Australia’s diverted profits tax
The centralization of intellectual property (such as patents, licenses and trademarks) and functions (such as procurement, marketing, manufacturing and distribution) into regional or global hubs is one of the main drivers of efficiency and risk management for life sciences multinational enterprises (MNEs).
Such centralization can also give rise to questions of whether the tax outcome of such an arrangement reflects the economic substance of the arrangement and whether the legal form of the arrangement is used to inappropriately divert profits from a higher tax jurisdiction.
In light of these concerns, Australia has recently announced its intent to introduce the Diverted Profits Tax (DPT) regime to facilitate increased scrutiny, more efficient dispute resolution and a tighter focus on economic substance over legal form in relation to MNEs with Australian operations. The DPT broadly aims to achieve these objectives by:
- Further strengthening Australia’s anti-avoidance provisions
- Imposing tax at a higher rate than the corporate income tax rate where it applies
- Applying where the profits recognized by each entity in the supply chain are not reflective of the economic substance of the arrangement
- Compressing the fact-gathering stage in a DPT tax dispute to 12 months
- Imposing evidentiary restrictions on any information or documents not volunteered to the Australian Taxation Office (ATO) within the 12-month fact-gathering period
With the increased focus by the ATO on transactions within the life sciences sector, it is important to consider how to manage the technical and procedural issues arising from the DPT.
Broadly stated, the DPT will apply where an MNE enters into a scheme involving a low tax jurisdiction for a principal purpose of obtaining a tax benefit and achieves this outcome. There must also be a mismatch between the outcome of the scheme and the economic substance of the scheme. The following requirements must be met for the DPT to apply:
- The MNE has a global turnover equal to or greater than AU$1 billion and Australian turnover of greater than AU$25 million.
- There is a scheme involving foreign associated entities located in jurisdictions with a corporate tax rate less than 24%.
- The Australian entity in the MNE receives a tax benefit in connection with the scheme.
- The principal purpose of the MNE in entering into the scheme was to obtain a tax benefit.
- The result of the scheme does not reflect the economic substance of the scheme’s participants.
The DPT has a similar operation to the second limb of the UK’s DPT regime in that both sets of rules target arrangements with related foreign entities in low-tax jurisdictions where there is insufficient economic substance.
The ATO has seven years after an income tax assessment is issued to apply the DPT to that income year. The DPT will override the operation of Australia’s double tax agreements to the extent that it applies to the MNE’s circumstances, and Mutual Agreement Procedures under the relevant double tax agreement will not be available to provide relief to tax imposed under the DPT.
If the DPT applies to an MNE, the Commissioner may impose a penalty tax at 40% of profits diverted from Australia. Challenging the application of the DPT is complicated by administrative and procedural rules that have the effect of requiring payment of the DPT liability up front and imposes a period of 12 months in which no appeal can be lodged to challenge the application of the DPT.
During this 12-month period, the MNE will be required to provide information on its position to the ATO, and any information not provided will be inadmissible in an appeal. The bar on admissibility applies regardless of whether the ATO had requested the information. Specifically:
- From the time the ATO informs the MNE of its intention to apply the DPT, the MNE has 60 days to make submissions before the final DPT assessment is issued.
- Payment of the DPT amount is due within 21 days of the ATO issuing a DPT assessment.
- There is a 12-month review period in which an MNE may provide the ATO with further information.
- During the review period, the MNE cannot appeal the DPT assessment to obtain a refund of the DPT amount paid. After the review period, the MNE can only appeal to the Federal Court and has a shortened window in which to file an appeal.
- Any evidence not provided to the ATO in the 12-month period is inadmissible in court proceedings to challenge the DPT assessment.
Considerations for the life sciences sector
Life sciences MNEs typically have a number of cascading license and service agreements throughout various jurisdictions, with the effect of centralizing the ownership of intellectual property (IP) in one or more jurisdictions from which the development, enhancement, maintenance, protection and exploitation (DEMPE) of those IP rights are managed.
For the purpose of the DPT, life sciences MNEs will need to consider the profits generated at each stage of their supply chain and consider whether that reflects the economic substance of the arrangement as a whole. Further evidence will also need to be gathered on which reasonable hypothetical counterfactual may apply and whether the principal purpose of the arrangement was to obtain that tax benefit, or to obtain a tax benefit and a reduction in a foreign tax liability.
Challenging a DPT assessment
The ATO has been aggressively investigating and challenging MNEs on their tax affairs in Australia. Armed with an increased budget and a government mandate to crack down on perceived multinational tax avoidance, the ATO will likely not shy away from prosecuting DPT matters, albeit we anticipate that triggering the DPT will be reserved for more extreme cases.
The pharmaceutical industry has been a particular focus of the ATO, with significantly increased audit activity in the sector. MNEs in the pharmaceutical sector should expect ATO inquiries in this regard once the DPT legislation is passed by the government.
Before challenging a DPT assessment, taxpayers will need to consider:
- Cash flow considerations in relation to paying the DPT amount up front
- Legal form vs. economic substance on a whole-of-supply-chain basis
- Whether the hub entity can operationally manage the totality of commercial risks faced in the business
- Which evidence to provide the ATO during the review period in order to preserve admissibility on appeal
- The short time frame for gathering the necessary evidence and seeking legal advice
- The cost/benefit of settling on a transfer pricing basis or obtaining an advance pricing agreement vs. the risk of paying tax at 40%
- Potential reputational risk arising from tax avoidance litigation
Download the full article, Australia’s diverted profits tax and the life sciences industry from our report EY Life Sciences Report: Asia.