions

 

  1. Taxing the internet shopper

When the GST Act and Regulations were drafted in 1999, e-commerce was in its infancy – it was not fully envisaged that people would prefer to shop from the comfort of their mobile devices rather than visiting a bricks and mortar shop! Over the years, however, Australian internet sales have grown rapidly and are now in excess of $20 billion per annum.

This has caused dismay from Australian businesses who have increasingly complained about an unequal playing field, since Australian consumers are often able to avoid incurring GST on their internet purchases from non-resident businesses. Online video-on-demand provider, Netflix is a prime example where a subscription to their services is currently not subject to GST under existing laws.

In response to these concerns, the government has introduced amendments that extend GST to supplies of digital products, certain services and low value goods imported by consumers.

As a result of these amendments, Australian consumers will soon find themselves paying 10% more for many online purchases. In addition, many overseas suppliers will be required to register and pay GST, though in some cases the GST liability may be shifted to an electronic distribution platform or goods forwarder. To ease the administrative burden, the Commissioner will permit some foreign businesses affected by the amendments to hold a limited GST registration.

 

  1. Existing GST framework

By way of background, GST is payable on “taxable supplies” and “taxable importations”.

Taxable supplies

For a supply to be taxable it must, among other things, be connected with Australia.[1]

In the context of physical goods brought to Australia, a supply is connected with Australia if the supplier either imports the goods or installs or assembles them in Australia. Therefore, if the consumer imports the goods, the supply will generally not be connected with Australia and will not be a taxable supply.

In the context of supplies other than physical goods or real property (e.g. digital products and other services), a supply is connected with Australia if:

  • The thing is done in Australia;
  • The supply is made through an enterprise that is carried on in Australia; or
  • The supply is the supply of a right to acquire another thing that is connected with Australia.

If the location of performance is not in Australia, a supply by a foreign entity will generally not be connected with Australia and will not be a taxable supply.

Taxable importations

For an importation to be taxable it must be of tangible personal property. Therefore, an importation of digital products or services is not a taxable importation as these are not tangible goods. Furthermore, GST regulations specify that an importation of low-value tangible goods (i.e. those with a customs value of $1,000 or less) is a non-taxable importation and therefore no GST is payable.

 

  1. Applying GST to Digital Products and Other Services

Amendments to the GST Act[2], which take effect from 1 July 2017, extend the scope of the GST to digital products and other services imported by Australian consumers.

The media have dubbed the amendments the ‘Netflix tax’ and have focused on their application to digital products such as streaming or downloading of movies, music, apps, games and e-books. However, what may be missed is that the amendments apply equally to supplies of services such as consultancy and professional (e.g. architectural, legal or educational) services.

Australian consumer

As a result of the amendments, a supply of digital products and other services will be connected with Australia (and therefore potentially a taxable supply) if the recipient of the supply is an ‘Australian consumer’.

An Australian consumer, in relation to a supply, is an Australian resident (as defined for income tax purposes) who is not entitled to an input tax credit (ITC) in respect of the acquisition. To be entitled to an ITC, a consumer must be registered for GST and the supply must be acquired to some extent for an enterprise they carry on. The amendments are therefore intended to capture private consumption only.

Example: [3]

Global Movies supplies Fellini with video on demand services. The supply is not performed in Australia and Global Movies does not carry on an enterprise in Australia.

Fellini is a resident of Australia, does not carry on an enterprise and is not registered for GST. The supply by Global Movies is connected with Australia as a result of the amendments.

Had Fellini not been a resident of Australia, the supply would not have been connected to Australia, even if he was in Australia when the supply was made.

Reasonable belief safeguard

It may not always be practical for a supplier to determine if the recipient of a supply is an Australian consumer. Recognising this, the amendments provide a safeguard; if the entity that would be liable for GST takes reasonable steps to establish whether the recipient of a supply is an Australian consumer and, having taken these steps, reasonably believes that the recipient is not an Australian consumer, they may treat the supply as if it had been made to an entity that was not an Australian consumer.

