Tax Insight: ATO’s Taxpayer Alert on Treaty Shopping

By Toby Eggleston, Hugh Paynter, Professor Graeme Cooper

The ATO has released a new Taxpayer Alert [TA 2022/2] on treaty shopping arrangements, in particular: “arrangements designed to obtain the benefit of a reduced withholding tax ... rate … in relation to royalty or [unfranked] dividend payments from Australia.”

Background

The document states it was issued because the ATO is, “currently reviewing international transactions for these types of arrangements and engaging with taxpayers and advisers in respect of existing and proposed arrangements as part of our engagement and assurance activities”. It goes on to state that the ATO is “concerned that some taxpayers have entered into, or are considering implementing, arrangements interposing entities in treaty jurisdictions to obtain a more favourable tax outcome under a DTA in the form of reduced WHT rates.”

Treaty shopping might seem like “old news” – in a 2010 Tax Determination, the ATO had set out its view that Part IVA applies to treaty shopping, and in 2020, the ATO issued a Practice Statement on how it proposes to administer the Principal Purpose Test inserted into many of Australia’s treaties. But, as well as being a reminder of those views, the new document draws attention to the ATO’s increased powers to challenge arrangements it considers abusive. It takes a more expansive view of the circumstances which the ATO will query, and it gives some interesting insights into the factors the ATO considers might indicate abuse.

Treaty shopping

Because “treaty shopping” is a nebulous term, there is no agreement on the boundary between abusive and permitted structures. That problem is made more difficult because the rules in question do not, for the most part, focus on structures as such; rather, they focus on why a structure was put in place (for example, through an objective test assessed on evidence).  As with all ‘purpose’ tests, the outcome of disputes will turn on on the extent and quality of evidence that a taxpayer can adduce.

The Taxpayer Alert starts with the most obvious scenario: a single entity (resident in a jurisdiction with which Australia has a treaty) is newly incorporated and “interposed” between an Australian resident and the ultimate beneficial owner (resident in a jurisdiction with which Australia has no treaty, or the treaty allows Australia to insist upon a higher withholding tax rate). This entity may do nothing more than collect royalties or dividends, and then on-pay a similar amount, and in the same form.

The Alert then expands this example: the ATO will also query:

• a structure which involves a chain of related entities (not just a stand-alone entity);
• a structure which involves income flows through several countries (not just a single country);
• the use of existing entities (not just newly incorporated entities); and
• arrangements which create new cash flows ab initio and arrangements which re-route existing cash flows.

One surprising part of the Taxpayer Alert is the suggestion that the ATO will also challenge situations where “the interposed entity may have significant existing operations and employees …”

The Taxpayer Alert therefore identifies two fact patterns on a spectrum – one where an entity has no prior operations to speak of, and another where an entity has substantial operations.

This is surprising for two reasons:

• first, significant existing operations and a sizeable workforce are features that are likely to be necessary to obtain residency status in the relevant treaty country and unlikely to have arisen as a vehicle for treaty shopping; and
• second, it is difficult to understand how the ATO might successfully challenge situations where the substance of an interposed entity is aligned with its form (that is, where the interposed entity has the capacity to administer necessary functions in connection with the IP and as a question of fact, does so).

An obvious implication of the Taxpayer Alert is that the ATO is now concerned about taxpayers using ‘real’ companies with ‘real’ operations to mask cash flows which, had they been passed through a “letterbox company”, would more clearly be amenable to attack.

The Alert contains two examples of arrangements the ATO may challenge. The Alert identifies a list of indicia that the ATO considers might suggest ‘treaty shopping’:

• terminating an existing licensing arrangement and replacing it with an arrangement with similar terms but between different parties resident in different countries;
• the intermediate entities’ main activities are the receipt and on-payment of royalties;
• amounts received by an intermediate entity are not invested in the intermediary’s own commercial operations – they are either on-paid or kept in passive investments;
• the operations of the intermediary are controlled by directors who are not resident in that country; and
• several of the companies share common directors.

