Executive summary

On 7 February 2018, the Australian Taxation Office (ATO) publicly released a draft practical compliance guide (PCG 2018/D2 or the Guide) relating to aspects of Australia's Diverted Profits Tax (DPT), for comments by 9 March 2018.

The Guide is important for multinational businesses as it is intended to:

• Assist taxpayer actions depending on how the ATO will perceive the DPT risk of the arrangement, including the ATO "products" available to potentially provide further certainty
• Outline likely ATO actions based on ATO assessment of DPT risk
• Explain the ATO approach to the DPT sufficient economic substance test (SES test), with 10 scenarios to illustrate SES higher risk and lower risk outcomes

PCG 2018/D2 follows confidential consultation (including EY) around an earlier version.

PCG 2018/D2 is not a complete guide to the DPT and compliance aspects. It is intended to complement:

• The ATO draft Law Companion Guide (LCG 2017/D7) to the DPT, which itself is open for comment by 16 February 2018, and
• The ATO Practice Statement (PSLA 2017/2) which outlines the internal ATO processes for proposing and raising DPT assessments.¹

The Guide also cross-references:

• Recent PCGs – PCG 2017/1 (dealing with procurement, marketing, sales and distribution hubs) and PCG 2017/4 (cross-border related party financing arrangements), and
• The work the ATO would expect from affected taxpayers and the ATO approach on DPT aspects of those PCGs.

In addition, the Guide cross-references ATO guidance on captive insurance companies, contained in Taxation Ruling TR 96/2.

Although further work is needed on PCG 2018/D2 and LCG 2017/D7, it is a positive development and will assist businesses to:

• Calibrate the risk of ATO DPT questions during ATO compliance activities
• Prepare for the approaches and issues the ATO will target
• Consider proactive approaches to the ATO DPT team if desired, to reduce later controversy risk

Detailed discussion

Overview

The Guide highlights:

• The ATO approach to the DPT is risk-driven, focusing on higher risk taxpayers
• DPT issues are integrated into ATO normal compliance processes and teams
• Where businesses have foreign related party debt and marketing hub situations which are classed as green zone under the two relevant PCGs, taxpayers should not expect that the ATO will engage with them in relation to the DPT
• Taxpayers may proactively engage with the ATO to seek entry to the Advance Pricing Agreement program (where possible), apply for private rulings, or contact the DPT specialist team
• The documentation which taxpayers with DPT risks will want to assemble for the DPT in general, for the Principal Purpose Test (PPT), the sufficient foreign tax test (SFT test) and the SES test

Transactions with high risk of ATO DPT interest

PCG 2018/D2 outlines some framing questions in assessing DPT risks for a taxpayer that is a significant global entity (SGE), exceeds the AU$25m Australian revenue threshold and has international related party dealings.

The questions identify transactions with higher potential risk of DPT risk. These are prior or future:

• Transactions which transfer offshore valuable intangible assets
• Transactions which transfer offshore functions and/or risks
• Significant transfers of value relative to overall profitability
• Characterization of payments as service fees rather than royalties
• Use of hybrid entities and/or instruments
• Back-to-back or flow-through arrangements
• Offshore profits disproportionate to staff headcount and/or capability
• Transactions with unusual features given the relevant business operations

The Guide then sets out framing questions for the SES test, including a significant focus on:

• Capacity of the foreign party to bear the functions, assets and risks as compared with the Australian party, with a strong emphasis on headcount of the foreign and Australian entities
• Whether reorganized structures have seen significant actual changes in the people, functions, assets and risks of the relevant entities

PCG 2018/D2 does not really allow taxpayers to precisely calibrate whether they are in the high risk or low risk category. It does not, for example:

• Use the many-colored risk matrix approach of the marketing hub and related party debt PCGs
• Discuss calculating whether foreign affiliates have satisfied the SFT test – as the law companion guide to the DPT outlines, the SFT will be difficult to satisfy in some common scenarios
• Discuss how to calculate tax benefits for DPT purposes

Documentation requirements are covered in some detail in the Guide. It outlines the documentation the ATO might look to for purposes of:

• The general application of the DPT
• The PPT
• The SFT test
• The SES test
• Intellectual property (IP) arrangements

It also cross-references to the PCGs for marketing hubs and related party financing arrangements.

Sufficient economic substance in foreign entity

PCG 2018/D2 outlines 10 scenarios to illustrate the SES test risk assessment:

• A lease in lease out arrangement with a foreign interposed head-lessor (high-risk and low risk variants)
• Intangibles migrated from an Australian subsidiary of a pharmaceuticals group (high-risk and low risk variants)
• Limited risk Australian distributors within a global group (high-risk and low risk variants)
• A foreign IP transfer with new IP created overseas while existing IP is wound down in Australia (high-risk and low risk variants)
• A marketing hub, which is only high risk
• A captive insurance arrangement (low risk variant only)

The scenarios do not analyze in detail all the issues relevant to DPT risk so the scenarios are useful directional indicators only.

The scenarios do highlight that taxpayers will need significant defense files and documentation packages to anticipate queries from the ATO.

The clear risk of parallel transfer pricing and DPT analysis

It is clear from PCG 2018/D2 and earlier discussions that the ATO will not delay or defer DPT analysis until after transfer pricing discussions and negotiations have broken down. This is despite statements in the explanatory materials to the DPT law that it was intended to give the ATO additional powers for non-cooperative taxpayers.

In our discussions with the ATO relating to the DPT application versus operating provisions, we put a proposition to the ATO that DPT would be most likely when information to apply the operative provisions is not available and/or the purpose test was unlikely to be complied with (as the scheme has artificial/non-commercial aspects). Although this proposition had some support, the ATO seemed to be uncomfortable with including any guidance that could potentially limit their ability to apply DPT concurrently with the operative provisions.

While DPT assessments will not be raised other than under the PSLA process, businesses will need to plan for ATO parallel consideration of DPT and transfer pricing risks.

Next steps

EY will be providing feedback to PCG 2018/D2 and LCG 2017/D7, including:

• The need for more clarity at a practical level when the ATO will move to a DPT review process rather than the operative transfer pricing and other provisions of the Tax Acts
• The need for more guidance on when an arrangement may give rise to a DPT tax benefit
• Enhancing the scenarios by broadening the analysis and how to mitigate risks
• Clarifying that the non-tax financial benefits of an arrangement (which are relevant to the PPT) must focus on non-tax financial benefits expected at the time of implementation of the arrangement

Taxpayer input is welcomed on the issues in assembling defense files and documentation for DPT purposes. We are very interested in some of the practical challenges being faced in assessing the risks which can be shared on a no names basis with the ATO in order to better inform their drafting of the PCG.

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ENDNOTE

¹ See EY Global Tax Alert, Australian Tax Office releases further guidance regarding Cross-Border Related Party Financing and the Diverted Profit Tax, dated 19 December 2017.

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CONTACTS

For additional information with respect to this Alert, please contact the following:

Ernst & Young (Australia), Sydney

• Sean Monahan
  sean.monahan@au.ey.com
• Anthony Seve
  anthony.seve@au.ey.com
• Paul Balkus
  paul.balkus@au.ey.com

Ernst & Young (Australia), Perth

• Andrew Nelson
  andrew.nelson@au.ey.com

Ernst & Young LLP, Australian Tax Desk, New York

• David Burns
  david.burns1@ey.com

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ATTACHMENT

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