Key Income Tax Developments In Australia - November & December 2018.

Legal News & Analysis - Asia Pacific - Australia - Tax

8 January, 2019

 

This Bulletin outlines the key Australian income tax developments in the last month affecting your business, including the release of an ATO discussion paper in relation to earnout arrangements.

 

Top 5 developments in tax this month you need to know

 

RELEVANT AREA AT A GLANCE
Draft ATO transfer pricing guidance in relation to inbound distribution arrangements (PCG 2018/D8)

The ATO has released a draft Practical Compliance Guideline PCG 2018/D8 which outlines the ATO's approach to assessing the transfer pricing risk of various types of inbound distributors.  

Based on the profit markers set out in PCG 2018/D8, inbound distributors can assess their transfer pricing risk as low, medium or high. If an inbound distributor is assessed as having a low transfer pricing risk, the ATO will generally not apply compliance resources to review the transfer pricing outcomes of the inbound distributor.

MIT withholding — information exchange countries updated

The list of  countries whose tax residents can access a 15% withholding tax rate on most "fund payments" from managed investment trusts (MITs) has been updated.

A fund payment, which represents a distribution of Australian source net income of a MIT (excluding certain amounts including dividends, interest and royalties) is generally subject to withholding at 30% unless made to a tax resident of an "information exchange country".

With effect from 1 January 2019, the list of information exchange countries will include an additional 54 countries including Switzerland, Israel, Philippines, Chile, Philippines, Bulgaria, Turkey and Vanuatu.

Arrangements that mischaracterise intangibles (TA 2018/2) The ATO has issued Taxpayer Alert TA 2018/2 in relation to the mischaracterisation of activities or payments in connection with intangible assets. According to the Alert, the ATO is currently reviewing international arrangements that mischaracterise intangible assets and/or activities or conditions connected with intangible assets. The ATO's concerns include whether intangible assets have been appropriately recognised for Australian tax purposes and whether Australian royalty withholding tax obligations have been met. 
Exposure draft legislation to amend the PRRT

The Government has released exposure draft legislation to implement its response to the Petroleum Resource Rent Tax (PRRT) Review, which include:

  • lower up-lift rates for certain categories of carried-forward expenditure (eg, the general expenditure uplift rate for new projects will be the Government long-term bond rate (LTBR) + 5% for 10 years after the project first earns assessable petroleum receipts and then the uplift rate will be the LTBR); and
  • removing onshore petroleum projects from the scope of the PRRT from 1 July 2019 (onshore projects generally do not result in any PRRT payable and may be used to transfer exploration expenditure to more profitable offshore projects).

Comments on the exposure draft can be made until 15 January 2019.

Federal Court decision on the foreign income tax offset (FITO)

In Burton v FCT [2018] FCA 1857, Mr Burton was an Australian resident who had made capital gains through a discretionary trust from the sale of certain investments in US oil and gas wells. He was assessed on the gains in Australia with the benefit of the 50% CGT discount and in the US. Mr Burton claimed the "foreign income tax offset" (FITO) on all the tax paid in the US on the basis that all the gains formed part of the calculation of his assessable income and were therefore "amount[s] included in [his] assessable income" for purposes of the FITO rules. McKerracher J dismissed the appeal, deciding that the relevant section in the FITO rules refers to an amount that is itself assessable income rather than an amount that merely forms part of the calculation of assessable income.

Mr Burton has appealed to the Full Federal Court.

 

Spotlight on ATO discussion paper in relation to earnout arrangements

 

What you need to know

 

The ATO has issued a discussion paper in relation to the income tax treatment of earnout arrangements that do not qualify for look-through treatment.

 

This follows an announcement by the Board of Taxation that it has recently completed a post-implementation review of contingent consideration (including earnouts).

 

The purpose of the ATO discussion paper is to seek feedback on the need and priority for additional public advice and guidance on the tax treatment of earnouts that do not quality for look-through treatment.

 

However, the discussion paper also indicates a willingness to review views expressed in existing ATO guidance to identify areas which should be clarified or changed.

 

The ATO has released a discussion paper in relation to earnout arrangements that do not qualify for "look-through" treatment under Subdivision 118-I of the Income Tax Assessment Act 1997 (ITAA 1997).