The range of ATO powers

The Taxpayer Alert draws attention to the large arsenal of powers available to the ATO:

• the anti-abuse rule already expressed in the dividend, interest and royalties articles in several of Australia’s treaties;
• the Principal Purpose Test inserted into Australia’s “covered treaties” by the Multilateral Instrument;
• the transfer pricing rules;
• Part IVA;
• the Diverted Profits Tax; and
• the debt-equity rules (presumably in the context of internal re-organisations).

While the ATO might want to deploy all these provisions, the rules are not fungible and there are critical differences between them. Most of those provisions will require the preparation of evidence to demonstrate the factors that motivated taxpayers (either in a subjective or objective way) to enter into the arrangements. That said, some of the provisions turn on a finding of “purpose”, others do not; some look for the taxpayer’s actual purpose, while others infer purpose from particular facts; some will be switched off if there is real activity in an intermediate entity or country; and so on.

The takeaway

The Taxpayer Alert says outbound royalty and unfranked dividend flows “will be subject to increased scrutiny” and it hints strongly that the ATO is more than a little sceptical of some of the justifications it has heard so far:

• the intermediate country provides “a superior business environment … for conducting its licensing operations”; and
• the intermediate entity “creates operational synergies” between entities in the group.

The key takeaway from the Taxpayer Alert is that the ATO wants to see more than overarching ‘motherhood-type’ statements or assertions. The ATO appears to require “contemporaneous evidence in relation to the relevant facts and circumstances of such arrangements to test the veracity of the commercial benefits that are asserted by taxpayers and/or their advisers” and, in the absence of contemporaneous evidence, the ATO is probably going to infer that “accessing the reduced WHT rates was one of the principal or main reasons for interposing [entities].”

In our experience, it is common for taxpayers to have arrangements that meet the indicia that the ATO considers might suggest ‘treaty shopping’, but also with valid commercial reasons. In view of the ATO’s Taxpayer Alert, it will now be necessary for taxpayers to prepare for ATO reviews of their arrangements. This will include a methodical articulation of the commercial reasons and background for their royalty (and other) arrangements, ideally based on contemporaneous documentation.

Final note: The new Government’s proposal for denying deductions on royalty payments to low tax jurisdictions.

Last week the Parliamentary Budget Office released its costing on each parties’ election commitments. The measures costed by the PBO included a proposal to deny tax deductions for the use of intellectual property when royalty payments are made to either:

• a jurisdiction subject to the ‘sufficient foreign tax test’, as outlined in Section 177L of the Income Tax Assessment Act 1936. Given the company tax rate of 30% for significant global entities, countries where the corporate tax rate is below 24% would be considered to not pass the ‘sufficient foreign tax test’. This test is not simply based on headline rates and a company resident in a ‘high tax’ country can fail this test due to losses or other tax credits; or
• a jurisdiction that houses intellectual property in a tax preferential patent box regime. The following countries were identified as having an intellectual property tax-preferential regime: Belgium, Cyprus, France, Hungary, India, Ireland, Israel, Italy, Luxembourg, Malta, Netherlands, Portugal, Singapore, the Slovak Republic, Slovenia, Spain, Switzerland, Turkey, and the United Kingdom.

For this purpose, royalties categorised by the ATO as ‘copyright, patent, design or model, plan, secret formula or process, trademark, or other’ are in scope of the proposal.

When originally announced prior to the Federal election, the ALP’s Plan to Ensure Multinationals Pay Their Fair Share of Tax suggests that the policy is directed towards “[l]imiting the ability for multinationals to abuse Australia's tax treaties when holding intellectual property in tax havens” whereas the PBO costings appears to include jurisdictions that house IP in a “tax preferential patent box regime” and therefore countries that are not traditionally considered to be tax havens (such as the UK).

The costings indicate the proposal is intended to apply from 1 July 2023.

We will provide a further update when the legislation is introduced. However, it would seem likely that, in view of the above:

• the former Government’s patent box regime won’t become law anytime soon; and
• the recipient countries affected (particularly our major trading partners and economic partners, such as the UK and India) will most likely put pressure on the Government not to enact this proposal.