The ATO is particularly concerned with cross border finance in which an Australian entity received (or expects to receive under prospective structures) foreign investment on terms that:

  • Are not consistent with 'vanilla' debt or equity instruments;
  • Enable the foreign investor to participate in the management, control or capital of the Australian entity; and/or
  • Provide the foreign investor with direct exposure to the economic return for the entity.

The ATO has indicated that it is concerned with these arrangements and will review the tax characterisation adopted by the taxpayer. The ATO has highlighted that it would most likely apply the general anti-avoidance rules and/or the transfer pricing provisions to arrangements that reduce the amount of withholding tax payable.

There are two examples in the Taxpayer Alert which provide limited insights into the ATO's concerns.

The first example is a debt facility which contains the following features:

  • An interest rate that exceeds the interest rate obtainable from traditional debt financiers;
  • A contingent return on the occurrence of an event (such as the sale of an asset) which provides an equity-like exposure;
  • A reduction in Australian withholding tax and non-payment of other Australian taxes;
  • A deferral of interest payments until the disposal of the asset; and
  • A reduction in the Australian entity's taxable profit on sale based on the amount payable to the foreign investor.

The second example is more specific. It concerns an Australian entity that holds a mining right, raises capital from an offshore investor and has the following features:

  • The offshore investor provides capital in exchange for a right to receive percentage payments of the gross revenue on the sale of the natural resources (which are presumably the subject of the mining right);
  • A United States based entity which is a subsidiary of the parent entity of the offshore investor (and presumably therefore a related entity) acquires the mining rights and receives payments;
  • The offshore entity does not obtain a legal interest in the mining rights;
  • The return payable to the offshore entity is not subject to Australian income tax or withholding tax.

The ATO provides a laundry list of concerns with such arrangements, including:

  • Deliberate structuring for the purpose of avoiding Australian tax otherwise payable to the foreign investor, or obtaining a treaty benefit, including withholding tax;
  • The potential for CGT event D3 to arise in relation to the second example (granting a right to income from mining);
  • Failure to characterise the arrangement as a debt interest and have due regard to the thin capitalisation provisions;
  • Failure to report the dealings between foreign entity (including associates) and the Australian entity (including associates) as related party dealings; and
  • Failure to make the necessary FIRB disclosures.

Observations

In flagging the potential application of the Australian domestic anti-avoidance rules and treaty based anti-avoidance rules (together with a plethora of other provisions) the ATO has indicated that it has significant concerns with these types of arrangements.

Given the severity of the anti-avoidance rules, the concern for taxpayers is the lack of guidance available to delineate between acceptable commercial practices and those that are within the sights of the ATO. The ATO appears to have indicated that arrangements which are not 'vanilla' or which 'take advantage' of a tax treaty will be subject to closer scrutiny even though such arrangements may be simply addressing circumstances in which 'vanilla' finance is not available. That being said, if taxpayers have arrangements which provide for deductible distributions linked to significant equity exposure, they should review their arrangements carefully and ensure any commercial reasons for use of the instrument has been documented.

It is expected that the ATO will provide further detailed guidance to assist taxpayers, particularly given the importance of offshore finance to Australian entities.

However, in the meantime any funding (debt or equity) arrangement in place that departs from traditional vanilla debt or ordinary shares may need to be reviewed. This would be so, particularly in light of the need to complete Reportable Tax Positions Schedules and the need to advise the FIRB in any reportable transactions that no ATO Taxpayer Alerts apply.

Taxpayers should consider obtaining independent advice on the application (or non application) of TA 2020/2.