The Australian tax system is subject to ongoing legislative change and contains complex rules that, together with commercial and legal considerations, affect mergers and acquisition (M&A) transactions in Australia.
The Australian tax system is subject to ongoing legislative change and contains complex rules that, together with commercial and legal considerations, affect mergers and acquisition (M&A) transactions in Australia. Several significant developments in tax law have occurred since the last edition of this publication.
This report provides an overview of some recent developments and key Australian tax issues that are relevant for buyers and sellers in M&A transactions in Australia.This report also discusses the Australian accounting and legal context of M&A transactions and highlights some key areas to address when considering the structure of a transaction.
Tax reform has proceeded apace in recent years in Australia. Many of the implemented and proposed changes affect the M&A environment.The key areas of focus include the following.
Recently implemented changes
Diverted profits tax: As of 1 July 2017, the diverted profits tax (DPT) gives the Australian Taxation Office (ATO) more powers to deal with global groups that have ‘diverted’ profits from Australia to offshore associates in jurisdictions with a tax rate of less than 24 percent, using arrangements that have a ‘principal purpose’ of avoiding Australian income or withholding tax. The DPT can apply to both Australian inbound and outbound groups, where the global group has annual global income of 1 billion or more Australian dollars (AUD).
If the DPT applies, income tax is payable on the amount of the ‘diverted profit’ at a rate of 40 percent. There appears to be a risk that the mutual agreement procedure in Australia’s tax treaties would be unavailable where DPT applies — in which case unalleviated double taxation would result.
Chevron case: While not a change in law, the recent decision in the Chevron case is significant from an Australian tax perspective. The case involved the transfer price applied to an AUD3.7 billion intercompany loan agreement used to fund development of gas reserves. The decision resulted in a AUD340 million tax bill for Chevron.
In the decision, the Full Federal Court applied a different approach to determining the characteristics of the hypothetical independent parties referred to in the transfer pricing law.
The implications of this revised approach are potentially significant for taxpayers as it would enable features of the taxpayer in the context of the multinational group to which it belongs to be taken into account. Acting inconsistently — or being perceived to act inconsistently — with internal company policies (e.g. to borrow externally at the lowest rate possible, to provide a parental guarantee for external borrowings by subsidiaries) would likely be problematic from a transfer pricing perspective.
Earn-out arrangements: The Australian government has introduced a bill that changes the capital gains tax (CGT) treatment of the sale and purchase of businesses involving certain earn-out rights. Where capital gains and losses arise in respect of ‘look-through’ earn-out rights, these changes retrospectively adjust the gain/loss for the seller. This
treatment applies to earn-out arrangements entered into on or after 24 April 2015.
Previously, the ATO’s position called for the valuation of all earn-out rights at the time they were provided. The old rules continue to apply to earn-out rights that do not meet the definition of ‘look-through’ earn-out rights.
Non-resident capital gains withholding tax: Withholding tax applies on capital gains of foreign sellers disposing of certain Australian real property interests under contracts entered into on or after 1 July 2016. As of 1 July 2017, these rules were amended to increase the CGT withholding rate for foreign tax residents to 12.5 percent (from 10 percent) and reduce the withholding threshold to AUD750,000 (from AUD2 million).
In practice, these obligations should be considered when negotiating and drafting sale and purchase agreements, including the insertion of new clauses and application for variation certificates. A buyer who fails to correctly withhold is exposed to penalties equal to the amount that was required to be withheld plus interest.
Management investment trusts: The Australian government enacted legislation for a new managed investment trust (MIT) tax regime with effect from 1 July 2015. MIT structures are commonly used by non-Australian residents who have invested in property assets. The proposals would introduce (among other things), an MIT attribution model to determine income amounts taxable to the beneficiaries and broaden the test for the widely held ownership requirement in order to qualify as a MIT. These changes should improve the availability of the regime and provide greater certainty for investors. See ‘Attribution MITs’ later in this report.
