Background
The Australian Tax Office (ATO) has released a draft Practical Compliance Guideline, PCG 2023/D2, (PCG), outlining its draft compliance approach to mischaracterisation and migration issues for intangible assets by international related parties. It replaces the previously published and finalised draft PCG 2021/D4, which has been re-released as draft PCG 2023/D2 after almost two years of internal ATO deliberations.
The new draft PCG focuses on the following cross-border arrangements:
- Arrangements involving migration of intangibles – Restructures relating to the intangible assets of multinationals that result in, for example, an offshore related party accessing, using, holding or benefiting from the intangible assets.
- Arrangements involving mischaracterisation of Australian activities – This is where certain activities which involve the development, enhancement, protection and exploitation (DEMPE) of intangible assets may be mischaracterised to derive tax advantages.
Collectively, the above arrangements are referred to in the PCG as Intangible Arrangements.
Key takeaways
- In contrast to PCG 2021/D4, the PCG has an increased focus on how multinationals can practically assess risk, with a two-tier assessment regime (focusing alternatively on migration and mischaracterisation arrangements) and, like many PCGs, a points system for rating risk, with a focus on the substance of the arrangement and related tax outcomes.
- Similarly to PCG 2021/D4, the PCG imposes substantial evidentiary and documentary requirements on taxpayers.
- The PCG is intended to stand alongside the compliance approach for other tax issues in connection with Intangible Arrangements, including TA 2018/2 (Mischaracterisation of activities or payments in connection with intangible assets) and TA 2022/2 (Treaty shopping arrangements to obtain reduced withholding tax rates)).
- Intangible Arrangements which exhibit features or have similar effects to arrangements described in TA 2020/1 (Non-arm’s length arrangements and schemes connected with the DEMPE of intangible assets) are automatically given a rating of high risk.
Overview
At its core, the PCG sets out a two-part risk assessment framework in the form of two risk assessment tables. Taxpayers are directed to one table or the other depending on whether the DEMPE activities relating to the relevant intangible asset are accompanied by a corresponding migration of intangible assets. Taxpayers can calculate a risk score which categorises their Intangible Arrangement as high, medium or low risk according to the ATO.
The new draft PCG also provides examples of arrangements in each risk category – many of these examples are the same as PCG 2021/D4, however there are some new arrangements included in the new draft PCG. An appendix details the documentation and evidentiary expectations of the ATO.
What has changed since PCG 2021/D4?
Scope of the PCG
The focus of PCG 2021/D4 extended beyond the risk assessment of Intangible Arrangements in a transfer pricing context, and instead expressly applied to a broad range of tax risks associated with Intangible Arrangements, including withholding tax, CGT, capital allowances, general anti-avoidance rules and diverted profits tax.
The new draft PCG states that the focus of the PCG is the ATO’s compliance approach regarding migration and mischaracterisation issues primarily in situations where the ATO is applying resources to GAAR (including diverted profits tax) or transfer pricing. It explicitly states that the PCG does not affect the ATO’s compliance approach to other tax issues that might arise in connection with Intangible Arrangements. However, this apparent limitation of scope is offset by the ATO’s remarks that it will likely prioritise resources to assess tax compliance risks generally in circumstances where an Intangibles Arrangement is considered high risk.
The new draft PCG also notes, for the avoidance of doubt, that the compliance approach outlined does not cover the proposed anti-avoidance rule regarding denying deductions for payments relating to intangible assets connected with low corporate tax jurisdictions. See KWM alert here: https://www.kwm.com/au/en/insights/latest-thinking/denying-deductions-for-payments-relating-to-intangible-assets-connected-with-low-tax-jurisdictions.html
Risk assessment framework
The risk assessment framework in PCG 2021/D4 utilised a holistic approach through consideration of risk factors categorised by the ATO as high, medium or low risk. The new risk assessment framework provides a clearer approach to the ATO’s risk assessment by:
- using a quantitative method of calculating risk through the point system; and
- categorising risk factors by assessing the substance of the relevant entity involved in the arrangement and tax outcomes.
