International tax considerations
This section outlines the key international tax considerations that you need to be aware of when doing business or investing in Australia.
Australia endorses the OECD’s BEPS 2.0 project
In October 2021, the Organisation for Economic Co-operation and Development (OECD) released a statement that provided a glimpse into how multinational enterprises (MNEs) will be taxed in years to come (October Statement).
Notably, 137 jurisdictions have agreed to the October Statement (including Australia). The October Statement builds on the two-pillar solution to base erosion and profit shifting (BEPS) that the OECD has been developing in recent years.
Pillar One is aimed at reallocating rights to tax certain MNEs to ‘market jurisdictions’. These rules will only apply to multinationals with an annual global revenue exceeding €20 billion and with a pre-tax profit to revenue ratio exceeding 10%. The new multilateral convention to implement Pillar One is scheduled to be finalised by mid-2023 for entry into force in 2024.
Pillar Two is aimed at ensuring certain MNEs with revenue above €750 million are subject to a global minimum corporate tax rate of 15% by introducing Global anti-Base Erosion (GloBE) rules. The OECD released technical guidance on Pillar Two on 2 February 2023 to clarify the interpretation of GloBE rules to ensure coordinated implementation in domestic legislation.
The Federal Government in the 2023-24 Federal Budget, announced that it will fast-track Australia’s implementation of Pillar Two by introducing:
- a 15% global minimum tax for MNEs, achieved by way of legislating:
- the Income Inclusion Rule (IIR) for income years commencing on or after 1 January 2024, and
- the Undertaxed Profits Rule (UTPR) for income years commencing on or after 1 January 2025.
- a 15 per cent domestic minimum tax (DMT) applying to income years starting on or after 1 January 2024.
Although the rules will apply to in-scope MNE groups from 1 January 2024, the measure is not yet law in Australia.
On 21 March 2024, exposure draft legislation to implement these measures was released for consultation by Treasury. Consistent with previous government announcements, the legislation is drafted so that the IIR will operate to attribute the profits of subsidiaries in low taxed jurisdictions to the parent entity in proportion to the parent entity’s ownership in the subsidiary and for the parent entity to pay any additional top-up tax to achieve the minimum 15% tax. Similarly, the DMT will apply to the profits Australian subsidiaries of MNE groups to raise their tax rate to 15%. Where income is not caught by the IIR or DMT, the UTPR will operate as a backstop to adjust the profits of the subsidiary in the low tax jurisdiction to achieve the minimum 15% tax. Inbound entities doing business in Australia will need to pay close attention to the commencement date, as the rules will apply and create compliance obligations for Australian subsidiaries where Pillar Two might not yet have come into effect for its parent entity’s jurisdiction.
If you have any questions about the possible tax implications of doing business or investing in Australia, please contact our team.
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Australian double tax treaty network: Multilateral Legislative Instrument
Australia has a complex system of bilateral DTAs with 47 countries. Consistent with its plan to significantly expand the tax treaty network, in October 2023 the Australian Government entered into its first DTA with Iceland, and in November 2023 signed its first DTA with Portugal.
The purpose of the DTA network is to allocate taxing rights between different jurisdictions and Australia in respect of income or gains derived by non-resident taxpayers. DTAs also address common tax issues such as taxation of interest, dividends, royalties, permanent establishments and dealing with issues of ‘source’. The intention is to prevent double taxation of the same income or gain in different jurisdictions by way of either a full tax exemption or foreign tax offsets.
The Multilateral Legislative Instrument (MLI) is a multilateral treaty that came into force in Australia on 1 January 2019. The MLI modifies the operation of applicable Australian DTAs by implementing measures to prevent multinational tax avoidance and resolve tax disputes more effectively.
Whether the MLI applies to certain treaties will depend on whether both jurisdictions have taken the necessary actions to implement the MLI for that specific DTA and as such, must be considered on a treaty-by-treaty basis.
The intention of the Multilateral Legislative Instrument is to prevent double taxation of the same income or gain in different jurisdictions by way of either a full tax exemption or foreign tax offsets.
Australian withholding taxes
Interest, unfranked dividends, and royalty payments made by Australian residents to non-residents are subject to a final withholding tax. Unfranked dividends and royalty payments are generally subject to a 30% withholding tax, while interest payments are generally subject to a 10% withholding tax.
However, these rates may be modified by the relevant DTA. To prevent double taxation, withholding tax is not payable on franked dividends, as franked dividends are paid out of profits that have already been subject to corporate tax in Australia. Certain interest payments to non-resident super funds and sovereign entities are exempt from withholding tax, where the relevant provisions are satisfied.
