Treasury has just released a much anticipated Exposure Draft (ED) and Explanatory Memorandum (EM) relating to the OBU provisions.

The ED provides a number of welcome reforms, including an extension of the types of eligible OB activity, confirmation of the choice principle, and improvements to the OBU expense allocation rules.

The reforms do not widen the scope of "eligible OB activities" to the extent that industry might have hoped - in particular, there remains a significant opportunity to extend the eligible activities to any TOFA financial arrangement rather than continue with the prescriptive list of activities as currently proposed. Nonetheless, the industry will be pleased to see that Treasury has not proceeded with its initial proposals to prohibit dealings with related parties and dealings between OBUs.

As expected, there are a number of matters that will require clarification, as discussed further below. PwC will be preparing a submission to Treasury on the reforms in due course.

A snapshot of key reforms

The ED proposes five key reforms effective for income years commencing on or after 1 July 2015. It remains unclear as to what transitional arrangements may be required (if any).

The key reforms are:

  1. Expanding and clarifying the scope of eligible OB activities, particularly in regard to commodities trading, funds management activity, and guarantee-type activities.
  2. Codifying the “choice” principle to allow taxpayers to choose for eligible transactions to be booked into the OBU.
  3. Replacing the statutory formula for calculating general OB deductions with an apportionment method that is based on the extent to which an expense/loss related to producing OB income.
  4. Clarifying that OB income and deductions relating to dealings between an OBU and its PE are deemed to arise on arm’s length terms.
  5. Integrity measures that limit the scope of “trading activity” for OBUs trading in foreign entities, where the OBU holds a participation interest of 10% or more in the foreign entity.

The reforms in detail, and our view

1.     Scope of eligible OB activities

The ED extends or modifies the list of eligible OB activities to include:

  • Unfunded commitments to lend money.
  • Acting as an arranger in certain syndicated lending arrangements.
  • Advisory activities relating to provision of advice in relation to disposal of investments – noting that this was previously uncertain.
  • Trading with any person in non-deliverable forward foreign currency contracts - noting the ATO's historic view that such contracts were not “trading in foreign currency”.
  • Leasing activity with an offshore person regarding offshore property.
  • Trading in commodities with an offshore person, subject to certain conditions (see below).
  • Removal of the Australian asset restriction in connection with investment management activity (see below).
  • Provision of guarantees, letters of credit, and certain similar arrangements to offshore persons even where there is an immaterial Australian connection (see below).

Trading in commodities

The ED introduces trading with an offshore person in commodities, as an eligible OB activity. The activity is only eligible if it is "incidental" to an eligible contract activity. Whilst this would seem to allow trading in a commodity in order to hedge a commodity derivative, not  all commodities trading is within scope. Further, the term "commodities" is not defined, and clarification will be required as to whether this includes intangible things such as electricity.

Permitted investment management activity

There are also welcomed changes to permitted investment management activity. Previously, investment management activities were ineligible if the portfolio's average Australian asset percentage exceeded 10%. This was an arbitrary test which was difficult to control as investment values changed over time. The new rules remove this requirement so that managing a portfolio which partly includes Australian assets can now be an eligible activity (even if greater than 10%). Fees derived from managing the portfolio will continue to qualify for the concessional OBU tax rate only to the extent of the non-Australian assets.

Although welcome, we note there are still difficulties with the definition of investment management activity that have not been addressed – for example the requirement that the currency in which the investment is made is not AUD. This continuing requirement is difficult to reconcile with the removal of the Australian asset restriction and limits the effectiveness of the proposed amendment.

Guarantees and similar arrangements

The ED amends the scope of "guarantee-type activity", which (in respect of providing a guarantee or letter of credit, or underwriting a risk) was previously restricted to activities or risks that had no connection to Australia. The revised provisions acknowledge that these activities or risks may have some connection with Australia provided they are not "material”. While this is a positive and practical development, further clarification as to what constitutes "material" activity or risk will be required in due course.

2.   The "choice" principle

The ED codifies the choice principle under the OBU regime by confirming that a taxpayer may book eligible OB activity in its DBU. In essence, the choice is effected by the taxpayer recording the particular thing that would otherwise be an eligible OB activity in a separate set of "non-OBU accounting records". There is no requirement to lodge the records with the ATO.

