On 26 September 2018, the ATO released Law Companion Ruling LCR2018/6 and Practical Compliance Guideline PCG 2018/5 on the Diverted Profits Tax (DPT). The DPT rules in Part IVA of the Income Tax Assessment Act 1936 aim to ensure that significant global entities cannot reduce their Australian tax by diverting profits offshore through arrangements with related parties.
By way of background, Australia’s DPT legislation applies to significant global entities (broadly, groups with annual global income of AUD$1 billion or more) for income years commencing on or after 1 July 2017 in circumstances where the amount of Australian tax paid is reduced by diverting profits offshore through related-party arrangements and certain other conditions are satisfied.
Where the rules apply and the Commissioner decides to make a DPT assessment, a 40% tax is imposed on the diverted profit.
The ATO’s position on DPT serves as a reminder that all taxpayers with cross-border related party dealings are encouraged to assess the potential application of the DPT. This will start with the preliminary consideration of whether the taxpayer is a significant global entity that has, in broad terms, Australian income in excess of AUD $25 million and then specific consideration of particular transactions within the DPT framework.
Taxpayers should undertake a process to evaluate their risks and supporting documentation for the more complicated areas of DPT law, namely the principal purpose test and whether it could be concluded that an Australian tax benefit exists.
1. Law Companion Ruling LCR 2018/6
LCR 2018/6 discusses the rules around which the DPT operates – primarily the principal purpose test and the 11 matters considered by the Commissioner in applying this test (section 177). The ruling notes that the same test applies for the purposes of the multinational anti avoidance law, except the relevant matters considered by the Commissioner are different.
Quantifiable non-tax financial benefits
If a scheme that limits a taxable presence in Australia results in significant quantifiable non-tax financial benefits, this may provide a strong indication that the scheme was not entered into for a principal purpose of obtaining a tax benefit. Quantification of the non-tax financial benefits that will or may reasonably be expected to result from the scheme will generally be based on the outcomes that were anticipated at the time of entry into the scheme, provided that those outcomes were based on reasonable commercial assumptions.
Sufficient foreign tax test
Foreign tax liability is determined by quantifying the total of the increases in the amount of foreign income tax that is liable to be paid as a result of the scheme.
The definition of foreign income tax is intended to cover taxes that are substantially equivalent to Australian income tax.
Sufficient economic substance test
This test in section 177M of the Income Tax Assessment Act 1936 is an exception to the application of the DPT. The test is satisfied where the profit made as a result of a scheme by each relevant entity reasonably reflects the economic substance of the entity’s activities in connection with the scheme.
The term ‘profit’ in section 177M is used in a more general sense than ‘taxable income’.
Profit and economic substance
LCR 2018/6 also explains that it is a question of fact whether the profit made by an entity as a result of a scheme reasonably reflects the entity’s activities in connection with the scheme. In determining this, it is necessary to have regard to:
- the relative economic significance of the functions performed by the entity in connection with the scheme; and
- the entity’s relative contribution within the context of the overall value chain, to generating the total profit made as a result of the scheme.
In applying the test, it is the economic substance of the entity’s activities in connection with the scheme that is relevant, not the overall economic substance of the entity itself.
For the purposes of the DPT, it will be necessary to examine the functions, assets and risks not only of the relevant Australia taxpayer, but also other entities connected to the scheme.
2. Practical Compliance Guideline PCG 2018/5
PCG 2018/5 sets out the ATO’s taxpayer engagement framework for the DPT and outlines the ATO’s approach to risk assessment and compliance activity when the DPT is identified as a potential area of concern.
ATO compliance approach
A DPT risk will typically be identified by the ATO in the course of its ordinary compliance activities. While the ATO’s decision-making process will be guided by the circumstances of the particular case, it will generally prioritise its resources to address arrangements it considers pose the highest risk.
Once a DPT risk is identified, the ATO’s compliance approach may include ongoing monitoring of the risk or active consideration as part of a review. The ATO will consider information available to it and may request further information from the taxpayer. Even where the ATO considers a DPT risk to be low, it says it may continue to monitor the arrangement having regard to any additional information that becomes available.
Risk assessment framework
The ATO generally expects affected taxpayers to initially undertake their own risk assessment, having regard to the “framing questions” set out in PCG 2018/5. These framing questions cover:
- preliminary matters;
- transaction-specific issues;
- the principal purpose test ; and
- the sufficient economic substance test. Appendix 2 to PCG 2018/5 contains a series of high and low risk scenarios in relation to this test.
The ATO stresses that these framing questions are intended to serve as a general guide only and should not be viewed as an exhaustive list of the issues it may consider.
If taxpayers believe there is a potential DPT risk associated with their arrangements, the ATO expects them to engage with it. Taxpayers seeking greater certainty from the ATO can apply for a private ruling, seek entry to the APA program or contact the ATO’s DPT specialist team.
While there are no specific record-keeping requirements for the DPT, the ATO expects taxpayers to keep appropriate records of their arrangements and transactions in the normal way. In order to aid taxpayers to do this, PCG 2018/5 outlines the kinds of documentation the ATO may have regard to when considering the application of the DPT. These documents include:
- lodged Australian income tax returns and notices of assessment;
- international dealings schedules and working papers;
- Country-by-Country reporting data and other information obtained via exchange of information processes;
- a general submission by the taxpayer outlining its views on the application of the DPT (including the basis for satisfying any exemptions);
- annual reports or general purpose financial statements;
- contemporaneous transfer pricing documentation; and
- intercompany agreements and policies regarding such dealings.
The ATO cautions that the documentation outlined in PCG 2018/5 is intended as a general guide only and should not be viewed as an exhaustive list of the kinds of documentation the ATO may take into account.
Where there is a risk that the DPT may apply to an arrangement covered by a proposed settlement, the ATO says it will generally seek to resolve the matter before proceeding with the settlement. The ATO may, at the taxpayer’s request, include a clause relating to the DPT in the settlement deed.