With the advent of technology such as the internet, smart logistics, smaller lead times etc., markets once only accessible to big business are now increasingly open and available to small and micro businesses.
However, this has also led to an increase in the taxation compliance burdens for such business, with taxation regimes once considered to only affect the “big end of town” potentially now having ramifications for small to medium businesses, sometimes without their knowledge. Additionally, Governments around the world are recognising the tax leaks that can arise from multinational business and are constantly seeking to introduce new legislation to close or manage any perceived tax gaps. The OECD also now can impact domestic taxation laws through its global recommendations and policies.
Accordingly, where business previously only had to consider the tax implications of regimes such as withholding tax, transfer pricing, permanent establishments and thin capitalisation, they now have potential exposures to the full suite of compliance regimes, such as Country-by-Country reporting, and the foreign hybrid mismatch rules.
More often than not, many of these regimes need to be considered together – for example a loan may have implications under the withholding tax, transfer pricing, international dealings schedule, thin capitalisation and foreign hybrid mismatch rules.
This article provides a reminder of some of the key components and objectives of these regimes and the potential impact they can have for entities of all sizes dealing internationally.
The withholding tax rules in Division 128 of the Income Tax Assessment Act 1936 (“ITAA 1936”) are one of the most common international-related tax regimes taxpayers will encounter.
Broadly, these rules require an Australian payer to withhold a flat rate of tax from certain payments of dividends, interest and royalties to a non-resident. As the income is then treated as non-assessable non-exempt income for the non-resident recipient, the withholding tax is a final tax.
While these provisions are generally well understood, complexities still arise particularly in relation to what constitutes a royalty, as well as the interplay of the Australian domestic withholding tax rules and any Double Tax Agreements between Australia and the non-resident recipient’s country.
The question of an entity’s tax residency is core to the function of each country’s tax system, as it is determinative of a country’s taxing rights in relation to that entity. However, it is a question that is becoming more, not less, complex to answer with time, particularly due to the constant movement of individuals across borders.
The complexity of this area for individuals has recently been highlighted in the Full Federal Court case, Harding v Commissioner of Taxation  FCAFC 29, where the taxpayer was unanimously found to not be an Australian tax resident (the Commissioner has since sought special leave to appeal); and for companies via the Commissioner’s ruling TR 2018/5, which provided his view on when a foreign-incorporated company’s central management and control would be in Australia such that it would qualify as an Australian tax resident.
This complexity is only increased as entities are required to consider not only domestic tax residency rules, but also those in the double tax agreements (“DTA”) between countries (refer below), particularly where two countries may try to claim residency status for that entity.
Whether it is an Australian business expanding overseas, or a foreign business expanding into Australia, consideration will need to be given to whether the entity’s activities comprise a permanent establishment (“PE”). An entity that has a PE in another country is exposed to tax obligations in that country.
The question of what constitutes a PE can be a complex one that often depends on the specific domestic tax laws of the relevant country, interplayed with the definition of a PE under any applicable DTA. Depending on the specific definitions involved, having a single person complete contracts could be sufficient to constitute a PE for one business, but for others it may require a staffed office.
The existence of a PE can have both income tax and Goods and Services Tax/Value Added Tax consequences, depending on the country involved.
Double Tax Agreements
Broadly, DTAs are formal bilateral agreements between two countries that aim to prevent double taxation and fiscal evasion, as well as providing clarity for countries regarding which country has taxing rights of income derived cross-border.
How a DTA will apply to a taxpayer will depend on their residency status, what activities the taxpayer is undertaking, and what type of income is being derived.
DTAs can be key to providing double taxation relief and need to be consulted where cross-border transactions and investments arise.
Australia currently has DTAs with around 40 countries. Broadly, however, these DTAs only deal with income tax matters (as opposed to indirect taxes such as Goods and Services Tax/Value Added Tax).
Goods and Services Tax/Value Added Tax
Many countries have a Goods and Services Tax (“GST”) or Value Added Tax (“VAT”), which is an indirect or consumption tax that applies to most goods and services sold or consumed in the relevant country.
