Australia continues to be heavily dependent on inbound investment, an underlying reality that shapes much of the tax debate in the country. While Australian-based companies invest offshore to access growth opportunities not available at home, history suggests that successful Australian-based multinationals often become attractive takeover targets for non-Australian investors. While a healthy Australian-based multinational community is vital to the country's economy, the reality is that as a small, open market, direct foreign inbound investment will always be critical.
This article considers the tax environment for the inbound investor and highlights some of the opportunities and constraints.
Tax climate
For an investor looking at Australia for the first time, it is perhaps helpful to consider the overall state of the nation in business and personal tax areas. There are some key features.
Australian income tax law is inordinately complex, with a patchwork of legislation that was half rewritten in the mid-1990s. In addition, there are in excess of 500 public taxation rulings and determinations. Business tax reform is virtually an ongoing process.
The main indirect tax is the goods and services tax, which has been in existence for just on three years. Other taxes are state-based and include stamp duty and payroll tax.
The income tax rate that applies to companies is, in global terms, a competitive 30%. However, the income tax rates for individuals are relatively high, with the top marginal rate of 48.5% (including medicare levy) currently at taxable income above A$60,000 ($40,000).
The business tax system is devoid of incentives designed to specifically attract the foreign investor. There are no concessional regimes even for businesses in those sectors that the federal government is keen to attract foreign investment into (the only concession concerns research and development activities).
State governments may grant specific concessions on state taxes where the investor makes commitments to investments and job creation. These are negotiated on a case-by-case basis.
Withholding taxes apply to interest, royalties and to dividends paid out of untaxed income. Non-resident investors are also subject to Australian tax on capital gains made on the sale of shares in Australian companies, with limited exemptions for portfolio shareholdings in public companies.
For almost a decade, the Australian Taxation Office (ATO) has had a strong focus on transfer pricing - and was one of the first tax authorities to follow the lead of the US in implementing comprehensive documentation requirements.
The tax system is based on a self-assessment concept. The ATO audit strategy has changed many times over the past decade in response to perceived revenue risk areas. There continues to be a focus around transfer pricing audits, but other areas attracting interest of late include tax losses and the new tax-consolidation regime.
There are limited tax concessions available to inbound executives, but potential traps exist around capital gains, pension entitlements and option and reward arrangements.
Based on the above, the reader could be excused for thinking that Australia is particularly unwelcoming for the foreign investor - however, the complexity and lack of incentive merely puts the foreign investor on the same footing as domestic investors. For the past decade, there has been much debate around the idea that tax policy should take a more interventionist stance (although the likelihood of any fundamental policy changes is unlikely in the near future).
Strategies for the inbound investor
Each inbound investor will have particular commercial goals and tax-management objectives that shape the way in which their investment is structured and financed. The key parameters of the Australian tax system that are relevant include the following.
Imputation and dividend payments
The Australian imputation system allows income taxed in the hands of an Australian company to be paid out to a non-resident shareholder free of dividend withholding tax (DWT). In contrast, untaxed income is subject to DWT when paid out as a dividend to a non-resident. The DWT rate is 30% where the recipient is a resident of a country with which Australia does not have a double-taxation agreement (DTA), and normally 15% where a DTA exists. The notable exception to this is a zero withholding tax on certain dividends paid to US residents under the new protocol to the US/Australia DTA.
Deductions for borrowing costs
A deduction is generally available to an Australian resident for interest paid on borrowings used to acquire either an income-producing business or income-producing shares. Foreign investors looking to acquire a pre-existing business commonly establish an Australian company to make the purchase of assets or shares, so as to allow interest costs to be deducted in calculating Australian tax.
Thin capitalization
Tax deductibility for borrowing costs is restricted by thin-capitalization rules. For the foreign investor these generally limit tax-deductible debt to an amount broadly equal to 75% of net assets (ignoring the debt), although there is an arm's-length fallback test. In both cases the measure is against Australian assets, which, for example, excludes investments in foreign subsidiaries. The measures apply to all debt, whether from related parties or not, and whether from Australian residents or not.
Importantly, where an Australian company is set up to acquire the shares of another, or a business, the full acquisition price (including acquired goodwill) can be leveraged up to the 75% limit under the thin-capitalization rules.
Grouping rules
With effect from July 1 2002, and subject to transitional rules, the Australian tax law applying to company groups fundamentally changed. Previous rules that allowed offset of one company's tax loss against the income of another were replaced with a consolidation regime. Under this new system, a wholly-owned group of companies files one tax return in the name of the Australian head entity and all of the transactions of the group are treated as transactions of that entity.