However, the choice rule is accompanied by a broad rule that deems the taxpayer's choice in respect of a particular "thing" to be automatically effective in respect of other "things" that form part of a "single scheme" where it is reasonable to do so. The EM provides an example of an asymmetric swap, where a choice to book one leg of the swap in the DBU automatically results in the other leg of the swap being deemed to be booked in the DBU.

We consider the deeming rule to be too broad and we suspect it may lead to unintended consequences.  For example, would it be reasonable to aggregate as part of a single scheme a portfolio foreign currency hedge that hedges foreign currency loan receivables which are booked across both the OBU and DBU? If aggregation were required, this could potentially require the OB lending activity to be booked in the DBU. Should this aggregation be necessary, we believe that a more appropriate aggregation test needs to be identified in order to provide greater certainty – perhaps similar to the grouping and disaggregation rules in the TOFA provisions.

Alternatively, as the example in the EM suggests that this rule is intended to apply as an integrity provision only, the aggregation rule should be drafted clearly to apply in those limited circumstances only.

3.       OBU expense allocation

The ED removes the statutory method for apportioning a general OB deduction based on the relative income of the DBU and OBU, and introduces a test that is more aligned to the general deductibility test in section 8-1. Essentially, this test requires general deductions to be apportioned to the OBU to the extent that they relate to the production of income.

Some taxpayers may welcome this amendment as it may reduce compliance costs and removes the possibility of unintended and anomalous outcomes. It should also alleviate concerns regarding the ability to deduct section 25-90 expenditure, enabling the expenditure to be more reasonably apportioned between the DBU and OBU.

Guidance may be required in due course as to the ATO’s view of appropriate apportionment methodologies.

4.       Transactions between an OBU and its PE

The ED seeks to clarify the treatment of internal financial dealings between an OBU and its PE, by introducing a rule to deem the amount included in an OBU's OB income or allowable OB deductions to be the arm's length amount.

We welcome the clarification in the ED and EM that expressly acknowledges an OBU can transact with its PE. However, we note that there are still some matters that require further clarification. In particular:

  • While the rule deems the amount that arises between the OBU and the PE to be an arm's length amount, the rule remains silent on the broader question of whether such internal dealings give rise to assessable OB income or an allowable OB deduction in the first place. The ATO has expressed doubts about this in the past, and as currently drafted the potential deficiencies in section 121EB(1) to (3) remain unaddressed.
  • Clarification will be required in due course on how the OBU's accounts should be adjusted to reflect any transfer pricing adjustments and what documentation is necessary to appropriately recognise the internal dealing.

5.       Trading in shares in foreign subsidiaries

Finally, the ED introduces an integrity rule that excludes trades involving foreign entities from being "trading activities", if the OBU holds a 10% or greater participation interest in the foreign entity just before the trade occurs. The integrity measure aims to prevent OBUs from converting ineligible non-OB activities undertaken by the offshore subsidiary into eligible OB activities, by trading in the shares of the offshore entity.

This is a welcome watering down of the government’s original announcement to introduce an almost blanket prohibition on dealings by an OBU with related parties. The government has listened to industry calls for this to be a targeted integrity provision only.

While it is necessary to have such an integrity provision, we see two concerns with the rule as drafted:

  1. The rule does not consider whether the foreign entity is undertaking what would otherwise be non-OB activities if done directly by the OBU. Therefore the OBU is effectively penalised in circumstances where the foreign entity's activities would otherwise be eligible OB activities (and therefore are presumably not the target of the integrity measure). Unless a purposive test is introduced to consider the activities of the foreign entity, the scope of the integrity measure will remain broader than its intended impact.
  2. The EM does not explain why a 10% participation interest has been chosen.  As the behaviour the integrity provision seems to target involves an OBU manufacturing a particular outcome for itself under the regime, we would consider it more appropriate to apply the integrity rule in circumstances where the OBU has control over the foreign entity (for example, by referring to the control thresholds in the CFC regime).

A transitional rule may be required to ensure that adverse outcomes do not arise in respect of transactions entered into before the integrity rule becomes effective.

Conclusion

It is clear that Treasury has gone to considerable effort to implement reforms across a wide range of financial services arrangements. We welcome the opportunity to make submissions to ensure that the ED operates in a clear and practical manner and will be making a submission in due course.

PwC would be pleased to assist you in preparing any submissions or considering the impact of the proposed reforms for your business. Submissions are due on 8 April 2015.