Tax Insight - New Limits on Deducting Payments Involving Intangibles

Treasury has released for consultation an Exposure Draft of new provisions which will, in some cases, deny large Australian businesses a deduction for amounts connected with intangibles if paid to associates. If enacted in their current form, the new rules would apply from 1 July 2023. Submissions on the Exposure Draft are due by 28 April 2023.

1. Background

One of the tax policies which the ALP announced in its unsuccessful campaign for the 2019 election was a proposal to, “stop multinationals from getting a tax deduction when they unfairly funnel royalty payments to arms of their own company that pose a multinational tax risk.” The announcement listed the sources of “tax risk” as treaty shopping, funnelling income into tax havens, holding patents in countries with patent box regimes and negotiating “a sweetheart deal” with another country.

In April 2022, in the campaign for the 2022 election, the ALP announced a similar proposal to limit, “the ability for multinationals to abuse Australia’s tax treaties when holding intellectual property in tax havens.”

In August 2022, Treasury released a Discussion Paper outlining the design of, “a new rule limiting MNEs’ ability to claim tax deductions for payments relating to intangibles and royalties that lead to insufficient tax paid.” (This Paper is examined in more detail in our Tax Insight available here.)

Treasury has now released an Exposure Draft of provisions to give effect to the policy. The detail has evolved significantly in the last 4 years. The Exposure Draft is available here.

2. Key Elements

The new rule will deny a deduction to an Australian entity for a payment (or crediting an amount or incurring a liability to make a payment) where 5 key conditions are met:

1. the payer is a significant global entity;
2. it is making the payment to an associate, whether directly or indirectly;
3. the payment is, “attributable to a right to exploit an intangible asset”;
4. as a result of some arrangement, income from the exploitation of an intangible is derived by the recipient or another associate; and
5. that income is derived in a low corporate tax jurisdiction.

3. Some of the pitfalls

At first glance, the intended scope of the section seems easy grasp, but the apparent simplicity of the drafting hides many traps. Most of the complexity arises from:

• asserting that a transaction can be re-characterised to reveal a payment for a right to use an intangible; and
• asserting that the Australian taxpayer is to be denied a deduction because another transaction, to which the taxpayer is not a party, occurs between other entities in the same corporate group, which shifts income into a low tax jurisdiction.

Royalties versus deductible “payments”

While the focus of the 2019 announcement was on limiting the deductibility of “royalty payments” made by MNEs, by 2022, Treasury’s Discussion Paper revealed the policy had expanded to include payments which were not technically “royalties” and did not trigger royalty withholding tax. The Paper gave as examples, payments for goods, payments for services or payment of management fees.

The Exposure Draft adopts this broader scope. The Explanatory Memorandum says the drafting is meant to extend to, “a payment … made for other things, such as services or tangible goods …” Hence, an Australian SGE may find deductions are being denied for the cost of trading stock or management fees or payments for services.

However, it seems the drafting is not enlivened for payments which are not deductible, but rather form part of the cost of depreciating assets or the cost base of CGT assets.

Embedded royalties: payments “attributable to” a right to exploit an intangible asset

In order for a deductible payment to be in jeopardy, it is necessary that “the [deductible] payment is attributable to a right to exploit an intangible asset …”

Obvious examples would include payments for the right to use a copyright, patent or registered design in the Australian entity’s operations, payments for the right to display trademarks and logos in marketing activities, payments for rights to broadcast radio and TV content, and so on. The drafting extends the definition to include payment for rights to exploit things which aren’t property at law, such as gaining access to confidential information. The phrase “attributable to” is probably meant to capture payments for supporting services in connection with the licensing of IP or revealing information. In all these cases, the Australian entity acquires rights in connection with an intangible which is owned (and remains owned) by another. The Explanatory Memorandum says the word “exploit” is meant to be broader than “use,” but the essence of the test still requires that the Australian entity gets a limited right to exploit something owned by another.