Businesses providing goods and services in Australia need to consider whether they are required to be GST-registered and pay GST on their taxable supplies.
The reach of the GST in recent years has been increased, with the Government introducing rules such as the “Netflix tax”, which can add GST to digital services to Australian consumers by foreign providers (such as Netflix, Stan and iTunes).
In addition, from 1 July 2018, the Government extended the GST to apply to sales of low value goods (i.e. less than AUD 1,000) imported by consumers into Australia (as goods above this threshold were already subject to GST and customs on import). Businesses with sales of such goods of over AUD 75,000 now need to register for GST and pay GST on their taxable sales. As such businesses could be the merchants selling goods, electronic digital platform operators or re-deliverers, this has led to a confusion as to who is the relevant entity in the supply chain responsible for collecting and paying the GST (for example, if someone is selling products via Amazon, there is often confusion regarding whether the seller or Amazon is the relevant responsible party).
Controlled Foreign Company rules
The controlled foreign company (“CFC”) rules can require Australian residents who have substantial interests in Australian-controlled foreign companies (i.e., the CFC) to include a share of the income earned by the CFC in their assessable income on an accruals basis. That is, the Australian resident controller is required to recognise a portion of the income earned by the CFC for the income year in their own tax return, even if the CFC has not paid any dividend or other return to them.
There are different attribution rules depending on whether the CFC is located in a “listed” country (essentially a country with comparable taxation rules) or “unlisted” country (any other country), with less types of income being “attributable” to the controller if the CFC is located in a listed country. Additionally, there are exceptions where the CFC is carrying on an active business and their “passive” income is below a specific threshold.
The exempting entity rules in Division 208 of the International Tax Assessment Act 1997 (“ITAA 1997”) apply to corporate tax entities that are, or have been, directly or indirectly owned at least 95% by “prescribed persons” (i.e. tax-exempt entity and non-residents), even where residents may ultimately own the corporate tax entity. Under these rules, “franked” distributions paid by an exempting entity or former exempting entity will generally be treated as an unfranked distribution in the hands of the recipient (with certain exceptions).
For non-residents shareholders, there is minimal practical impact of these rules as the distributions generally are still exempt from withholding tax, resulting in the same Australian tax position.
However, for resident shareholders, the tax impact can be significant as the benefit of the franking credits accrued by such a company are essentially lost. This is something resident shareholders need to be aware of, especially when acquiring an Australian company from non-residents.
For multinational businesses, the transfer pricing rules in Division 815 of the ITAA 1997 are another common international tax regime that is encountered.
These rules apply to cross-border related party transactions (whether in relation to sales, purchases, loans, service fees etc.) and aim to restrict attempts to shift profits of multinational businesses to low-tax jurisdictions through the use of non-arm’s length pricing.
Changes to these rules that began applying from the 2014 income have increased the importance of having supporting evidentiary documentation showing that rates and prices chosen are at arm’s length, as entities without such documentation are at risk of greater penalties should the Commissioner determine a transfer pricing benefit was obtained. Certain entities that satisfy specific eligibility criteria may be able to use simplified transfer pricing documentation, which can provide some relief from ATO reviews in relation to the covered transactions.
International Dealings Schedule
As many practitioners and taxpayers would be aware, the International Dealings Schedule (“IDS”) is an income tax return schedule that discloses information about related-party international dealings to the ATO.
Generally, the trigger point for needing to complete an IDS is whether or not the entity has international dealings with related parties worth more than AUD 2 million in total (i.e. across all related party dealings). Care needs to be taken when determining if this threshold is exceeded, as income and expenses need to be aggregated and not set-off. For example, a company with AUD1.1 million of related party income and AUD 1 million of related party expenditure will breach the AUD 2 million threshold and be required to lodge an IDS.
An IDS may also need to be completed if the thin capitalisation provisions (refer below) apply to the entity or if the entity has overseas operations.
The thin capitalisation provisions in Division 820 of the ITAA 1997 have been around for a number of years and have undergone a number of refinements.