Example:[4]

Peter, an Australian resident who is not registered for GST, orders a videogame online from a non-resident supplier while visiting family in London. He pays using a credit card from a UK bank and gives the address and phone number of his relatives as contact information. The supplier reasonably believes that Peter is a not an Australian resident and may therefore treat him as not being an Australian consumer and the supply as not connected with Australia.

In some circumstances, the process for making a supply may be largely automated. Such supplies may also be covered by this safeguard if the business systems and processes provide a reasonable basis for identifying if the recipient is an Australian consumer.

Penalties for misrepresentations by customers and extending the reverse charge provisions

Australian consumers may have incentives to avoid GST by misrepresenting their status. To address this, the amendments broaden the existing administrative penalties for making false or misleading statements.

Furthermore, the amendments extend the compulsory reverse charge rules so that they apply where an Australian business has made a wholly private or domestic acquisition but has made representations that it is not an Australian consumer in respect of the supply. The operation of this reverse charge rule will mean the supply is a taxable supply and the recipient, not the supplier, is liable for GST.

Example:[5]

Leslie, an Australian resident registered for GST, acquires a movie from Online Movie Co (OMC) for a wholly private purpose. She is therefore an Australian consumer in relation to the supply. However, Leslie provides OMCS with her Australian Business Number (ABN) and declares that she is registered for GST. Accordingly, OMC does not charge GST. Under the extended reverse charge provisions, Leslie is obliged to pay the GST.

Electronic Distribution Platforms

Consumers may purchase digital products and services via an electronic distribution platform (EDP). The Apple App Store is an example of an EDP, Amazon is another.

The operators of EDPs are often better resourced and therefore better placed to comply with Australia’s GST laws. On this basis, where supplies are made through an EDP and are connected with Australia under these amendments, responsibility for the GST liability is generally shifted from the supplier to the operator of the EDP. In other circumstances the supplier and operator of the EDP may agree that the operator will be liable for GST on the supply.

Registration and Limited Registration

Supplies that are connected with Australia because they are made to an Australian consumer will generally count towards the GST registration threshold of $75,000. However, these supplies may also be GST free because they are used or enjoyed outside Australia.

It would be unnecessary for foreign suppliers to register for GST if the only supplies they make that are connected to Australia is also GST-free. Therefore, the amendments ensure such supplies are only included in GST turnover if the supply is made through an enterprise carried on in Australia.

Some entities that are required to register under these amendments will not have any other connection with Australia. These entities will have no claim to ITCs and will therefore not need to claim GST refunds.

To ease the administrative burden on such entities, the Commissioner will allow them to opt to be a ‘limited registration entity’. Such entities will only be required to provide minimal information when registering for GST and lodging business activity statements. Limited registration entitles are not entitled to claim ITCs or to have an ABN. They will report quarterly.

 

  1. Applying GST to Low Value Imported Goods

The government has also released draft legislation[6] to amend the GST Act to ensure that GST is payable on certain supplies of low value goods that are purchased by consumers and imported into Australia. This amendment again is intended to level the playing field between local and overseas businesses.

The changes, if passed, will also apply from 1 July 2017.

Supplies of low value goods that are connected with Australia

As a result of the amendments, a supply of goods will be connected with Australia if:

  • The supply involves the goods being brought to Australia with the assistance of the supplier;
  • The goods are low value goods; and
  • The recipient acquires the supply as a consumer.

Bringing goods to Australia with the assistance of the supplier

The supplier provides assistance where it makes arrangements with third parties for the transport of the goods or facilitates the consumer making such arrangements. However, if a supplier merely makes the goods available for collection or provides contact information to unrelated transport companies it will not be providing such assistance.

Low value goods

Broadly, a low value good is tangible personal property that has a customs value of $1,000 or less at the time of supply.

If multiple goods are supplied and each is individually below $1,000 but the total is above the threshold, the supply is a supply of low value goods unless it would be unreasonable to treat each good as a separate supply (for example the supply of 100 floor tiles). A supply that involves both low value and other goods is treated as two or more separate supplies.

