The ATO on Thur 17.3.2016, issued Decision Impact Statements on the following:
- Orica Ltd v FCT  FCA 1399 – In this case, the Federal Court held Pt IVA applied to a scheme whereby deductions of $112m were claimed for interest on inter-corporate loans made by an Australian subsidiary of a US corporate group. In doing so, the Court dismissed the taxpayer’s claim that the dominant purpose was not to obtain a “tax benefit” but to generate income for the US companies (in the form of interest earned on the loans made to them via the Australian subsidiary) so that the US companies could absorb “unbooked” US tax losses of some A$52.9m that could not be otherwise used. The ATO said it considers the decision to be consistent with the established case law on Pt IVA and the penalty provisions. The ATO said it “will give close attention to schemes that exhibit similar features; namely schemes in which, in effect, entities inject capital into foreign subsidiaries and then borrow the funds back again at interest, where the interest is said to be deductible under s 25-90 of the ITAA 1997”.
[LTN 52, 17/3/16]
This decision concerned the application of Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) to a cross-border financing arrangement. Under the arrangement, deductions were claimed under section 25-90, or alternatively section 8-1, of the Income Tax Assessment Act 1997 (ITAA 1997) for interest paid by an Australian-resident group company to a US-resident group company with significant carried-forward US tax losses. The funds deposited with the Australian company had originally been lent by the Australian company itself to a third group entity, and then paid to the US company by way of subscription for redeemable preference shares in it.
Brief Summary of Facts
Between 2002 and 2006, members of the Orica corporate group entered into the following intra-group arrangement (implemented in three tranches – Series B, C and D):
- Australian-resident Orica Finance Ltd (OFL) lent Australian-resident Orica Explosives Holdings (OEH) the AUD equivalent of USD $590m.
- OEH used the loan proceeds to subscribe for redeemable preference securities issued by a US resident subsidiary, Orica US Services Inc. (OUSSI).
- OUSSI then placed USD $517m on deposit at interest with OFL.
OUSSI conducted Orica’s North American explosives business. It had incurred significant operating losses and had consequently accumulated US tax losses in the years leading up to the scheme. The losses had initially been recognised in Orica’s consolidated balance sheet as a Future Income Tax Benefit (FITB) asset for US purposes. However, under the Australian accounting standards, to maintain recognition of the value of the FITB in Orica Limited’s subsidiary, the FITB had to be ‘virtually certain’ it could be used in the future. Given OUSSI’s protracted poor financial performance, the FITB asset was written off in 2001.
The scheme caused OUSSI to receive income that was assessable in the US. This enabled re-recognition and use of the US tax losses. Orica re-recognised the losses over a period of three years. In 2006, when the US losses had been fully used, the arrangement was unwound.
The interest expenses of OFL were claimed as deductions in Australia under section 25-90 of the ITAA 1997 (which gives a deduction for interest paid on debt interests to derive ‘non-assessable non-exempt’ foreign source income). In dispute were deductions claimed between 2004-2006 by Orica Ltd as head company of the consolidated group of which OFL was a member. Deductions for the years in dispute amounted to A$88,650,627.
With the exception of a US$48,999,338 dividend paid on the redemption of the Series B Redeemable Preference Shares, no dividends were paid to OEH on any of the preference shares issued by OUSSI under the scheme.
The expert evidence before the court was that the scheme improved the reported profits over the re-recognition period. The three consequences of the arrangement were:
- a cumulative reduction of A$33.8m in the income tax expense recognised on the payment of interest by OFL to OUSSI
- an increase of $45m in the income tax expense of OUSSI, and
- a cumulative reduction in the income tax expense of OUSSI, equal to the increased amount, by bringing into account the unbooked benefits of the tax losses.
The Commissioner submitted that the deduction under section 25-90 of the ITAA 1997 for interest paid by OFL to OUSSI was a tax benefit to which Part IVA applied.
Issues decided by the Court/Tribunal
Pagone J found that Part IVA applied to the deductions claimed by Orica Ltd for each of the years in dispute.
Orica conceded that the deductions obtained under the scheme were tax benefits under the former terms of section 177C of the ITAA 1936. This confined the dispute to an analysis under paragraph 177D(b) of the ITAA 1936 (as it then was) as to whether it would be concluded from the matters listed in that paragraph that a person who entered into or carried out the scheme did so for the dominant purpose of enabling the taxpayer to obtain a tax benefit in connection with the scheme.
His Honour found (at paragraph ) that that a reasonable person would so conclude.
Pagone J also found that the scheme penalty amount under section 284-145 of Schedule 1 to the Taxation Administration Act 1953 should not be reduced to 25% in the circumstances because the taxpayer’s position was not ‘reasonably arguable’: section 284-15.
ATO View of Decision
The ATO considers the decision to be consistent with the established case law on Part IVA and the penalty provisions.
The case shows that the anti-avoidance legislation is capable of defeating artificial or contrived arrangements that shift taxable profits out of the Australian tax base.
The ATO will give close attention to schemes that exhibit similar features; namely schemes in which, in effect, entities inject capital into foreign subsidiaries and then borrow the funds back again at interest, where the interest is said to be deductible under section 25-90 of the ITAA 1997. Typically in these schemes the corresponding income from the interest flows is for some reason not taxed anywhere at a comparable rate. We informally refer to these schemes as ‘loan-ups’.
As well as Part IVA, some loan-up schemes currently under examination raise questions as to whether the conditions for deducibility in section 25-90 of the ITAA 1997 are met. In particular, the ATO may question whether the requisite income-generating purpose is genuinely present, especially if the scheme seems incapable of generating a positive net return for the borrower. This issue was not raised in Orica but it might be in future cases.