Which is why the attempt to capture embedded royalties is so fraught. In what circumstances can a payment for trading stock or management services be re-labelled as “attributable to” a right to exploit an intangible? The Explanatory Memorandum offers no explicit guidance about how and when a payment is “attributable to” a right to exploit an intangible. The example in the Explanatory Memorandum involves a taxpayer who distributes products under a distribution agreement. It pays for management and other services it acquires under the agreement; it is allowed (at no cost) to display logos etc when marketing the goods. The Example asserts, without explanation, that a portion of the management fee paid to the other party is attributable to exploiting the IP. The Example is equally reticent about how to quantify the non-deductible portion of the payment saying simply that, “to the extent that the payment of these fees is attributable to the right to exploit the trademark …” it will be non-deductible.

The new rule does not apply to payments connected to every kind of intangible. Rather it is focused on payments for an intangible right over another intangible asset. Hence, the new rule does not apply if the payment is made for a right to use or exploit:

• a tangible asset (eg, rentals under an equipment lease); or
• land (eg, payments of rent, or fees for a licence over land).

And the new rule does not apply to rights over every kind of intangible asset: a right to exploit a financial arrangement affected by the TOFA rules is excluded (eg, interest, dividends, gains or losses in relation to some debt or equity interests).

And, one would have thought, the rule should not extend to payments to buy rather than exploit – whether to buy goods, or land or an intangible – though the drafting says it will be a payment to “exploit” an intangible if the payment is being made to allow the entity to sell or license the intangible. So, it is hard to see how a payment to buy branded goods could involve a disguised payment to exploit the brand. TA 2018/2 Mischaracterisation of activities or payments in connection with intangible assets, which foreshadowed these rules, says it does not apply to, “resellers of finished tangible goods where the activity of reselling the goods involves an incidental use of a brand name that appears on the goods and related packaging.” One would hope the final legislation will include a similar limitation in these rules.

But this issue of embedded royalties is clearly a major concern to the ATO which is trying to challenge them under current law. It is understood the ATO is arguing, in its case against Pepsi, that the transactions involved there were amenable to challenge under the diverted profits tax. And the issue was the major focus of TA 2018/2 Mischaracterisation of activities or payments in connection with intangible assets. The TA says the transactions outlined in the TA may contain a “royalty” liable to withholding tax, may trigger transfer pricing rules or might trigger Part IVA. The new provision will add another option to the list.

Payments pursuant to “arrangements”, involving multiple entities

In order for a deductible payment to be in jeopardy, it is necessary that:

• “the [deductible] payment is attributable to a right to exploit an intangible asset …”; and
• the taxpayer or an associate acquires the intangible asset, or a right to exploit the intangible asset or actually exploits the intangible asset; and
• that acquisition happens under
  • the arrangement between the taxpayer and its associate which conferred the right to exploit the intangible asset, or
  • a related arrangement (the parties to which are not itemised).

So the drafting contemplates at least one, and possibly several arrangements:

• the plain vanilla case is: the taxpayer pays a royalty to an associate in a tax haven for a right to exploit an intangible asset and it gets the right it bargained for;
• the drafting easily captures back-to-back arrangements: the taxpayer pays a royalty to an associate not in a tax haven for a right to exploit an intangible asset, and associate pays another fee to an associate which is in a tax haven for the rights which it has licensed to the Australian entity. The legislation expressly refers to the Australian entity making the payment “to the recipient directly or through one or more other entities”;
• a more complex case is: the taxpayer pays a royalty to an associate not in a tax haven for a right to exploit an intangible asset; another associate of the taxpayer which is in a tax haven owns or licenses the same or related intangible under an agreement and derives income from another associated entity. The only requirement for this scenario is that (i) the arrangement between the Australian payer and the recipient and (ii) the arrangement between the other entities are somehow “related.”

