tag:theconversation.com,2011:/global/topics/thin-capitalisation-7760/articlesthin capitalisation – The Conversation2016-05-04T01:40:58Ztag:theconversation.com,2011:article/580412016-05-04T01:40:58Z2016-05-04T01:40:58ZThin capitalisation – the multinational tax avoidance strategy the budget forgot<p>It is now apparent that multinational tax avoidance and aggressive tax planning is a significant fiscal risk to the country. </p>
<p>We have already seen major amendments to Australia’s tax regime to tackle base erosion and profit shifting (BEPS). <a href="https://theconversation.com/government-pitches-for-integrity-in-tax-and-super-experts-respond-58153">Several more significant measures</a> were announced in the federal budget, most notably the diverted profits tax, aimed at multinationals which shift tax to a lower taxing jurisdiction. </p>
<p>Yet to date, a very simple tax minimisation strategy has been largely ignored in the ongoing reforms and was ignored in the federal budget.</p>
<p>Excessive debt loading is a problem that not been afforded the same attention as other aggressive tax planning strategies adopted by multinationals. Nevertheless, excessive debt loading is a very simple technique used by multinational entities to reduce their overall tax liability. And, it is recognised as a global problem. Another term for excessive debt loading is thin capitalisation. </p>
<p>Money is mobile so a multinational can simply shift debt into high tax counties to ensure that a tax deduction is received for the interest paid. This reduces the overall profits in the high tax country, thereby reducing their tax liability. In Australia’s case, the entity loads up their Australian operations with tax-deductible debt. </p>
<p>Excessive debt loading was highlighted as an aggressive tax practice by the <a href="http://www.aph.gov.au/Parliamentary_Business/Committees/Senate/Economics/Corporate_Tax_Avoidance">Senate Inquiry</a> into Corporate Tax Avoidance. In part two of its <a href="http://www.aph.gov.au/Parliamentary_Business/Committees/Senate/Economics/Corporate_Tax_Avoidance/Report_part_2">report</a>, handed down on 22 April 2016, the Senate Inquiry highlighted the fact that debt-related deductions span a number of related areas including thin capitalisation and transfer pricing. They also emphasised the difficulty in finding publicly available “real life” examples. </p>
<p>The OECD has also recognised that the ability of multinationals to adjust the amount of debt to achieve favourable tax results is a serious global problem. The <a href="http://www.oecd.org/tax/beps-2015-final-reports.htm">report</a> on Action Item 4 of the OECD/G20 BEPS program specifically addresses the BEPS risk arising from three different types of strategies:</p>
<ul>
<li><p>Groups placing higher levels of third part debt in high tax countries</p></li>
<li><p>Groups using intragroup loans to generate interest deductions in excess of the group’s actual third party interest expense</p></li>
<li><p>Groups using third party or intragroup financing to fund the generation of tax exempt income</p></li>
</ul>
<p>Australia already has a thin capitalisation regime designed to tackle this sort of behaviour. Thin capitalisation rules have existed in Australia since 1987. The current regime, introduced in 2001 and found in Division 820 of the Income Tax Assessment Act 1997, is designed to prevent multinationals from claiming excessive debt deductions to reduce their Australian taxable income. </p>
<p>The rules operate by disallowing a proportion of the otherwise deductible interest expense where the debt allocated to Australia exceeds certain limits. The limits are determined by reference to what is known as the “safe harbour” debt amount, an “arm’s length” debt amount, and a “worldwide gearing” debt amount. However, the problem of excessive debt loading still exists. </p>
<p>Of particular interest is the safe harbour debt amount generally referred to as the allowable debt to equity ratio. Prior to the budget there was a suggestion that Australia’s thin capitalisation rules would be tightened for the second time in as many years with an adjustment to the ratio. However, instead reform proposals centred around the diverted profits tax and “anti-hybrid” rules, with thin capitalisation ignored. </p>
<p>When the OECD’s final report on BEPS was released last October, Treasurer Scott Morrison indicated in a <a href="http://sjm.ministers.treasury.gov.au/media-release/003-2015/">media release</a> that Australia had already tightened its thin capitalisation rules and intimated that no further changes would be made. Clearly, the Federal Government is again sending a message that it does not see any problems with the current regime. </p>
<p>However, Australia is not moving towards the OECD’s suggested “best practice” approach. The Federal Government seems to be at pains to ensure the OECD leaves it alone when it comes to thin capitalisation rules. </p>