An exemption from interest withholding tax is also available to Australian resident companies where they satisfy the ‘public offer test’ on the issue of debentures and syndicated loan facilities (this is commonly referred to as the 128F exemption).
Royalty withholding tax and ‘intangibles’
In PepsiCo [1] the Federal Court applied Australia’s royalty withholding tax rules to ‘embedded royalties’, finding that payments expressed as consideration for Pepsi concentrate were, to an extent, consideration for a licence to use intellectual property granted under an exclusive bottling agreement. Noting that one of the relevant agreements for the supply of concentrate was explicitly expressed as “royalty-free.”
Subject to the outcome of the appeal, the PepsiCo decision effectively endorsed the long-held ATO position on ‘embedded royalties’ and intangibles arrangements – namely that royalty withholding tax obligations may apply to arrangements involving intellectual property licensing, whether or not the relevant payments are expressed as consideration for intellectual property.
The decision was appealed to the Full Court of the Federal Court. The outcome of that appeal is expected later in 2024 and may have significant impact on multinational companies licensing intellectual property in Australia.
The ATO have released taxation ruling TR 2024/1, practical compliance guideline PCG 2024/1 and Taxpayer Alert TA 2018/2 which provide further guidance on when payments made in respect of software and intellectual property rights will be characterised as ‘royalties’ to which separate withholding tax obligations may apply.
As part of the 2024-25 Federal Budget, on 15 May 2024 the Federal Government announced a new penalty for significant global entities that are found to have mischaracterised or undervalued royalty payments to which royalty withholding tax would otherwise apply.
CGT withholding
Australia also has a CGT withholding regime. Subject to limited exceptions, a purchaser is required to withhold and remit to the ATO 12.5% of the purchase price from a transaction where the vendor is a foreign resident (or deemed foreign resident), and the transaction involves TAP (as discussed under the CGT section above) with a value of $750,000 or more under the foreign resident capital gains withholding (FRCGW) regime.
As part of the 2024-25 Federal Budget, the Government announced an increase in the rate of FRCGTW from 12.5% to 15%. The Government has announced that it will consult on the implementation of this measure, with more details and draft legislation yet to be released.
Limitations on interest deductions – Thin Capitalisation and Debt Deduction Creation Rule
The thin capitalisation rules (or ‘Thin Cap’ for short) is an integrity regime aimed at preventing excessive gearing of Australian businesses. After an extended process of drafting and consultation, the details of the new Thin Cap regime were finalised in early 2024 with the release of the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share – Integrity and Transparency) Bill 2023 (Cth), which received Royal Assent on 8 April 2024.
Old Thin Cap rules
The old Thin Cap rules seek to deny Australian taxpaying entities tax deductions for interest and other financing costs where, broadly, the average total debt of the entity exceeds 60% of the average value of total assets. Where the level of debt exceeds this threshold, debt deduction denial will occur unless the entity satisfies the “arm’s length debt test” or elected to apply the “worldwide gearing test”.
Financial entities and authorised deposit institutions (ADI) can elect to continue to apply the old Thin Cap rules. All other taxpayers will be subject to the new Thin Cap rules, if Thin Cap applies to those entities.
New Thin Cap rules
Broadly, the new Thin Cap rules apply to “general class investors” – a new, broad concept including old law concepts of ‘inward’ and ‘outward’ investors – and work by disallowing an entity’s debt deductions based on the entity’s earnings or profits for the income year, determined by reference to either:
- a “fixed ratio” test of 30% of an entity’s earnings before interest, taxes, depreciation, and amortization for tax purposes (Tax EBITDA),
- a “group ratio” test of the group’s worldwide net interest expense and Tax EBITDA as based on its financial statements; or
- a “third party debt” test will apply to deny debt deductions attributable to related party debt (thus limiting debt deductions to external debt only).
Where the taxpayer does not satisfy one of the above Thin Cap tests, debt deductions will be denied (where the “fixed ratio test” is elected, denied deductions can be carried forward for up to 15 years). Despite an extensive consultation process, industry and tax professionals have raised significant concerns on the application of the new Thin Cap regime and the potential to generate inequitable tax outcomes for genuine commercial structures. The new Thin Cap regime will commence retrospectively from 1 July 2023.
There is a de minimis threshold of $2 million of the pre-tax value of the interest and debt deductions which must be met before the Thin Cap regime will apply to an entity. Australian groups which are not foreign controlled with 90% or more of their assets in Australia are exempted from the Thin Cap regime. The regime is complex as there are multiple thresholds and tests depending on how the Australian taxpayer is classified. The regime will apply to Australian entities investing overseas, their associates (outward investors) and foreign entities investing into Australia (inward investors).
