Permanent Establishment Podcast

In October, I joined the team at Tax & Super Australia to record a podcast on PE’s to accompany my article. You can listen to it here (episode 139):

 

https://www.taxandsuperaustralia.com.au/TSA/Products_Services/Professional_Development/Podcast/TSA/Publications/Tax_Wrap_podcast.aspx

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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

 

 

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.

How long is a piece of string? Getting the market value right for taxation purposes

The following article originally appeared in the March edition of ‘The Taxpayer’ journal, published by Tax & Super Australia. My apologies for any formatting issues – I could not upload a pdf of the article.

 

A century on from the High Court’s landmark decision in Spencer v Commonwealth[1], Simon Dorevitch sheds light on the term ‘market value’ and its implications for tax purposes.

“Price is what you pay. Value is what you get”

Warren Buffet

Under Australia’s tax laws, taxpayers are frequently required to determine the market value of an asset or liability. The Inspector General of Taxation found that there are “at least 206 different tax provisions that may require a taxpayer to determine an unrealised value of an asset or liability, or an alternative value to a realised asset or liability”.[2]

Examples of these provisions include;

·        The market value substitution rule,[3] which can modify the capital proceeds or cost base in respect of a CGT event happening to a CGT asset where, for example, the parties were not dealing with each other at arm’s length.

·        The first used to produce income rule[4], where a taxpayer is deemed to have acquired their dwelling for its market value for the purposes of determining the extent of tax payable under the main residence exemption.

·        The $6 million net market value asset test,[5] which can determine access to the small business CGT concessions where the taxpayer is not a small business entity.

·        The ‘principal asset test’,[6] which can determine whether a membership interest in an entity is an indirect Australian real property interest and therefore taxable Australian property.

·        The GST margin scheme, which may require the supplier to work out the GST payable by reference to the value of real property at a particular date.[7]

In most cases the market value of an asset will be the price agreed to by parties dealing at arm’s length. The ATO states; “where a market exists for an asset, that market is widely considered to be the best evidence of market value of the asset”.[8] For example, if shares are listed on a stock exchange, the market value will typically equal the listed price.

However, in many other cases it is not so straightforward. It is therefore unfortunate that, despite the ubiquity of the market value concept, the legislation provides scant guidance as to its meaning – leaving taxpayers to look to the courts and ATO to fill the void. Some ATO practical guidance is contained in its publication ‘Market valuation for tax purposes’ (search QC21245).

Legislative Guidance

Subdivision 960-S states that the expression ‘market value’ is often used with its ordinary meaning but may, in some cases, have a meaning that is affected by the subdivision.

The subdivision provides that, when working out market value, taxpayers should;

·        Reduce the value by any input tax credits to which the taxpayer would be entitled if it had acquired the asset for a taxable purpose.[9] This rule attempts to ensure that the market value reflects the real economic outlay to the taxpayer (since they can claim a refund of input tax credits via the Business Activity Statement).

·        Disregard anything that would prevent or restrict conversion of a non-cash benefit to money when working out the market value of a non-cash benefit.[10]

This subdivision, or the Tax Acts elsewhere, does not explain what is the ordinary meaning of market value and so this is where one turns to case law for guidance.

Case Law Guidance

The case of Spencer v Commonwealth is widely accepted as the most important judicial pronouncement on the ordinary meaning of ’market value’. Spencer provides that a valuer is to assume a hypothetical market operating under specific assumptions. The market value is the price that buyers and sellers would negotiate in such a hypothetical market.

Griffith CJ said;

“the test of the value of land is to be determined, not by inquiring what price a man desiring to sell could actually have obtained for it on a given day, i.e. whether there was, in fact, on that day a willing buyer, but by inquiring: What would a man desiring to buy the land have had to pay for it on that day to a vendor willing to sell it for a fair price but not desirous to sell?”.

