Thursday, 15 September 2016

ATO identifies concerns with offshore PE and debt capital arrangements

The Australian Taxation Office (ATO) issued two “taxpayer alerts” on 10 August 2016 that summarize tax issues the ATO has under risk assessment. One of the alerts concerns arrangements where expenses are attributed to an offshore permanent establishment (PE) of a subsidiary of an Australian income tax-consolidated group that has entered into transactions with another member of the group. The other alert deals with funding arrangements where the ATO has concerns that some taxpayers are incorrectly adopting a treatment under the thin capitalization rules that leads to claims for higher debt deductions.

PE issues 

The arrangement identified by the ATO involves an amount being paid by one member of the tax-consolidated group to another member (e.g. for services, loans, intangibles, etc.). For Australian tax purposes, the transaction is effectively ignored under the “single entity rule” applicable to tax-consolidated groups. However, the expense is attributed to an offshore PE of the group, and therefore is deductible in the foreign jurisdiction in computing the profits attributable to that PE. Under the foreign branch exemption rule, the profits attributable to a foreign PE generally should be exempt in Australia. The result of the arrangement, if effective, is a deduction in the foreign jurisdiction and
no income recognition in Australia. The ATO has expressed a number of concerns, including the risk of over-allocation of profit to the foreign PE and that the Australian group is incorrectly claiming deductions in Australia for expenses that relate to the foreign PE. The ATO also noted that the general anti-avoidance rule may apply.

The ATO is further developing its technical position in response to the facts and circumstances of each particular arrangement and, in the meantime, is actively pursuing compliance activities and reviewing such arrangements.

Thin capitalization

The thin capitalization alert deals with financing arrangements involving an instrument that is a debt interest for tax purposes, but that is classified (wholly or in part) as equity for accounting purposes.
The thin capitalization rules provide a safe harbor that broadly requires a comparison between debt and assets. It, therefore, is necessary to calculate the amount of debt, as defined under the thin capitalization rules. The ATO is concerned that, in computing the debt amount for purposes of the thin capitalization rules, taxpayers are excluding amounts that are treated as equity for accounting purposes. As a result, the amount of debt for thin capitalization purposes is arguably understated.
The ATO view is that the entire financing amount should be taken into account, and it supports its position on a number of bases including, if required, a potential application of the general anti-avoidance rule. If the ATO view prevails, this could result in a disallowance of interest deductions, together with interest and penalties (up to 90% of the primary tax amount).

Source: Deloitte