The Diverted Profits Tax – An explanation of its form and effect

In the 2016-17 Federal Budget, the Government announced that it would introduce a diverted profits tax (DPT). The DPT will come into effect on 1 July this year and will imposes a 40% tax on company profits it deems to have been diverted offshore.

The DPT intends to ensure that the tax paid by significant global entities (SGE)[1] accurately reflects the real economic substance of their commercial activities in Australia and aims to prevent the use of contrived arrangements to divert profits offshore. It is also intended that this measure will encourage SGE’s to supply sufficient information to the ATO to facilitate the timely resolution of tax disputes[2].

It is intended the DPT will complement the application of the existing anti-avoidance rules in Part IVA of the Income Tax Assessment Act 1936 and encourage greater compliance by large multinational enterprises with their tax obligations in Australia, including with Australia’s transfer pricing rules in Division 815 of the Income Tax Assessment Act 1997[3].

It is also intended that the measures will encourage greater facilitation with the ATO, address information asymmetries and allow for quicker resolution of disputes[4].

Central constituents of the DPT

The diverted profits tax carries over a number of identical concepts directly from the MAAL; including, the concept of Significant Global Entity and the shift from sole or dominant purpose to that of principal purpose[5]. Consistent with the MAAL and Part IVA, the determinative consideration for the DPT is whether the arrangement had the ultimate purpose of obtaining an Australian tax benefit determined in reference to the considerations under section 177D(2).

In these respects the DPT is identical to the MAAL; there are however a number secondary tests in order for the DPT to apply.

  • The $25 million income test — exempts taxpayers where total income does not exceed $25 million;[6]
  • The sufficient foreign tax test — this test will apply if the increase in the foreign tax liability, resulting from the operation of the scheme, is 80% or more of the reduction in the Australian tax liability;[7]
  • The sufficient economic substance test — this test will apply if, the profit that is generated by any or all of the parties to the scheme, or any part of the scheme, or otherwise connected with the scheme reasonably reflects the economic substance of the entity’s activities in connection with the scheme[8].

Comparison of the DPT with the MAAL and Part IVA:

The key differences in the DPT from the MAAL include the imposition of a penal tax rate on diverted profits and importantly any amount assessed will fall due and payable 21 days after the Commissioner issues a notice of assessment[9].

This applies irrespective of whether the taxpayer has commenced legal proceedings to challenge the assessment. For this reason alone there are already a number of prominent tax professionals and legal scholars that are highly critical of the DPT[10].

There are a number of further deficiencies in the DPT that raise serious questions about the efficacy of the DPT and also give rise to considerable administrative law issues. These issues are unfortunately too substantive to be covered by this paper, though will hopefully form the basis of further publications and collaboration with other tax and administrative law scholars.

Without putting too fine a point on it, the DPT is rather over-egging the pudding when it comes to preventing large-scale multinational tax avoidance. The provisions of the MAAL are innately sensible and well conceived. Despite drafting which suggest that this will be interpreted as merely a gateway provision to higher penalties; if the courts do hold the MAAL to operate a stand-alone test for significant global entities then the MAAL really will represent significant shift in legislative direction and bring the focus of taxation back to the economic substances of the transaction.

The DPT however is cumbersome, difficult to interpret and raises serious administrative law issues, including natural justice and fairness. Though the secondary tests incorporated in the DPT have some merit, in particular the sufficient foreign tax test, it is highly questionable why they have been incorporated in a separate and protracted legislative test rather than supplementing the existing MAAL; which itself is built upon the existing provisions of Part IVA.

How the DPT will be interpreted remains to be seen; it is possible that judicial interpretations will flush out the merits of the DPT and form it into a defined an separate test from the MAAL and Part IVA; this is however unlikely given the existing aversion to the DPT amongst the legal profession.

Internal administrative oversight framework

 The ATO is presently developing what it considers to be a “robust internal DPT administrative oversight framework.” it is foreshadowed that this framework will introduce several levels of oversight and additional safeguards to provide assurance around the DPT process, including:

  • An internal DPT panel comprising senior executive representation, who approve the escalation of a DPT review to a preliminary general anti-avoidance rules (GAAR) panel.
  • Utilisation of an existing preliminary GAAR Panel process, consisting of at least one external and internal member. Consistent with ordinary GAAR Panel procedures no taxpayer representation is available.
  • Deputy Commissioner sign-off before a DPT assessment can be issued.
  • Full GAAR panel, which allows taxpayer submission and representation, at the end of the period of review (generally 12 months) following a DPT assessment.

The ATO is of the opinion that these process will ensure that DPT will only be applied in appropriate circumstances and appropriately focused on tax avoidance arrangements by related parties to divert profits offshore[11].

Legislation and supporting material

The DPT legislation received Royal Assent on 4 April 2017, with Schedule 1 to the Treasury Laws Amendment (Combating Multinational Tax Avoidance) Act 2017 implementing the provisions of the DPT and the Diverted Profits Tax Act 2017 establishing the rate of tax. The substantive provisions themselves are contained in part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) alongside the general anti-avoidance provisions and the MAAL.

The ATO is at present developing a law companion guideline, which aims to provide guidance on some of the concepts that for the DPT. They also intend to produce a practical compliance guideline, which is intended to provide broad administrative guidance, addressing some of the practical implications of the law and outlining the administrative approach.

