Australian thin capitalisation reforms delayed and PepsiCo Federal Court decision
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Australian thin capitalisation reforms delayed and PepsiCo Federal Court decision

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Jock McCormack of DLA Piper Australia reports on substantial amendments to the prior draft of Australia’s thin capitalisation reforms and a landmark ruling concerning the application of royalty withholding tax and diverted profits tax

In the first of two major developments, the proposed reforms to Australia’s thin capitalisation rules have been further delayed with the referral of the proposed amendments for a second time to the Senate Economics Legislation Committee on December 5 2023. Furthermore, in a broad-ranging decision, Moshinsky J of the Federal Court has held that certain payments made in relation to bottling agreements were royalties and thus subject to royalty withholding tax or that diverted profits tax would apply.

Thin capitalisation reforms

On November 28 2023, the government released substantial amendments to the prior draft of the thin capitalisation reforms. These amendments dealt with a broad range of measures impacting, among other things:

  • The third-party debt test;

  • The debt deduction creation rules; and

  • The meaning of ‘obligor group’ and ‘tax EBITDA’.

Following extensive consultation on these reforms, the proposed amendments were referred to the Senate Economics Legislation Committee, with a report due on or before February 5 2024.

These reforms were intended to align Australia’s interest limitation rules for multinationals with the OECD’s earnings-based best practice model, which allows affected taxpayers to deduct net interest expense up to a benchmark earnings ratio; i.e., 30% of the entity’s tax EBITDA (i.e., the primary test known as the fixed ratio test).

These proposed reforms have raised major issues and concerns, particularly impacting those involved in capital-intensive industries such as economic and social infrastructure, property, energy, and natural resources. Further issues related to the perceived retrospective application of the reforms continue to impact multinationals, as the principal changes were intended to apply from July 1 2023, with limited transitional concessions for existing debt arrangements.

PepsiCo v Commissioner of Taxation

On November 30 2023, the Federal Court handed down its decision in relation to PepsiCo, Inc. v Commissioner of Taxation, dealing with the application of royalty withholding tax and, in the alternative, diverted profits tax.

The Australian Taxation Office (ATO) was successful in arguing that certain portions of the payments made in relation to bottling agreements were royalties and thus subject to royalty withholding tax, limited to 5% under the US–Australia double tax agreement. Furthermore, Moshinsky J held in principle that diverted profits tax would otherwise apply.

This is the first Australian court decision on diverted profits tax in Australia and is being closely monitored. The ruling strengthens the ATO’s armoury with regard to multinationals.

A significant component of the judgment focuses on determining the amount of the royalties (based on various experts’ advice) and the court in principle determined that the royalty component was 5.88% of Schweppes Australia Pty Limited’s net revenues from sales (subject to further revision/adjustment). The case dealt with the use of, or right to use, the relevant trademarks and other intellectual property.

Clearly, the PepsiCo decision will have wide-ranging implications for the access to, and use of, intellectual property across a broad range of sectors and on ATO rulings dealing with royalties and related matters, including the licensing/distribution of software and DEMPE of intangibles.

The decision might be expected to go on appeal and should be closely monitored.

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