We are reviewing cross-border round robin type arrangements that involve funding of an overseas entity or operations by an Australian entity, where the funds are subsequently provided back to the Australian entity or its Australian associate in a manner, which purportedly generates Australian tax deductions while not generating corresponding Australian assessable income.

One example of this kind of arrangement was considered by the Federal Court in Orica Limited v FCT [2015] FCA 1399.

The arrangements being reviewed essentially involve the round robin movement of funds where:

  • an entity claims income tax deductions in Australia for costs of borrowing or obtaining other financial benefits (including satisfaction of liabilities) from an overseas party
  • the loan or other financial benefit provided by the overseas party is in substance funded, directly or indirectly, by an investment by the entity claiming the deductions or its Australian associate
  • the return on the Australian investment, reflecting the financing costs payable to the overseas party, comes back to Australia in a non-taxable or concessionally taxed form, for example, as a distribution from an overseas subsidiary which is not assessable under Subdivision 768-A of the Income Tax Assessment Act 1997 (ITAA 1997).

Potential tax consequences

The potential tax consequences are primarily in relation to applying the:

  • rules relating to deductibility of financing costs
  • rules for income qualifying as not assessable under section 23AH of the Income Tax Assessment Act 1936 (ITAA 1936) or Subdivision 768-A of the ITAA 1997
  • rules relating to attribution of expenses and income to operations carried on or through a permanent establishment
  • rules that treat cross border dealings as on conditions which might be expected between independent parties dealing wholly independently (i.e. transfer pricing rules)
  • general anti-avoidance rules.

Common features

Relevant arrangements may display some or all of the following features:

  1. the entity claiming the Australian tax deductions is related to the overseas party providing the loan or other financial benefit
  2. the overseas party is an entity resident in a low tax jurisdiction, or is otherwise not taxable in the overseas country on any financing costs payable by the entity claiming the deductions, for example, because it can claim foreign tax credits or tax losses in the overseas country
  3. use of hybrid entities or instruments such that:
  4. the financing costs payable to the overseas party which are deducted in Australia are not taxable in the relevant overseas jurisdiction, or
  5. the financing costs are deducted twice, i.e. once in Australia and once by the hybrid entity or the hybrid entity’s owners in the overseas jurisdiction
  6. the financing costs payable to the overseas party is not income taxable in Australia under Australia’s controlled foreign company (CFC) provisions
  7. the non-assessable foreign sourced income distributed to the Australian entity increases its ‘conduit foreign income’ balance so it can distribute unfranked dividends funded from its Australian profits to its foreign shareholders free of dividend withholding tax
  8. there is no cash transfer of relevant funds and relevant steps are said to be carried out by journal entries
  9. the arrangement produces a commercial outcome or achieves an overall advantage to the global group because of the Australian tax benefits.

[There are some helpful examples with diagrams in the Tax Alert.]

The ATO’s concerns about purported tax effect

We are concerned that the taxpayer may not be entitled to a deduction under section 8-1 (general deductions), section 25-85 (deductions for dividends on ‘debt interests’), section 25-90 (deductions for amounts incurred to derive foreign non-assessable non-exempt income) or section 230-15 of the ITAA 1997 (losses deductible on financial arrangements) are, as the case may be, because the borrowing may not have the sufficient necessary nexus with the requisite kind of income. Depending upon the facts, the principles in Taxation Determination TD 2009/21 (requirement for s25-90 deduction) or Taxation Determination TD 2016/6 (‘debt interest’ cost not deductible under s25-90) may be applicable.

Even if effective under the substantive provisions, we are concerned that these arrangements are being used for the purpose, or for purposes which include, the claiming of Australian tax deductions or the artificial creation of conduit foreign income to avoid payment of Australian dividend withholding tax on unfranked dividends funded from Australian profits. This might attract the application of Part IVA of the ITAA 1936.

We are also concerned about whether the actual commercial or financial dealings between the Australian entities and the overseas related parties are on conditions that might be expected to operate between independent parties dealing wholly independently with each other for the purposes of applying Subdivision 815-A or Subdivision 815-B of the ITAA 1997 (‘transfer pricing’), or involve non-arm’s length consideration for the purposes of applying section 136AD of the ITAA 1936.

[ATO website – TA 2016/10] [LTN 179, 15/9/16]