Issacs J expanded on this by adding;

“To arrive at the value of the land at that date, we have…to suppose it sold then, not by means of a forced sale, but by voluntary bargaining between the plaintiff and a purchaser, willing to trade, but neither of them so anxious to do so that he would overlook any ordinary business consideration.               We must further support both to be perfectly acquainted with the land, and cognisant of all circumstances which might affect its value”.

This test was also adopted in Abrahams v FC of T[11] where Williams J said that market value is;

“The price which a willing but not anxious vendor could reasonably expect to obtain and a hypothetical willing but not anxious purchaser could reasonably expect to pay … if the vendor and purchaser had got together and agreed on a price in friendly negotiation”.

Where neither party is anxious, both parties are knowledgeable, negotiations are conducted at arm’s length and the other Spencer market assumptions are satisfied, the actual market will align with the hypothetical market and market value will align with the agreed price.

However, applying the test in Spencer is not always straightforward in practice – for example in cases of special value or aggregated disposals.

Special Value

One point of contention is how to determine market value where there is a buyer willing to pay more than an asset’s intrinsic value because it has a particular adaptability or usefulness to them. This may occur where, for example, there a parcel of land that a neighbour wants to acquire. It could also reflect synergistic advantages such as economies of scale or reduction in competition; for example, a business acquiring a supplier or a competitor.

It can be argued that such a special value should be excluded when determining market value, since the buyer could be characterised as being ‘anxious’. The opposing argument is that market value should include this special value since doing so reflects the Spencer assumptions that both parties are ‘cognisant of all circumstances which might affect (the asset’s) value’ and that the hypothetical purchaser will put the land to its highest and best use.

The ATO’s view, as expressed in ‘Market valuation for tax purposes’[12] is that special value is not usually relevant in determining market value. The guide states that where “the special value is known or available to the wider market, this would be reflected in an objective valuation of the asset”. However, “if a special value is known or available only to one potential buyer and not known or available to the wider market, it will not be reflected in the market value”. This appears to reflect the view that a special purchaser would bid just enough to outbid other interested purchasers, rather than making an offer which reflects the complete value to them.

With respect, it appears that the ATO has taken an alternative interpretation. There is strong judicial support for including special value. For example, in Brisbane City Council v Valuer-General (Qld)[13] it was held that “all possible purchasers are to be taken into account, even a purchaser prepared for his own reasons to pay a fancy price”. In a comprehensive and widely cited review of cases that have addressed the question of special value[14], Professor Bernard Marks found that, “on any proper analysis” the proposition that special value be excluded from market value could not be sustained.

Aggregated Disposals

Market value should be assessed at “the highest and best use of the asset as recognised in the market”. However, the highest and best use may depend on whether the asset is considered on a stand-alone basis or in combination with other assets.

In Hustlers case[15] it was necessary to value three adjoining parcels of land. The Court accepted a valuation based on their combined use as a commercial business. A valuation prepared on a stand-alone basis was rejected, as was a valuation based on use as a retail shop (even though it gave the highest value), since there was no evidence of such demand. The principal established, and reaffirmed in other cases such as Collis[16], is that market value reflects the highest and best use, including on a consolidated basis, provided there is actual demand for such a use.

Miley’s Case[17]

This recent and controversial case addressed many of the issues discussed above. The taxpayer was one of three equal shareholders who sold their shares to a single purchaser. The amount paid by the purchaser reflected a premium for control of the company and therefore the proceeds received by Mr Miley included one-third of this premium.

The AAT found that the correct enquiry was directed towards determining the market value of Mr Miley’s 100 shares alone – not as part of a package comprising the entire 300 shares in the company. The Deputy President went on to accept Miley’s argument that the market value of the CGT asset is to be determined by reference to the Spencerhypothesis and is not necessarily equal to the amount actually paid. Accordingly, the control premium was to be deducted from the sale proceeds to arrive at the market value of the shareholding. It should be noted that the ATO have indicated they will appeal this decision.