Acquired as a consumer

A recipient, who may not be the person to whom the goods are delivered, is a consumer in relation to a supply if they are not entitled to an ITCs for the acquisition.

A business can confirm that a recipient is not a consumer by requesting their ABN and a declaration that they do not acquire the goods for an enterprise they carry on in Australia. Unlike the amendments relating to digital products and other services, there is no requirement that the consumer be an Australian resident.

Example:[7]

Wei, a resident of Hong Kong purchases artwork valued at $700 in Vietnam and arranges for the seller to deliver it to his niece in Australia. The supply is connected with Australia, despite the fact that Wei is not a resident and outside of Australia when the purchase is made.

Supplies not connected with Australia

A supply that satisfies each of these three requirements will not be connected to Australia if the supplier reasonably believes that the goods will be imported as a taxable importation and the goods are imported as a taxable importation. If the supplier’s reasonable belief turns out to be incorrect, they will include the additional GST payable on their next Business Activity Statement and no penalties will apply.

Electronic distribution platforms

Where low value goods are supplied through an EDP, the GST liability will generally shift from the supplier to the operator of the platform. This is consistent with the EDP rules applying to cross-border supplies of digital products and other services – discussed above.

Goods forwarders

Goods forwarders may help arrange a purchase, take delivery of the goods and/or arrange for their pick-up, make storage arrangements and deliver, or arrange delivery of the goods to the consumer.

In contrast, entities that merely deliver goods to Australia are not treated as goods forwarders. If a supply to a consumer involves goods being delivered outside of Australia and brought to Australia with the assistance of a goods forwarder, then the supply will be connected with Australia and the goods forwarder will generally be treated as the supplier.

Example:

Sam is an Australian resident who is not registered for GST. Sam purchases a hockey stick valued at $300 from a US store. Sam instructs the store to send his purchase to a mail forwarding service (MailMe). MailMe then sends the hockey stick to Australia and delivers it to Sam. MailMe, and not the US store, is treated as making the supply and will need to register if it has a GST turnover of $75,000 or more.

Limited Registration

The amendments allow non-resident suppliers (including operators of EDPs treated as suppliers) and non-resident goods forwarders of low value goods to be limited registration entities

Simon Dorevitch is Senior Tax Consultant

A&A Tax Legal Consulting

 

As always I would like to remind readers that

  1. The article does not constitute advice and is not intended to be comprehensive. While I have attempted to ensure the accuracy of the article I do not give any assurances. Please seek your own professional advice.
  2. The views in the article are mine alone and do not necessarily represent those of my employer or Tax  & Superannuation Australia

 

[1] The GST Act now refers to the “Indirect Tax Zone” rather than Australia. However, for simplicity, this article will continue use the term Australia.

[2] Tax and Superannuation Laws Amendment (2016 Measures No .1) Bill 2016

[3] Example 1.1 from Explanatory Memorandum to Tax and Superannuation Laws Amendment (2016 Measures No .1) Bill 2016

[4] Example 1.4 from Explanatory Memorandum to Tax and Superannuation Laws Amendment (2016 Measures No .1) Bill 2016

[5] Example 1.5 from Explanatory Memorandum to Tax and Superannuation Laws Amendment (2016 Measures No .1) Bill 2016

[6] Treasury Laws Amendment (2017 Measures No. 1) Bill 2017

[7] Example 1.5 from Explanatory Memorandum to Treasury Laws Amendment (2017 Measures No. 1) Bill 2017

The Employee Share Scheme rules have changed. Should you be taking advantage of the new concessions?

Recruiting and retaining high-quality staff is essential to the success of almost any business. Research suggests that companies in which employees have an ownership interest are more productive than those that do not. In this article I ask – do the new employee share scheme rules provide an opportunity for the savvy employer?

Background

An ESS is a scheme under which shares, stapled securities or rights (e.g. options) to acquire them (ESS interests) in a company are provided to an employee or their associate in relation to the employee’s employment. If these ESS interests are provided at a discount to market value the discount is taxable in the hands of the employee.