<p>No one doubts that thin capitalisation rules require a balance between maintaining the integrity of the tax base, or preventing BEPS, and not impeding the efficient allocation of capital. The OECD however points out that there is evidence that excessive debt loading is a serious problem to the erosion of the tax base. It provides a model which it argues is best practice for domestic law. The ratio aspect of the OECD recommendation is similar to Australia, but the approach is not. </p>
<p>Australia’s current approach relies on a ratio of debt to equity. The OECD BEPS recommendation is a fixed ratio rule but one that is a percentage of its earnings before interest, taxes, depreciation and amortisation (EBITDA). It then recommends a ratio of between 10-30%. Alongside the fixed ratio, the OECD recommends a group ratio rule. </p>
<p>There is an argument that Australia’s current regime is relatively close to the common approach suggested by the OECD. There is a ratio test, albeit based on different factors. There is also a worldwide gearing option similar to the OECD’s group ratio rule. However, the different ratio approach can make a significant difference. Australia links its ratio to debt and equity of the entity, an approach that the OECD argues is easy to manipulate. The OECDs model links its ratio to interest and earnings. This approach is aimed at ensuring that net interest deductions are directly linked to the taxable income generated by its economic activities. </p>
<p>The OECD proposals are designed to ensure that profits are taxed where the underlying economic activity occurs and where value is created. We need to ask ourselves whether a thin capitalisation regime that focuses on debt, equity and assets achieves this goal. Perhaps this is a forgotten means of aggressive tax planning that needs to be explored and also targeted for reform.</p><img src="https://counter.theconversation.com/content/58041/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Kerrie Sadiq has previously received funding from the International Centre for Tax and Development and CAANZ. She is a Senior Adviser to the Tax Justice Network (UK).</span></em></p>Loading companies with excessive, tax deductible debt is a commonly used by multinationals to avoid tax - so why has the government ignored it?Kerrie Sadiq, Professor of Taxation, QUT Business School, Queensland University of TechnologyLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/496642015-10-29T19:29:33Z2015-10-29T19:29:33ZThe accounting trick that helps multinationals avoid paying tax<p>Chevron Australia’s aggressive tax strategies have resulted in an additional $322 million tax bill, but this may only be the beginning of the energy giant’s woes with the Australian Taxation Office. And others could face the same headache. </p>
<p>The recent Federal Court decision suggests significant accounting disclosure implications for large subsidiaries of other multinational companies operating in Australia which have employed similar strategies, and there will be other revelations to follow. </p>
<p>The Chevron issue involves an accounting measure that is commonly used by these subsidiaries which contributes to a lack of transparency around tax paid in Australia, as well as the web of companies tied to tax havens used by its parent company. </p>
<p>Central to the court case was a loan between Chevron Australia Holdings Pty Ltd and Chevron Texaco Funding Corporation under which Chevron Australia received $2.5 billion worth of advances through a Credit Facility Agreement.</p>
<p>Importantly, the CFA did not breach the <a href="https://theconversation.com/whats-needed-for-australia-to-seriously-tackle-tax-avoidance-32272">thin capitalisation rules</a> nor any other anti-avoidance provisions of <a href="http://www5.austlii.edu.au/au/legis/cth/consol_act/itaa1936240/">Part IVA of the Income Tax Assessment Act 1936</a> (ITAA). The critical issue is whether other provisions of the Act were contravened. </p>
<p>But the ATO argued that the CFA was not at arm’s length - where a related party transaction is made between companies and the acquisition price (in this case the interest on the CFA) exceeds a commercial amount. The ATO applied section 136AD(3)(d) of ITAA, allowing it to restate the true nature of the transaction as equal to the arm’s length amount, where a taxpayer has acquired property under an international agreement without arm’s length considerations. A penalty of 25% of the avoided amount is also allowed under the act. </p>
<p>Currently the ATO is also examining a similar, much larger transaction - $35 billion - by Chevron.</p>
<p>Chevron Australia is one of the largest companies in Australia with revenues predicted to reach over $10 billion and employing thousands of people. It has to be held to the highest levels of public accountability.</p>
<p>However, in preparing its financial report Chevron Australia applies the Reduced Disclosure Requirements (RDR) which is allowed under the Australian accounting standards. </p>