Syttadel Holdings[18] is another recent case which, like Miley, demonstrates that market value is not always equal to the contract price – even where the parties deal at arm’s length. At issue was the market value of a marina. Interestingly, valuers for the taxpayer and the ATO both agreed that the market value was considerably less ($4.5m and $5.3m respectively) than its $8.9m sale price. In its Decision Impact Statement, the ATO indicated that, while each case must be considered on its merits, it still considers that the sale price of its asset will generally be its market value.

What Should Taxpayers Do?

Where the market value of an asset needs to be ascertained, taxpayers are typically[19] not obliged to obtain a detailed valuation from a qualified valuer. They may compute their own valuation based on reasonably objective and supportable data.[20]

However, the onus is on taxpayers to establish that their valuation is correct. The ATO may challenge valuations where appropriate. Therefore, a taxpayer would be prudent to retain the services of a professional valuer if there is any doubt about the market value. Furthermore, the methodology adopted by the valuer should be one that is in accordance with valuation industry practices.

Taxpayers (or the valuer they appoint) should clearly document the process which was undertaken in reaching the value, to demonstrate that it was done in accordance with sound valuation principles. In the event of a dispute, a failure to keep adequate documentation will likely be fatal to a taxpayer’s position.   The ATO also outlines the various elements of a good valuation in its ‘Market valuation for tax purposes’ publication – one critical aspect is that “a market valuation is a valuation that applies the definition of market value for tax purposes…”.

Avoiding Penalties

The majority of taxpayers who use a qualified valuer will generally not be liable to an administrative penalty, even when the valuation ultimately proves to be deficient, since relying in good faith on an expert’s advice is generally consistent with the taking of reasonable care. However, penalties may still apply where;

·        The taxpayer has not given correct information to the valuer;

·        The taxpayer or their agent should reasonably have known that the information provided by the valuer was incorrect; or

·        The methodology or valuation hypothesis used by a qualified valuer may be based on an unsettled interpretation of a tax law provision or unclear facts.

Appraisals

Mindful of the cost of obtaining a profession valuation, taxpayers often ask whether an appraisal from a local real estate agent will suffice for land valuations. There is no rule preventing the taxpayer from doing this – it is the valuation process undertaken, rather than who conducted it, that governs the acceptability of a valuation. However, caution should be exercised before going down this path.

Where an appraisal is obtained, the valuer may not make reasonable enquiries or provide a definitive opinion on market value (for example, a range is used).  As such it may not be accepted by the ATO. Accordingly, if an appraisal is to be relied upon, it should only be done in the most straightforward of valuations, and preferably where errors will not have a significant impact on tax payable.

Private ruling

Taxpayers seeking certainty can apply to the ATO for a private ruling. They may ask the ATO to provide a valuation or ask the ATO to confirm a valuation that they have obtained. In either case the taxpayer must pay for the work of the ATO’s valuer. Generally, the cost will be less where the ATO is only asked to confirm a valuation. Obtaining a private ruling removes the risk of providing the ATO with a valuation that does not meet its requirements. However, the taxpayer may receive a valuation that they do not agree with but they are not obliged to use the valuation.

Simon Dorevitch is Senior Tax Consultant, A&A Tax Legal Consulting

[1] Spencer v Commonwealth (1907) 5 CLR 418

[2] Inspector-General of Taxation, ‘Review into the Australian Taxation Office’s administration of valuation matters’ p. 13

[3] ss 116-30 & 112-20 ITAA 1997

[4] s 118-192 ITAA 1997

[5] s 152-15 ITAA 1997

[6] s 855-30 ITAA 1997

[7] s 75-10 GST Act

[8] ‘Market valuation for tax purposes’, QC21245

[9] s 960-405 ITAA 1997

[10] s 960-405 ITAA 1997

[11] Abrahams v FC of T (1944) 70 CLR 23

[12] ‘Market valuation for tax purposes’, QC21245

[13] (1978) 140 CLR 41

[14] Bernard Marks, ‘Valuation Principles in the Income Tax Assessment Act’ (1996), Bond Law Review