In essence, these rules seek to limit the amount of debt used to fund the Australian operations of both foreign entities investing in Australia and Australian entities investing overseas. Where an entity’s debt-to-equity ratio exceeds certain limits, this will result in a portion of the entity’s debt deductions being disallowed.
While some taxpayers are excluded (for example, where the total debt deductions for the entity and its associate entities do not exceed $2 million), for affected taxpayers, the rules impose an additional yearly compliance burden that can have material tax implications if the ratios are not managed correctly.
Foreign limited liability partnerships and foreign hybrid companies that are taxed as partnerships in their relevant foreign jurisdictions and whose partners or shareholders have limited liability may be subject to the foreign hybrid rules in Division 830 of the ITAA 1997. Where the rules apply, such entities, which would generally be treated as companies and taxed accordingly for Australia taxation purposes, are instead treated as partnerships for Australian taxation purposes (that is, as a flow-through entity). Further, the rules limit the amount of losses which can be deducted by a partner or shareholder of the foreign hybrid against income from unrelated sources.
As a result of these rules, groups considering investing in limited liability partnerships, or certain foreign companies (such as a US limited liability company), need to consider whether such entities will be treated as companies for Australian tax purposes, or whether the foreign hybrid rules will shift the taxation obligation form the entity to the partners/shareholders.
Foreign Hybrid Mismatch Rules
The foreign hybrid mismatch rules in Division 832 of the ITAA 1997 are relatively new rules that seek to prevent multinational groups from obtaining ‘unfair’ competitive advantages through the exploitation of differences in the tax treatment of an entity or instrument under the laws of multiple jurisdictions.
One impact of these rules is that the knowledge taxpayers and their advisers need to have about the tax impact of an instrument or entity is no longer restricted to Australian domestic tax law – now, at least a rudimentary understanding of how the entity/instrument will be taxed in overseas jurisdictions is required.
While these rules may at first glance appear to be restricted to the bigger end of town, there is a “targeted integrity rule” that can apply to ordinary loans made to Australian entities from overseas parents via interposed foreign entities in low or no tax jurisdictions. Where this targeted integrity rule applies, this can result in the denial of deductions for interest payments to the interposed entity.
An understanding of these rules and how they may impact taxpayers is critical as there is no de minimis rule or materiality threshold and, more importantly, no “grandfathering” for instruments and entities that were in place prior to the start date of these rules.
Significant Global Entities
A significant global entity (“SGE”) is an entity that has annual global income of AUD 1 billion or more, or a member of a group of entities consolidated for accounting purposes where the global parent entity has annual global income of AUD 1 billion or more.
SGEs are subject to increased compliance and reporting in the form of Country-by-Country reporting (which can require the Australian entity to report information that it may not have or easily access), and the need to lodge General Purpose Financial Statements with the ATO (to the extent they are not already lodged with ASIC). Additionally, SGEs are subject to greater integrity measures in the form of the Multinational Anti-Avoidance Law and the Diverted Profits Tax. Administrative penalties have also increased: administrative statement penalties (e.g. for making a false or misleading statement) have doubled; failure to lodge penalties have been have been multiplied by five hundred (i.e. lodging a document five months late can now cost the taxpayer $525,000 per document).
While many small Australian subsidiaries may not expect these rules to apply to them due to their small size, where they are within a larger group internationally these measures can still apply to the Australian subsidiaries and impose significant and unexpected compliance and financial burdens.
As can be seen from the above, technological advances have allowed businesses both big and small to access a worldwide market. However, these advances have also resulted in these businesses being exposed to a suite of taxation regimes both domestically and internationally. Where previously such rules were thought only to apply to larger businesses, or multinational groups, increasingly smaller businesses need to understand these exposures, or they risk being subject to potentially excessively punitive, and potentially commercially unviable, penalties.
This article provides a general summary of the subject covered and cannot be relied upon in relation to any specific instance. Webb Martin Consulting Pty Ltd and any person connected with its production disclaim any liability in connection with any use. It is not intended to be, nor should it be relied upon as, a substitute for professional advice.