<p>The RDR allows large proprietary companies that do not have public accountability to voluntarily apply the disclosure requirements of just a few accounting standards. Applying the RDR relies on the idea that the only companies which have such accountability are those which issue publicly tradeable equity or debt securities.</p>
<p>The consequences of allowing large proprietary companies such as Chevron Australia (and almost every other subsidiary of a multinational operating in Australia) to use RDR are enormous in terms of transparency. The ATO, in the past, has indicated that it relies on the annual reports of companies for related party disclosures in identifying tax avoidance.</p>
<p>Non-disclosure of this information by large proprietary companies makes it difficult for the ATO and anyone else in Australia to identify tax avoidance. Hence, in July, the head of the Senate economics references committee inquiry into corporate tax avoidance, Senator Sam Dastyari, requested Chevron Australia provide five years of additional information around the operations of the US parent company Chevron Corporation’s subsidiaries in tax havens, and related party transactions between those subsidiaries and Chevron Australia.</p>
<p>The rationale behind disclosing related party transactions is that they cannot be presumed to be at arm’s length. For example, while Chevron Australia discloses that it has been charged for interest on a loan, information on who provided the loan and what interest rate was charged on this loan are not disclosed. As a result, users do not know whether the rate charged on the loan was commercial.</p>
<p>Furthermore, Chevron Australia does not disclose the key individuals’ remuneration. Knowing how these individuals are remunerated would help the users of annual reports understand their incentives to be involved in related party transactions. For instance, disclosures on related party transactions deter companies from engaging in “unfair” transactions. Such as related party transactions aimed at minimising taxes. </p>
<p>Chevron presented the requested additional subsidiary and related party transactions disclosures in a <a href="http://www.aph.gov.au/DocumentStore.ashx?id=17fe9c62-3016-44b2-8dd3-425799b45f3d&subId=399874">submission</a>.</p>
<p>But as presented, these appear not to meet the requirements of the relevant accounting standards. At the same time Chevron Australia’s auditor, whose US affiliate earned more than $60million in fees over the last two years from Chevron, gives its use of the RDR the green light.</p>
<p>Our analysis is that that subsidiaries of multinationals should not be able to apply the RDR to lessen their financial disclosure obligations as required by all Australian accounting standards. </p>
<p>The Australian public deserves to have large proprietary companies to be fully accountable with respect to financial disclosure. As Green’s leader Senator Di Natale commented: “Rather than chase these millions of dollars after they’ve been funnelled offshore, it would be more efficient to force public disclosure of comprehensive financial accounts.”</p><img src="https://counter.theconversation.com/content/49664/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>The authors do not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and have disclosed no relevant affiliations beyond their academic appointment.</span></em></p>A court decision slugging Chevron Australia with a tax bill also reveals the use of an accounting measure that obscures tax paid in Australia.Roman Lanis, Associate Professor, Accounting, University of Technology SydneyAnna Bedford, Lecturer, University of Technology SydneyBrett Govendir, Lecturer, University of Technology SydneyLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/287642014-07-04T04:23:16Z2014-07-04T04:23:16ZHockey to tighten tax laws for multinationals but loopholes still exist<p>Treasurer Joe Hockey has said that he will improve the structural integrity of Australia’s tax system to address <a href="http://www.smh.com.au/federal-politics/political-news/joe-hockey-moves-on-global-tax-dodgers-20140702-3b93o.html">international tax avoidance</a> by multinational enterprises. In particular, the tax law will be tightened to prevent a multinational from shifting profits from Australia by claiming excess interest expense deductions. </p>
<p>This tax avoidance technique is known as <a href="https://theconversation.com/the-g20-and-the-taxing-issue-of-making-big-business-pay-21466">thin capitalisation</a>. Basically, a multinational company can manipulate the gearing ratio of its Australian subsidiary with the aim to erode the tax base in Australia. This is achieved by paying outbound interest expenses to foreign group companies located in low-tax countries. </p>
<p>For instance, it was reported recently that Glencore, Australia’s largest coalminer, <a href="http://www.smh.com.au/business/glencore-tax-bill-on-15b-income-zip-zilch-zero-20140626-3awg0.html">paid almost zero income tax</a> over the last three years using this technique, despite earning A$15 billion. Its parent company’s financial statements revealed that the group has at least three wholly-owned subsidiaries incorporated in Bermuda, Luxembourg and Switzerland respectively, all three countries being notoriously popular locations for “group finance companies” in international tax avoidance structures of multinationals.</p>