To support implementation of the new risk assessment framework, specific risk scores using the new point system are included in each of the examples.
Documentation and evidence requirements have been removed as a consideration in the risk assessment. The focus is now solely on risk factors. Previous references to the documentation and evidence requirements are also removed from the risk factors in the risk assessment tables. However, the guidance on documentation and evidence requirements has not been excluded from the new draft PCG but merely restructured into Appendix 2. Practically though, we do not expect there will be any material change in the ATO’s expectations for documentation and evidence when conducting risk assessments.
Revised examples
The PCG contains two new examples of arrangements considered high risk:
- Example 5: Migration of pre-commercialised intangible assets – The example involves a newly founded Australian company transferring legal ownership of an intangible asset it develops to a foreign company for further commercialisation offshore. This example appears to capture Australian start-ups expanding overseas to commercialise their products.
- Example 6: Transfer of intangible assets to a foreign hybrid entity – The example involves an Australian company incorporating a wholly-owned Australian company, which itself also incorporates a wholly-owned foreign company. The foreign company is a “foreign hybrid company” and treated as a partnership for Australian tax purposes, meaning it is an eligible member of an Australian tax consolidated group. The entities consolidate for tax purposes, and intangible assets are transferred to the foreign entity which receives incomes from exploitation. There is no Australian CGT paid on the transfer of the asset to the foreign company. The foreign company is treated as a foreign branch for Australian taxation purposes.
Further:
- the PCG contains one new low risk example (Example 13 in the draft PCG) – service arrangement involving intangible assets - this example relates to an Australian entity that owns the relevant intangible assets and performs key DEMPE functions, but outsources support activities to offshore related parties, remunerated under adequately documented, arm’s length cost-based arrangements; and
- the PCG has removed the previous high-risk example in PCG 2021/D4 concerning non-arm’s length licence arrangements.
Further comments
- The new draft PCG marks the ATO’s latest piece of guidance in the intangibles space, indicating the regulator’s increasingly proactive focus on cross-border arrangements involving intangibles. It will sit alongside other ATO materials including Draft Taxation Ruling TR 2021/D4 relating to royalties and the character of receipts in respect of software and Taxpayer Alert TA 2018/2 relating to the mischaracterisation of activities or payments in connection with intangible assets. The ATO’s increasing focus on intangibles, and in particular the concept of “embedded royalties”, has caused concern internationally, including on the basis that the stance may not align with internationally recognised OECD principles. However, the draft PCG appears to make it clear that the ATO will continue to pursue intangible arrangements for the foreseeable future.
- The draft PCG also follows hot on the heels of Treasury’s release of an exposure draft of the Treasury Laws Amendment (Measures for Consultation) Bill 2023: Deductions for payments relating to intangible assets connected with low corporate tax jurisdictions, which proposes to introduce an anti-avoidance provision designed to deter significant global entities from structuring their arrangements so that income from exploiting intangible assets is derived by an associate in a low or no corporate tax rate jurisdiction, while tax deductions for payments attributable to intangible assets made by the SGE to an associate are claimed in Australia.
- The documentation and evidentiary requirements outlined in the draft PCG are burdensome. While it does contain a comment that the ATO does not intend to unnecessarily impose burdensome evidentiary requirements, taxpayers should carefully consider what documentation should be prepared when they are entering into new Intangible Arrangements, and whether the documentation for existing arrangements is sufficient.
- Previously, PCG 2021/D4 outlined broad expectations for documentation and evidence maintained by the taxpayer to undertake the risk assessment. In substance, the new Guideline appears to replicate the requirements in PCG 2021/D4, the only change being that they are now located in a new Part 3 and a new Appendix 2. It is possible that the separation of documentation and evidence requirements from the risk assessment process goes some way to alleviate the burden, but practically, one would expect the ATO to require as much documentation and evidence in support of a business’s position.
- Like PCG 2021/D4, the new draft PCG is to have retrospective effect and no transitionary period is included. This means taxpayers will need to consider implementing administrative arrangements consistent with the PCG as a matter of priority.