This reform is helpful for inbound investors as it allows debt finance costs to be offset against, and serviced by, operating profits with a minimum of planning. Where an Australian company acquires all of the shares of another, the amount paid for those shares is, in effect, pushed down into the underlying business assets acquired. This can lead to a higher asset depreciation base and an allocation of current value tax basis to goodwill and other intangibles. Post-acquisition spin-offs and disposals are more practicable than they were before these reforms.
Exit planning
While an exit from Australia is not a priority to an investor considering an investment, it deserves some consideration given the reach of Australia's tax on capital gains. Australia is one of only a handful of jurisdictions that seeks to tax non-residents on gains made on the disposal of shares in Australian companies (with exceptions for certain portfolio holdings of public company shares). New investors may want to consider whether they might invest into Australia through a subsidiary in a country that has a DTA with Australia that, arguably, prevents Australia levying tax on such gains. These treaties are few and far between, and the potential application of anti-avoidance law to treaty shopping would need to be considered.
Opportunities for the foreign investor
A foreign investor might look for opportunities to arbitrage the Australian taxation system against either their home country tax system or that of an intermediate country.
Hybrid entities
Australia taxes companies, limited partnerships and certain trusts as legal entities separate from their members or proprietors. General partnerships and certain other trusts are, in effect, transparent for Australian tax purposes. For investors from many jurisdictions there are opportunities to secure arbitrage by using an Australian entity that is treated as transparent in one jurisdiction and not in the other.
Similarly, Australia generally characterizes foreign entities by reference to Australian tax and commercial law principles. It is therefore possible for a foreign investor to look to a non-Australian entity as an opportunity to arbitrage.
Hybrid investments
Australian tax policy on financial instruments is set around the principle that they ought not to be bifurcated into components, and that an economic substance approach should be taken to characterization (as opposed to form). While the tests as to whether an instrument is equity or debt certainly have their basis in seeking out economic substance, there is a tie-breaker mechanism that makes it possible to create instruments that are alternatively debt or equity for Australian tax purposes with only subtly different terms.
This makes hybrid instruments a powerful tool for the inbound investor, particularly where the investment is being made from a jurisdiction that takes form over substance in characterizing financial instruments.
Some traps for the unwary
As with many tax systems, there are hidden surprises for those unfamiliar with Australia. Some of these are helpful to consider at the outset of an investment decision.
The Australian tax system has a general anti-avoidance provision which enables tax benefits to be cancelled where the underlying arrangement or transaction could be said, on an objective review of the facts, to have been entered into with the sole or dominant purpose of obtaining the tax benefit. It is not sufficient for there to be a commercial purpose for a transaction - the taxpayer may face the burden of proof in litigation that on an objective assessment of facts (some years hence) there was no dominant purpose of obtaining a tax benefit.
The country's tax-consolidation rules are the only mechanism for offsetting the loss of one Australian entity against the income of another. They only apply where there is 100% ownership within Australia. This can often cause problems where there are minorities involved, for example employee shareholders. When looking to acquire shares in an existing Australian company, the strategy to leverage an Australian acquisition vehicle needs to be tested against the risk of not obtaining 100% ownership.
In common with many other jurisdictions, Australia allows the carryforward of tax losses by an entity, subject to satisfying continuity of ownership or same business test rules. The same business test is administered on the basis that it means identical business and in a tax consolidation environment will become increasingly hard to satisfy. This places the onus on continuity of ownership and a close understanding of these rules is required by the foreign investor.
Review of international taxation arrangements
On May 13 2003 the Australian Treasurer announced the Government's response to an 18-month review of Australia's international tax arrangements. The focus of the review was on areas of tax law that might prevent Australian-based multinationals being competitive. Little attention was paid to the foreign investor aside from some discussions around expatriate taxation.
Some ancillary benefits may flow to foreign investors, however, as the government is proposing simplification reforms to Australian controlled foreign company laws (and to the taxation of dividends from foreign subsidiaries). These reforms have the potential to remove some disadvantages that presently exist in using Australia as a regional headquarters or holding company location.
Opportunities
While Australian tax law and practices can appear daunting, the attractive competitive corporate tax rate and the range of tax-planning opportunities available to a foreign investor often outweighs the complexity. Australia will inevitably continue to be reliant on foreign investment - the question for the next decade is whether, in a liberalized global economy, the government needs to incentivize direct foreign investment through the taxation system, rather than simply providing a level playing field.
Ian Farmer, National Lead Partner
PricewaterhouseCoopers
International Tax and Transaction Services
Tel: + 61 2 8266 2802
Email: ian.farmer@au.pwc.com
Tony Clemens, Partner
PricewaterhouseCoopers
International Tax and Transaction Services
Tel: + 61 2 8266 2953
Email: tony.clemens@au.pwc.com