[15] Hustlers Pty Ltd & Anor v The Valuer-General (1967) 14 LGRA 269

[16] Collis v FC of T (1996) 96 ATC 4831

[17] Miley and Commissioner of Taxation [2016] AATA 73

[18] Syttadel Holdings Pty Ltd v FC of T (2011) AATA 589

[19] Note that where a valuation is required under the GST Margin Scheme, taxpayers must use the services of a professional valuer

[20] CGT Determination TD 10(W)

 

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

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

“Hotel, Motel, Holiday Inn” – Deriving Rent and the small business CGT concessions

The following article appeared in the December 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.

 

“Hotel, Motel, Holiday Inn”[1] – Deriving Rent and Accessing the Small Business CGT Concessions

Simon Dorevitch examines the pitfalls of satisfying the active asset test for assets which are used to derive rent.

Back to basics: The active asset test

To access the small business CGT concessions, certain conditions must first be satisfied. One such condition is that the CGT asset satisfies the active asset test. Satisfying this test requires the asset to be an active asset of the taxpayer for the lesser of 7.5 years and half of the relevant ownership period.

A CGT asset is an active asset at a time if it is used, or held ready for use, in the course of carrying on a business by the taxpayer, their affiliate or an entity connected with them (relevant entities).

However, certain assets are specifically excluded from being an active asset. One such exclusion applies to assets whose main use by the taxpayer is to derive rent, unless the main use for deriving rent was only temporary. When determining the main use of the asset, the taxpayer is instructed to disregard any personal use or enjoyment of the asset by them and to treat any use by their affiliate or entity connected with them as their own use.

Carrying on a business

To qualify as an active asset, a tangible CGT asset must be used or held ready for use in the course of carrying on a business by the taxpayer or a relevant entity. There is no conclusive test for determining whether a business is being carried on. However, in Tax Ruling TR 97/11, the ATO has enumerated several indicators of a business that may be relevant, including;

  • The size, scale and permanency of the activity
  • Repetition and regularity of the activity
  • Whether the activity is planned, organised and carried on in a systematic and businesslike manner
  • The expectation, and likelihood, of a profit

It is highly likely that the operator of a hotel would be conducting a business. In contrast, most residential rental activities are a form of investment and do not amount to carrying on a business. However, the following examples indicate that it is possible to conduct a rental property business.

Example 1 – Taxpayer was conducting rental property business[2]

The taxpayers owned eight houses and three apartment blocks (each comprising six residential units), making a total of 26 properties. They actively managed the properties, devoting a significant amount of time (an average of 25 hours per week) to them. The ATO concluded that the taxpayers were carrying on a business.

Example 2 – Taxpayer was conducting rental property business [3]

The taxpayer owned nine rental properties. Although they were managed by an agent, the taxpayer spent considerable time undertaking tasks in connection with the properties. Despite finding that the taxpayer’s methods were unsophisticated and un-business-like, the AAT concluded that the taxpayer was carrying on a business.

TIP – PASSIVE ASSETS USED IN THE BUSINESS OF AN AFFILIATE OR CONNECTED ENTITY

The Small Business CGT Concessions may still be available where the taxpayer (i.e. owner of the asset) is not carrying on a business. This would be the case, for example, where the CGT asset is used in a business carried on by the taxpayer’s affiliate or connected entity and this other entity is a ‘small business entity’ (broadly one with a turnover less than $2m).

Deriving rent

An asset whose main use by the taxpayer is to derive rent cannot be an active asset (unless this main use was only temporary).