Debt Deduction Creation Rule
As part of the overhaul of the Thin Cap regime, the Debt Deduction Creation Rules (DDCR) were introduced and will apply from 1 July 2024, to disallow debt deductions to the extent that they are incurred in relation to certain debt creation schemes. Being, those schemes that lack genuine commercial justification and operate to create artificial interest-bearing debt to shift profits out of Australia through tax-deductible interest payments. The DDRCR are primarily aimed at the following two types of related party/associate transactions:
- Debt used to fund the acquisition of an asset from a related party, and
- Debt used to fund the payment of amounts or distributions to an associate. These rules will apply to both pre-existing arrangements and new arrangements (i.e. there is no grandfathering of existing financing arrangements) and will require careful consideration in relation to intragroup debt financing arrangements.
Transfer pricing
Australia, like many OECD countries, has a complex regime of transfer pricing rules which apply to cross-border related party transactions. The intention is to prevent related party transactions resulting in higher deductions or lower income being recognised in Australia, resulting in an overall lower level of tax being paid (commonly referred to as a ‘transfer pricing benefit’).
The regime requires a reconstruction of transactions to determine whether the transaction is on ‘arm’s length’ terms. This involves a study into what comparable independent parties transacting under similar conditions to the related parties would pay or receive for a particular transaction.
Transactions include the supply of goods and services, property, technology, and loan arrangements. Transfer pricing is currently a focus area for a lot of taxpayer disputes with the ATO, including Glencore [2] and SingTel. [3]
The case against Glencore concerned the pricing mechanism used in the purchase of copper concentrate by Glencore’s Swiss-based company from its Australian subsidiary. The decision marked a surprising but much-welcomed win for taxpayers.
The Federal Court found in favour of Glencore on 3 September 2019 and the Full Federal Court went on to dismiss the Commissioner of Taxation’s appeal on all but one issue. Bringing the matter to a close, the High Court dismissed the Commissioner’s application for special leave to appeal on 21 May 2021. Glencore provides some key takeaways with respect to arm’s length dealings with offshore related parties, such as the emphasis that should be placed on surrounding economic circumstances.
On 8 March 2024, the Full Federal Court handed down its decision in Singtel, confirming the first instance decision to deny SingTel a deduction for interest paid on a related party cross-border loan from its parent company. [4] In contrast to Glencore, the decision represented a significant victory for the ATO on the application of the transfer pricing rules in Australia, and provides guidance on the Commissioner’s application of the transfer pricing benefit rules and “arms-length” interest deduction rules.
As evidenced in SingTel, the Thin Cap regime and transfer pricing rules are often considered in conjunction when there are cross-border related party loan arrangements.
Hybrid mismatch rules
The hybrid mismatch rules operate in Australia to neutralise hybrid mismatches by cancelling deductions or including amounts in assessable income where there are:
- deduction or non-inclusion mismatches (D/NI) where a payment is deductible in one jurisdiction and non-assessable in the other jurisdiction;
- deduction or deduction mismatches (D/D) where the one payment qualifies for a tax deduction in two jurisdictions; and
- imported hybrid mismatches where receipts are sheltered from tax directly or indirectly by hybrid outcomes in a group of entities or a chain of transactions.
The ATO released PCG 2021/5 in 2021 which finalised the ATO’s compliance approach to the assessment of relative levels of tax compliance risk associated with imported hybrid mismatches and updated the draft PCG with only minor changes.
PCG 2021/5 provides a framework of seven colour-coded risk zones ranging from white zone (where the ATO has provided clearance to the taxpayer), through green (low risk) to very high risk (red).
Unsurprisingly, the guideline is conservative in its approach and states that taxpayers should refrain from claiming any deductions that have not been through a full and extensive verification process as set out in the guideline. In other words, taxpayers are expected to prove that deductions should not be denied because of the hybrid mismatch rules, which may seem strange in the context of Australia’s self-assessment framework.
Practically speaking, meeting the demanding expectations of the guideline will likely be difficult and burdensome, noting the ATO’s recommended “top-down” and “bottom-up” approaches for non-structured arrangements.
General anti-avoidance rules
Australia has extensive general anti-avoidance rules, commonly referred to as Part IVA. The Commissioner may reverse a tax benefit (such as the non-inclusion of an amount of assessable income, or the inclusion of a deduction) obtained in connection with a scheme that was objectively entered into for the dominant purpose of obtaining the tax benefit. The Commissioner will take into account the specific facts and surrounding circumstances of the scheme, including the manner the scheme was entered into, its legal form, and its substantive effect.