Recently the laws surrounding the taxation of ESS interests have changed. These changes apply to ESS interests acquired on or after 1 July 2015. The intention of the new law is to make employee share schemes easier, cheaper and more attractive and by doing so;

  • Facilitate better alignment of interests between employers and their employees, thereby leading to more productive relationships, higher productivity and reduced staff turnover.
  • Allow Australian businesses to be more competitive in recruiting and retaining talented employees in the international labour market and
  • Stimulate the growth of start-ups (which are often cash-strapped)

As an employer, now is a good time to consider whether an employee share scheme should be part of your organisation’s remuneration mix.

The previous state of play (i.e. prior to 1 July 2015)

The default position is that the discount is assessable in full in the year that the ESS interests are granted. However, if conditions are met, one of two concessions may be available;

  • A $1,000 reduction or
  • Deferral of the taxing point.

In my experience schemes that defer the taxing point are typically the most attractive and so the remaining of the article will focus on them. Deferral will be available when all of the following apply;

  • The employee has a genuine risk of losing the interests (e.g. by failing to meet performance criteria or being required to continue employment for a certain period)
  • The scheme is made broadly available – i.e. it is available to at least 75% of Australian employees with at least three years of service
  • After acquiring the ESS interest the employee does not hold an interest in the company of more than 5%.

Note that the second requirement only applies to shares and therefore employers who wish to target key personnel are advised to issue rights (i.e. options), rather than shares.

Where such conditions are met no tax will be payable until the earliest of one of the following times;

  • When the employee ceases employment
  • When the risk of forfeiture has been removed and there are no genuine restrictions on the disposal or exercise of the interest and
  • Seven years after acquisition

What has changed?

The new legislation introduces a number of significant changes;

  • The maximum period of deferral has been extended to fifteen years
  • In the case of rights the deferred taxing point is extended, from when the right can be exercised, to when it is actually exercised
  • The maximum level of ownership has been increased to 10%
  • Access to deferred taxation will be available in a broader range of situations
  • The circumstances where employees are entitled to a refund of tax previously paid on forfeited ESS interests has been broadened
  • New valuation rules have been introduced

The additional concessions for ‘start-ups’

The new rules also introduce further concessions for small start-up companies. Both ‘small’ and ‘start-up’ are defined very broadly and many employers will qualify. Under the concession an employee does not need to include a discount on ESS interests in their assessable income if certain conditions, beyond the general conditions that apply to all ESS concessions, are satisfied;

  • The employer must be an Australian company, it, and all companies in the group, must have been incorporated for less than ten years, it must not be listed on an exchange and the combined turnover of the group must not exceed $50m.
  • The employee must hold the interests for three years or until they cease employment
  • If the scheme relates to rights, the exercise price (i.e. strike price) must be at least equal to the market value of the share at the grant date and
  • If the scheme relates to shares, it must be made broadly available (see above) and the discount cannot be more than 15%

For capital gains tax purposes shares are deemed to have been acquired for their market value and rights for the employee’s cost of acquiring them. Furthermore, the exercise price of rights will form part of the cost base of the resulting shares. When a resulting share has been sold the tax on any gain can be halved if the rights were acquired more than 12 months earlier.

New valuation rules

Calculating the assessable discount requires the employer to determine the market value of the company, possibly at multiple points in time during the year. In the case of unlisted companies this can place a prohibitive administrative burden on the employer.

The regulations to the 97 Act contain safe harbour valuation methodologies. However, these are highly complex and, having not been updated since the 1990s, are based on outdated estimates.

New valuation methodologies have recently been issued by the Commissioner. It is expected that these will be simpler and will result in the value of most options being lower than the previous regulations.

Example

Employer Pty Ltd was established on 1 July 2007. On 1 July 2015 it was not listed, had a turnover of $40m and was not part of a corporate group.

At this time Employer granted, for no consideration, 10,000 options to Bob, an important employee. In three years time, if Bob continues to work for Employer, he may exercise the options for $2 each, being the market value of a share in Employer at 1 July 2015.