It has been argued that this exception does not apply to properties where the taxpayer carries on a business of leasing properties, but rather only to passive investment assets. The AAT rejected this argument, stating clearly that it does not matter if the taxpayer is in the business of leasing properties or not. [4]

There is no statutory definition of rent that is relevant in this context so the term takes on its common law meaning.

Where there is a question of whether the amount paid constitutes rent, a key factor to consider is whether the occupier has a right to exclusive possession of the property. If such a right exists, the payments involved are likely to be rent. Conversely, if the arrangement allows the occupier only to enter and use the premises for certain purposes and does not amount to a lease granting exclusive possession, the payments involved are unlikely to be rent.

Other relevant factors include the degree of control retained by the owner, the extent of any services performed by the owner (such as room cleaning, provision of meals, supply of linen and shared amenities) and the length of the arrangement.

Example 3 – Payments for use of a commercial storage facility were not rent[5]

Christine carries on a business of providing commercial storage space. Each space is available for hire periods of 1 week or more. She provides office facilities, on-site security, cleaning and various items of equipment for sale or loan. The agreements provide that in certain circumstances Christine can relocate the client to another space or enter the space without consent and that the client cannot assign the rights under the agreement. Having regard to all the circumstances, the ATO concluded that the amounts received by Christine were not rent.

Example 4 – Payments for occupancy of boarding house were not rent[6]

David operates an 8-bedroom boarding house. The average length of stay is 4-6 weeks. Visitors are required to leave the premises by a certain time and David retains the right to enter the rooms. David pays for all utilities and provides cleaning and maintenance, linen and towels and common areas such as a lounge room, kitchen and recreation area. The ATO concluded that the amounts received by David were not rent.

Example 5 – Payments for occupancy of holiday apartments were not rent[7]

Linda owns a complex of 6 holiday apartments, advertised collectively as a motel. Each is booked for periods not exceeding 1 month, with most bookings being for less than 1 week. Guests do not have exclusive possession of their apartment, but rather only a right to occupy on certain conditions. Clean linen, meal facilities and cleaning are provided to guests. The ATO found that Linda’s income was not rent.

Example 6 – Payments for short stays in a caravan park were not rent[8]

The taxpayer owned and operated a caravan park that consisted of fully-furnished self-contained cabins, caravans set up on blocks and sites for guests with their own caravans. Guests also had access to a shared amenities block. The ATO ruled that short-term guests (those staying less than 3 months) did not pay rent while long-term guests (3 months or longer) did.

Example 7 – Payments for occupancy of mobile home park were rent[9]

The taxpayer owned and operated a mobile home park that consisted of 77 sites and a ‘community hall’ with shared facilities such as a kitchen, toilet and recreation area. In reaching the conclusion that the payments for use of the park were rent, the AAT found that the following factors were relevant; the park owner agreed to give vacant possession to a resident on a certain date, the resident was granted exclusive possession and had the right of quiet enjoyment, and the residential site was occupied as the resident’s ‘principal place of residence’.

Example 8 – Payments for short stays in holiday unit were rent[10]

The taxpayer owned a holiday home that was used to provide short term tourist accommodation (i.e. stays of about one to two weeks). Crockery, cutlery and linen were provided but cleaning was done only after the occupants departed. The AAT found there to be little doubt that the occupants regarded themselves as having rented the unit for the period of their stay and as having exclusive possession. Therefore, the payments did constitute rent.

What is the main use?

Where a CGT asset is used partly to derive rent and partly in the business of the taxpayer or relevant entity, it will be necessary to determine the ‘main use’ of the asset. This is because an asset whose main use by the taxpayer is to derive rent cannot be an active asset (unless the main use for deriving rent was only temporary).

The term main use is not defined in Division 152 (which contains the small business CGT reliefs). Tax Determination TD 2006/78 states that no single factor will necessarily be determinative and resolving the matter is likely to involve a consideration of factors such as;

  • The comparative areas of use of the premises,
  • The comparative times of use of the asset and, most importantly.
  • The comparative level of income derived from the different uses of the asset.