Low corporate tax jurisdiction

The final requirement for triggering the rule is that, as a result of the agreement, the recipient or some other associate derives income in a low corporate tax jurisdiction.

A “low corporate tax jurisdiction” is defined to mean:

• a foreign country where the rate of corporate income tax is less than 15% or is nil; or
• a foreign country which the Minister has determined offers a preferential patent box regime which does not require sufficient economic substance (a test taken from the OECD’s Final Report on BEPS Action 5).

The drafting does not appear to capture a country which simply does not have a corporate tax.

The 2019 announcement said the new regime would use the “sufficient foreign tax test” from the Diverted Profits Tax, but the test finally settled upon in the Exposure Draft is far more manageable:

• the test focuses on the headline rate for the corporate tax of the country;
• if the country applies progressive rates to companies, the relevant rate is the highest headline rate;
• if the country applies different rates to residents and non-residents, ignore a rate which applies only to non-residents.

The drafting refers to “the rate of corporate income tax under the laws of [a] foreign country …” which means the test looks at the rate for the country, not the rate of tax being paid by a particular taxpayer (eg, does the taxpayer have losses or tax credits), nor the rate of tax imposed on a particular class of income (eg, is this kind of income exempt). However, the drafting does become more granular:

• the impact of deductions, losses and tax credits are excluded;
• if the income is exempt from tax, we are told the rate of tax on that amount is nil.

In theory, both of these matters should be irrelevant to identifying “the rate of corporate income tax under the laws of [a] foreign country …” but their presence confuses the matter, and indicates the headline rate may not be the end of the story.

Purpose of avoiding tax?

The 2019 announcement was clear that this rule would only be triggered if the taxpayer had a purpose of avoiding Australian tax: “a multinational can still get the tax deduction if the firm can substantiate to the Commissioner of Taxation that the royalty payments are not for the dominant purpose of tax avoidance.”

This test has now been abandoned in favour of a “results” test: it will be sufficient if, “the entering into of the arrangement … results in the recipient or another associate of yours deriving income” in a low corporate tax jurisdiction. So, the focus is now simply on what happened, not why it happened.

The Explanatory Memorandum says, “it is not intended for this anti-avoidance rule to inappropriately apply … where there is no tax avoidance behaviour” but the drafting contains no test of “purpose” or “intention” which might limit the inappropriate operation of the section.

This will be left to the ATO to administer, but how this issue is to be dealt with in practice is left unresolved.

4. Royalty Withholding Tax?

It is worth noting that nothing in the Exposure Draft deals with the interaction between this measure and the tax on payments which are royalties and subject to royalty withholding tax. It is conceivable that both measures will operate. In the case of a royalty paid to a non-treaty country, this might lead to an effective rate of 60%: 30% imposed on the recipient (and collected from the payer) and 30% imposed on the payer through the denied deduction.

The media releases accompanying the Exposure Draft have referred to “levelling the playing field for Australian businesses”. However, by both imposing royalty withholding tax and denying a deduction for the payer it is clear that these measures will tilt the field in favour of Australian enterprises. Whether this level of support is acceptable to our trading partners will be a watching brief. The US Treasury has already indicated its displeasure with the ATO’s expanded view of royalties as expressed in TR 2021/D4.

One would have expected the measure would not apply where the Australian payer has complied with Australian royalty withholding tax rules (including having regard to applicable tax treaties) but that suggestion has not been taken up in the current drafting.

5. Interaction with Pillar 2

Finally, there is no mention of the interaction of this measure with the OECD’s Pillar 2 project of a global minimum tax of 15%. If Pillar 2 is widely adopted (and the income inclusion rule is proposed to start for income years after 1 January 2024), then whatever justification for this measure will fall away given the income for exploiting intangibles will be picked up and taxed at a minimum of 15%.

6. Dates

The new rule will apply to payments made (or liabilities incurred) from 1 July 2023.

Submissions on the Exposure Draft are due by 28 April 2023.