On 1 July 2018, with the value of Employer’s shares being $5 each, Bob does in fact exercise all of his options. Immediately afterwards he sells the shares. Effectively, Bob has made a gain of $30,000 but he will not be taxed on this gain under the employee share scheme rules. Instead he will make a capital gain of $15,000, being half of $50,000 proceeds less an exercise price of $20,000.

Conclusion

Recent changes have made issuing ESS interests to employees more attractive, particularly for options. I would encourage all employers to consider if an employee share scheme is consistent with their overall business strategy and their strategy for retaining and recruiting key staff. If so it may be a good idea to include them in your remuneration mix.

Of course not all employee share schemes are created equal and, if you are considering implementing an employee share scheme, I recommend you contact a professional adviser for assistance in formulating the ideal scheme for your business.

Disclaimer

This post is intended to be a broad overview for information purposes only. It does not constitute advice. I urge you to seek professional advice that is tailored to your personal circumstances.

ESS

The ATO and Uber – Putting the Tax into Taxi?

Uber, and ride-sourcing services like it, have taken Australia and the world by storm. It is not surprising that the ATO wants their cut of revenue. In fact, the ATO has recently launched a ‘data-matching’ program to identify Uber drivers who haven’t complied with their tax obligations. Therefore, while some drivers may think that they can ‘drive away with no more to pay’ this is unfortunately not the case. Uber and other ride-sourcing drivers have GST and income tax obligations they must consider.

GST

The ATO’s position is that Uber drivers are providing ‘taxi travel’ services. This means that, if their activities are done ‘in the form of a business’, they will need to register for GST, regardless of the amount of income they earn. This puts Uber drivers in a different position to, say, Airbnb hosts who must only register for GST if their income exceeds $75,000. Only those Uber drivers who operate very infrequently or in a non-commercial manner may escape this requirement to register.

From 1 August 2015 driver’s must:

  • Apply for an Australian Business Number (ABN). On the application driver’s should choose category 46239 ‘Road Passenger Transport’ and describe their business as ‘ride-sourcing’. Note that if a driver is already registered for an ABN as a sole-trader (for example if they are an IT contractor) they should use the same ABN for their ride-sourcing activities.
  • Register for GST and
  • Lodge Business Activity Statements (BAS)

It is also strongly advisable that drivers maintain a logbook and keep records to substantiate their income and expenses.

GST must be collected on the full fare, before any Commissions are deducted. For example if the fare was $55 and Uber took $11 the driver would need to pay $5 GST.

However, credits can also be claimed to reduce the net GST payable. These credits must be reduced for any private portion of the costs incurred. For example, if a driver uses their vehicle 10% for rise-sourcing and 90% for private purposes and incurs $110 for fuel, they could only claim $1 of the $10 GST paid.

Finally, drivers must provide passengers with a tax invoice for all fares over $82.50 if requested (note that Uber may do this on the driver’s behalf)

Income Tax

The income earned from Uber, exclusive of any GST paid, is assessable and must be reported in the driver’s tax return. Uber drivers should set aside some of the money they earn to ensure that they have enough left over to pay tax at the end of the year. Uber will not do this on their behalf (nor will they pay superannuation to drivers).

Expenses incurred will be deductible but must be reduced by any private portion. Deductible costs may include commission’s paid, fuel, registration, insurance, repairs and maintenance, cleaning, mobile phone costs and parking.

What’s Next?

Uber has indicated that they will continue to fight the ATO and will take their case to the Federal Court. However, I am not optimistic about their chances of success. If I were their adviser I would be telling them that their case is weak and that the ATO are interpreting the law correctly. Their money would perhaps be better spent on convincing the government to either change the definition of taxi travel in the GST Act or repealing the requirement, in s 144-5, for suppliers of taxi travel to register, regardless of their turnover. Time will tell.

In conclusion, Uber is proving to be a nightmare for the taxi industry but with good preparation and record-keeping it doesn’t have to be a tax or administrative nightmare for its growing number of drivers.

Is the ATO correct? Is Uber? Should the law be changed? Let me know what you think.

Uber