Example 9 – Mixed use[11]

Mick owns land on which there are several industrial sheds. He uses one shed (45% of the land area) to conduct a motorcycle repair business and leases the other sheds (55% of the land by area) to unrelated third parties. The income derived from the repair business is 80% of the total income, while the income derived from leasing the other sheds is only 20% of the income. Having regard to all the circumstances, the ATO considers that the main use of Mick’s land is not to derive rent.

Example 10 – Mixed use[12]

The taxpayer owned a shopping centre. Most the shops (constituting 73% of the floor space) were rented by unrelated shopkeepers but some (27% of the floor space) were used by the taxpayer to conduct business. Despite this, the ATO ruled that the main use of the shopping centre was not to derive rent because the majority (63%) of the income generated from the asset was from the business and only 27% was generated from rent.

In a recent AAT case[13], the taxpayer argued that the word ‘use’ in ‘main use’ could include non-physical uses such as holding a property for the purposes of capital appreciation. This argument was rejected, with the AAT finding that the concept of use was a reference only to physical use.

Treat use by affiliate/connected entity as taxpayer’s own

When determining the main use of the asset the taxpayer is instructed to treat any use by a relevant entity as their own use.

Example 11 – Use by affiliate[14]

John rents 80% of a property to his affiliate Peter and uses the remaining 20% in his business. Peter uses 60% of the area rented to him in his business and rents the remaining 40% to an unrelated party. 32% of the property (80% x 40%) is being treated as being used to derive rent. However, the remaining 68% is either actually used in John’s business (20%) or is treated as being used in his business (48%, being 80% x 60%). Therefore, the main use of the property is not to derive rent.

 

Ignore private use

When determining the main use of the asset the taxpayer is also instructed to disregard their own personal use or enjoyment of the asset. This point can be illustrated by the following example;

Example 12 – Private use disregarded[15]

Neil rents 60% of a property to his affiliate Andrea, uses 15% in his business and the remaining 25% for his own personal use.  Because personal use by the owner or relevant entity is ignored in determining the property’s main use, the above proportions must be adjusted. Following the adjustments Neil rents 80% (60% x (100/75)) of the property to Andrea and uses 20% (15% x 100/75) in his business.

Is the main use only temporary?

Finally, a CGT asset whose main use is to derive rent will not be precluded from being an active asset if this main use is only temporary. There is scarce guidance regarding what is  considered temporary in this context. However, in the context of whether a share in a company or interest in a trust is an active asset, an example in the explanatory memorandum[16] indicates that a failure to satisfy the 80% look-through test for two weeks would be of a temporary nature only and therefore would not prevent the share or interest from being an active asset.

 

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] Rapper’s Delight by Sugar Hill Gang, 1979

[2] ATO’s Guide for rental property owners (NAT 1729-06.2016)

[3] YPFD and Commissioner of Taxation [20-14] AATA 9

[4] Jakjoy Pty Ltd v FACT [2013] AATA 526

[5] Example 2 of Tax Determination TD 2006/78

[6] Example 3 of Tax Determination TD 2006/78

[7] Example 4 of Tax Determination TD 2006/78

[8] PBR 1012886042948

[9] Tingari Village North Pty Ltd and Commissioner of Taxation [2010] AATA 233

[10] Carson and Commissioner of Taxation [2008] AATA 156

[11] Example 5 of Tax Determination TD 2006/78

[12] PBR 70707

[13] The Executors of the Estate of the late Peter Fowler v FCT [2016] AATA 416

[14] Example 2.13 of Explanatory Memorandum to Tax Laws Amendment (2009 Measures No. 2) Act 2009

[15] Example 2.14 of Explanatory Memorandum to Tax Laws Amendment (2009 Measures No. 2) Act 2009

[16] Example 1.12 of Explanatory Memorandum to Tax Laws Amendment (2006 Measures No. 7) Act 2007