<p>A simple example can illustrate the thin capitalisation technique. Assume a multinational is cash rich and does not have to borrow from third parties. Despite this enviable financial position, it can still establish a Bermuda group finance company (with zero income tax rate), which enters into an intra-group loan arrangement with its sister company in Australia. In this way, profits in Australia can be shifted to Bermuda through the artificially created interest expenses paid to Bermuda. </p>
<p>The existing tax law in Australia has a specific anti-avoidance regime designed to address the thin capitalisation arrangement. It denies deduction of outgoing interest expenses if the debt to equity ratio exceeds a 75%. Joe Hockey proposed to tighten the regime and lower the threshold to 60%. </p>
<h2>Effectiveness of measures</h2>
<p>Will the proposal be effective in preventing cases similar to Glencore from happening again? Probably not. The fundamental problem of the thin capitalisation regime is that instead of recognising the reality that a multinational operates as one single enterprise, the tax law insists on treating each company as a separate taxpayer. This means it fails to consider that the group as a whole bears lower or even no interest expenses. It will continue to allow deduction of intra-group interest expenses that are created artificially for tax avoidance purposes.</p>
<p>One should bear in mind that thin capitalisation is just one of the numerous tax avoidance techniques that multinationals can use to minimise their tax liabilities. Most of these techniques take advantage of the mismatch between the <a href="http://www.investopedia.com/terms/a/accounting-entity.asp">separate entity principles</a> embedded in the tax law and the economic reality that a multinational operates as one single enterprise.</p>
<p>The attachment to the separate entity principle by the tax law dictates that the Australian Taxation Office has no choice but to respect the intra-group transactions. The ATO may attempt to challenge the transactions to see if they are done on an arm’s length basis. Sadly, such an attempt is likely to be in vain, as the “successful” tax avoidance stories of Apple and Google have proved that the current transfer pricing rules are ineffective in tackling the modern international tax avoidance structures.</p>
<p>The anti-avoidance war tax authorities are fighting for is unfair, as multinationals have much flexibility to establish wholly-owned subsidiaries in low-tax countries and to create intra-group transactions that have no real economic impact to the group as a whole. It is a war that tax authorities are unlikely to win until the tax law is free from the handcuffs of the separate entity principle and can look at a multinational as a single enterprise.</p>
<h2>Global solution</h2>
<p>Hockey said <a href="http://www.theaustralian.com.au/national-affairs/policy/joe-hockey-clamp-on-company-tax-rules/story-fn59nsif-1226975730145">“we need a global solution to a global problem”</a>. How likely is it that the G20 will reach a consensus to take the bold step to reform the tax law with respect to the separate entity principle? A recent episode in the US may give us a hint. </p>
<p>A US Congressional hearing was held in April to investigate tax avoidance by Caterpillar, an iconic US multinational which manufactures industrial equipment and engines. Despite learning that Caterpillar had successfully shifted US$8 billion taxable income from the US to Switzerland, three of the four senators, who were the panel members in the hearing, defended Caterpillar. One senator <a href="https://www.law.uh.edu/news/faculty-news/spring2014/0408Wells.pdf">even declared in the hearing</a> that “I would like to take my time to apologise to Caterpillar for this proceeding… rather than having an inquisition, we should probably bring Caterpillar here to give them <em>an award</em>” (emphasis added). </p>
<p>This episode suggested that many US politicians were effectively captured by business lobbyists and were willing to let their multinationals not only avoid foreign income tax, but even US income tax. If the US isn’t overly enthusiastic about effective anti-avoidance measures, it is difficult to see how a meaningful international consensus to reform the international tax rules can be reached.</p><img src="https://counter.theconversation.com/content/28764/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Antony Ting does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.</span></em></p>Treasurer Joe Hockey has said that he will improve the structural integrity of Australia’s tax system to address international tax avoidance by multinational enterprises. In particular, the tax law will…Antony Ting, Senior Lecturer of Taxation Law, University of SydneyLicensed as Creative Commons – attribution, no derivatives.