 

Current treatment of earnouts

 

Earnouts are contractual provisions included in sale agreements under which the seller of a business (or company carrying on a business) will receive additional payments based on the future performance of the business (or company) sold.

 

Broadly, there are two ways of characterising an earnout arrangement for the purposes of the CGT provisions:

 

  • the first involves treating the earnout as a separate asset in the hands of the seller ("separate asset" approach); and
  • the second involves treating payments made under the earnout as capital proceeds paid in respect the disposal of the underlying asset ("look-through" approach).

 

Prior to the enactment of Subdivision 118-I, the ATO had released a draft ruling that adopted the separate asset approach to earnouts (TR 2007/D10). The ruling was never finalised and was withdrawn in 2016 because it was expected by the ATO that most earnouts would qualify for look-through treatment under Subdivision 118-I.

 

However, the restrictive definition of "look-through earnout right" in section 118-565 means that many earnouts that would otherwise be regarded as "standard" do not qualify for look-through treatment.   

 

The discussion paper

 

The reason given for the discussion paper is that the Board of Taxation is conducting a post-implementation review of the tax treatment of contingent consideration (including earn-outs), making this an opportune time to obtain feedback from taxpayers on the need and priority for additional public advice and guidance on the income tax treatment of earnouts.  

 

There is little information on the Board's website about the review other than brief mentions about its progress in the "CEO updates". In December's update, the CEO said that the Board had completed its post-implementation review. Presumably, the Board's report is now with the Government and will be released at a time of the Government's choosing. Given all the other matters on the Government's agenda and the forthcoming Budget, it may be some time before the report is released.

 

The discussion paper indicates that the Commissioner's views in TR 2007/D10 have not changed but that he is willing to consider "areas which need to be clarified or changed", including "where the 'separate asset approach' should not apply". The discussion paper does not give any examples of where it should not apply, but any move away from the separate asset approach would generally be welcomed. The separate asset approach is complex and difficult to apply in practice. This is particularly so given that earnouts are commonly seen for small to medium sized business and company sales, where the resources to comply strictly with the complexities of the separate asset approach are more limited.

 

Issues identified by the discussion paper

 

The discussion paper identifies a number of issues with the separate asset approach as being areas for further guidance from the ATO.  One of the key areas identified is the need for further guidance in relation to the tax treatment of the buyer under this approach.

 

Under the separate asset approach, the market value of the earnout right (worked out at the time of acquisition) is included in the cost base of the asset (being the business assets or ownership interests in an entity) acquired by the buyer. However, TR 2007/D10 does not address the tax implications for the buyer where the payments made under the earnout agreement differ from the market value of the earnout right other than to say that the payments have no effect on the buyer's cost base for the asset.

 

In this regard, TR 2007/D10 was only concerned with the CGT treatment of earnouts and did not consider whether payments made under an earnout could be deductible as a general deduction under section 8-1 of the ITAA 1997 or deductible over 5 years under section 40-880 of the ITAA 1997. In discussing the deductibility of the payments under these sections, the ATO seems to suggest that:

 

  • payments will only be deductible under section 8-1 if the circumstances are on all fours with Cliffs International Inc v FCT (1979) 142 CLR 140, a case described as "peculiar" in AusNet Group v FCT (2015) 255 CLR 439; and
  • in light of certain exclusions from section 40-880, there may be limited scope for the payments to be deductible under section 40-880. 

 

If this is correct, and payments under the earnout are not dealt with through adjustments to the buyer's cost base in the assets, it is not clear how payments under the earnout would be recognised in the tax system.  

 

Comment

 

Apart from the various technical issues identified in the discussion paper with the separate asset approach, a difficulty with the separate asset approach from a compliance perspective is the need to obtain valuations of the earnout right. The discussion paper recognises that there are compliance costs for the seller in obtaining a valuation, but seems to overlook that similar costs arise for the buyer. There are also inherent risks that the buyer and the seller will obtain different valuations for the earnout right. According to the discussion paper, the Commissioner is looking to develop administrative guidance that may reduce compliance costs associated with obtaining valuations.

 

Any such guidance on this, and the technical matters identified in the discussion paper, would be welcomed.

 

Comments on the discussion paper can be made until 1 February 2019.

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For further information, please contact:

 

Vivian Chang, Partner, Ashurst

vivian.chang@ashurst.com