In the context of discretionary trusts, the 2022 decision of the Federal Court in Minerva [5] had caused anxiety for trustees by applying Part IVA to seemingly routine distributions paid by trustees. However, on appeal the Full Federal Court unanimously found that choosing not to exercise a discretion to distribute income to one (resident) beneficiary rather than another was not a scheme to which Part IVA applied, finding that Part IVA does not require taxpayers to choose the transaction that results in the most tax being payable.[6]
This landmark appeal decision provides great relief for trustees in Australia by confirming a trustee exercising a discretionary power to make a distribution to a beneficiary does not trigger the general anti-avoidance provisions in Part IVA merely because another beneficiary would have paid more tax had they received the same distribution.
In the 2023-24 Federal Budget, the Federal government announced an unexpected expansion of the Part IVA legislation to include schemes:
- that reduce tax paid in Australia by accessing a lower withholding tax rate on income paid to foreign residents, and
- that achieve an Australian income tax benefit, even where the dominant purpose was to reduce foreign income tax.
These reforms are intended to apply for income years commencing on or after 1 July 2024, regardless of whether the scheme was entered into before or after 1 July 2024. However, as at the date of writing, no exposure draft legislation has been released for consultation.
Multinational Anti Avoidance Law and Diverted Profits Tax
Global entities with an annual income of $1 billion or more are subject to the Multinational Anti Avoidance Law (MAAL) and the Diverted Profits Tax (DPT).
The MAAL is designed to target contrived arrangements employed by large foreign enterprises to avoid paying tax in Australia, in circumstances where the enterprise is supplying goods or services to Australian customers. MAAL may apply where a significant global entity enters into or carries out such an arrangement for a principal purpose of for a principal purpose of obtaining an Australian tax benefit or an Australian tax benefit and a foreign tax benefit.
The DPT addresses complex arrangements where large entities may attempt to reduce the tax they pay in Australia by redirecting profits offshore. The DPT is a 40% tax applied to the ‘diverted profit’. DPT may apply where a significant global entity entered into or carried out a scheme for a principal purpose of obtaining an Australian tax benefit or an Australian tax benefit and a foreign tax benefit.
In November 2023, the PepsiCo [7] decision became the first Australian case to consider the DPT provisions. The Court found that that the ‘royalty-free’ licences granted under the exclusive bottling arrangements were entered into for the dominant purpose of avoiding royalty withholding tax and reducing its US tax liability. On that basis, the Court found that if the royalty withholding tax did not apply, DPT would apply to those payments at a rate of 40%.
PepsiCo appealed the decision to the Full Federal Court, arguing that neither royalty withholding tax nor DPT applied to its arrangements. The appeal was heard in early May 2024, with the highly anticipated judgment expected to shed further light on these provisions and may have significant impact on multinational companies with Australian operations.
The ATO view on the potential application of general anti-avoidance or transfer pricing rules to cross-border related party 'intangibles migration arrangements’ is set out in TR 2024/D1 and PCG 2024/D1, including the ATO’s compliance approach for these issues.
Research and development tax Incentives
The Australian Research and Development (R&D) tax incentive reduces R&D costs by offering tax offsets for eligible R&D expenditure for companies.
Eligible companies with an aggregate turnover of less than $20 million can receive a refundable tax offset, allowing the benefit to be paid as a cash refund if they are in a tax loss position. All other eligible companies receive a non-refundable tax offset to help reduce the tax they pay.
The program is available to companies that are:
- incorporated under Australian law, or
- incorporated under foreign law but an Australian resident for income purposes; or
- incorporated under foreign law and a resident of a country with which Australia has a double tax agreement.
Contact our team
If you have any questions about the above or would like assistance with tax advice for doing business in Australia, please contact one of our team members below.
Footnotes
[1] PepsiCo, Inc v Commissioner of Taxation [2023] FCA 1490.
[2] Federal Commissioner of Taxation v Glencore Investment Pty Ltd (2020) 112 ATR 378.
[3] Singapore Telecom Australia Investments Pty Ltd v Commissioner of Taxation [2024] FCAFC 29.\
[4] Appeal from Singapore Telecom Australia Investments Pty Ltd v Commissioner of Taxation [2021] FCA 1597; and Singapore Telecom Australia Investments Pty Ltd v Commissioner of Taxation (No 2) [2022] FCA 260.
[5] Minerva Financial Group Pty Ltd v Commissioner of Taxation [2022] FCA 1092.
[6] Minerva Financial Group Pty Ltd v Commissioner of Taxation [2024] FCAFC 28.
[7] PepsiCo, Inc v Commissioner of Taxation [2023] FCA 1490.