This is necessary, as there already exists much confusion regarding the interpretation of the provisions of the DPT.

Possible interpretations of the DPT

The actuative provisions of the DPT[12] sit within Part IVA of the ITAA 1936 as the newly inserted section 177J. There are two possible interpretations about how these provisions should take effect.

  • Stand alone provision – a less stringent test for avoidance for SGE’s;
  • Supplementary provision – a gateway provision to higher penalties.

The intention of the Tax office would seem to suggest that they prefer the former interpretation; a legal reading of the provisions however would favour the latter.

This ambiguity in interpretation may well form a substantive part of any legal challenge, should this legislation be scrutinised by the courts, consideration should be given to the likely approach the courts will take to resolving any ambiguity.

If one reads the legislation by way of classical statutory interpretation; focusing on the maxims of statutory interpretation, and in particular the principle of noscitur a sociis, then it would appear that in order to be enlivened, the DPT requires that a scheme must first be determined under section 177D.

The structure of s177J is such that subsection (1) yokes itself to the same criteria in s177D. The provision is set out thus.

177J Diverted profits tax—application          

  • This Part also applies to a scheme, in relation to a tax benefit (the DPT tax benefit) if:
  • a taxpayer (a relevant taxpayer) has obtained, or would but for section 177F obtain, the DPT tax benefit in connection with the scheme.

Emphasis has been added on the phraseology that presents difficulty, this suggests that in order for the DPT to have effect first a scheme must be established under s177D. Similarly the explanatory memorandum to the DPT discusses the context of the amendments as complementary to the application of existing anti-avoidance rules[13].

Consequently, in effect, the DPT does not afford any greater clarity or simplicity to the well-established difficulties in the interpretation and application of the general anti-avoidance provisions. Rather it adds a supplementary and complicated test for significant global entities as a means of enlivening greater penalties provisions.

This off course assumes the courts will take a literalist approach to interpretation; though some weight is given to parliamentary intention, with reference to the explanatory memoranda. It is nonetheless quite open for the courts to take a far more purposive approach to interpretation. Considering any guidance the ATO issues in the subject regarding its interpretation.

The DPT may well be interpreted as stand alone provisions. If this is the case the legislative shift from “sole or dominant purpose” to that of “principle purpose” and the focus away from the intention as to the adoption of a commercial structure towards how transactions are carried out within the structure may well result in a lower bar for establishing certain transactions as avoidance[14].

If the DPT is held to be separate tests for establishing tax avoidance then the legislation may well herald a dramatic shift in tax jurisprudence. If however it is held to be supplementary test to the general anti-avoidance rules for multinationals then the provisions will be of little effect beyond a limited group of substantial multinationals.

Whatever the case the DPT looks set to be a particularly interesting area of academic research and may well presents a number of additional considerations for CTA’s and legal advisors in the upper echelons of Corporate Australia.

[1] Introduced under the Tax Laws Amendment (Combatting Multinational Tax Avoidance) Bill 2015 and defined in the Income Tax Assessment Act 1997 (ITAA 1997) section 960-555 as either a global parent entity or member of a group of entities that are consolidated for accounting purposes as a single group, where one of the other members of the group is a global parent entity. And where the global or consolidated group income exceeds $1 billion (Australian) annually.

[2] The Australian Tax Office, “Diverted Profits Tax” (The Australian Tax Office, 2017).

[3] ibid

[4] ibid

[5] Bruce, “Multinational Anti Avoidance Law (MAAL) & Part IVA. “A Critical Analysis Of The Tax Laws Amendment (Combatting Multinational Tax Avoidance) Bill 2015 And Treasury Laws Amendment (Combatting Multinational Tax Avoidance) Bill 2017; And Comparison With General Anti-Avoidance Provisions”” (2017) 4 The Australian Tax Law Bulletin.

[6] Explanatory Memorandum; Treasury Laws Amendment (Combating Multinational Tax Avoidance) Bill 2017; Diverted Profits Tax Bill 2017 Pg. 10 par 1.11

[7] ibid

[8] ibid

[9] Explanatory Memorandum; Treasury Laws Amendment (Combating Multinational Tax Avoidance) Bill 2017; Diverted Profits Tax Bill 2017 Pg. 49 par 1.144

[10] Richard Gelski, “The Justice Hill Memorial Lecture – Law, Morality And Multinationals”, 32nd National Convention (The Tax Institute of Australia., 2017).

[11] The Australian Tax Office, “Diverted Profits Tax” (The Australian Tax Office, 2017).

[12] There are further substantive provision in sections 177K, 177L and177M however section 177J is the primary application provision. Penalty provisions are contained in section 177N, 177P, 177Q, 177R and the imposition of the rate of DPT is in the Diverted Profits Tax Act 2017 Cth (40% at time of writing)

[13] Explanatory Memorandum; Treasury Laws Amendment (Combating Multinational Tax Avoidance) Bill 2017; Diverted Profits Tax Bill 2017 Pg. 7 par 1.5

[14] Bruce, “Multinational Anti Avoidance Law (MAAL) & Part IVA. “A Critical Analysis Of The Tax Laws Amendment (Combatting Multinational Tax Avoidance) Bill 2015 And Treasury Laws Amendment (Combatting Multinational Tax Avoidance) Bill 2017; And Comparison With General Anti-Avoidance Provisions”” (2017) 4 The Australian Tax Law Bulletin.

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