Hybrid mismatch rules: Exposure draft legislation has been released proposing to introduce rules targeted at ‘hybrid mismatches’, which include:
Such structures can give rise to double deductions (where deductions arise in more than one jurisdiction for the same payment) or deduction/non-inclusion outcomes (where payments are deductible in one jurisdiction but not assessable in the other).
Where a hybrid mismatch arises, the proposals would either deny a deduction for an otherwise deductible payment or tax a receipt that would be otherwise non-taxable. The response depends on the tax treatment in the other jurisdiction, which could change over time as more countries introduce hybrid mismatch rules. These changes are expected to be legislated by the second half of 2018.
Similar business test: A ‘similar business test’ is expected to be introduced to test when income tax losses and bad debts incurred in income years starting after 1 July 2015 can be used. Businesses that have changed ownership and fail the continuity of ownership test can now access prior-year tax losses or bad debt write-offs by meeting either the ‘same- business test’ or the new ‘similar business test’.
Collective investment vehicle: Proposed measures would introduce a corporate collective investment vehicle (CIV) to create a potential alternative for some Australian investments outside of traditional trust structures. Trusts are often not
well understood by non-residents, and this new regime could simplify some inbound Australian investment structures.
These measures are the first stage of a new CIV regime that will be extended to limited partnerships in 2018.
Transparency of business tax debts: The government has released exposure draft legislation that will authorize the ATO to disclose business tax debts to credit reporting bureaus where the businesses have not effectively engaged with the ATO to manage their debt. This is a component of a growing focus on tax transparency which places increased focus on tax compliance management.
Asia Region Funds Passport: The Asia Region Funds Passport is a common framework of coordinated regulatory oversight to facilitate cross-border offerings of managed investment funds. Australia, Japan, Korea, New Zealand and Thailand signed the Passport’s memorandum of cooperation, which took effect on 30 June 2016. Australia is progressing draft legislation to facilitate its implementation in 2018.
A foreign entity that is considering acquiring an existing Australian business needs to decide whether to acquire shares in an Australian company or its assets. Many small and medium-sized businesses in Australia are not operated by companies. Trusts are also common, and, in these cases, the only choice usually available is the acquisition of business assets. For larger businesses, a company is by far the most common structure. The commentary in this report focuses mostly on companies, although much of it applies equally to other business structures.
Within Australian corporate groups, the distinction between share and asset transactions is largely irrelevant for income tax purposes due to the operation of the tax consolidation rules. Generally, these rules treat a sale of shares as if it were a sale of assets. The buyer is then effectively able to push the purchase price of the target down to the underlying assets. The distinction is more important when dealing with other taxes, such as stamp duty and GST.
Hence, the decision to acquire assets or shares is normally a commercial one, taking into account the ease of executing the transaction and the history of the target.
Purchase of assets
Asset acquisitions often constitute a permanent establishment (PE) in Australia, with the assets forming all or part of the business property of the PE. Accordingly, the disposal of the assets is likely subject to CGT, whereas the disposal of shares by a non-resident is not ordinarily subject to CGT.
The total consideration must be apportioned between the assets acquired for tax purposes. It is common practice for the sale and purchase agreement to include an allocation in a schedule, which should be respected for tax purposes
provided it is commercially justifiable. There may be a tension in this allocation between assets providing a useful cost base for income tax purposes and the stamp duty payable on the acquisition.
Although there are no specific income tax rules for allocating the purchase price among the various assets purchased, the market value consideration provisions in the CGT rules in effect arguably permit the ATO to determine an arm’s length transfer price different from that allocated to the asset by the parties.
Additionally, earn-out purchase price mechanisms are commonly used in asset deals where the value of the business asset is uncertain. Broadly, under these mechanisms, as proceeds for the sale of a target’s business assets, the seller receives a lump sum payment plus a right to future payments that are contingent on the performance of the business (i.e. earn-out right). See ‘Recent developments’ for discussion of recently enacted changes affecting earn-out rights.
Goodwill paid for a business as a going concern generally cannot be deducted or amortized.
Therefore, the buyer may wish to have the purchase and sale agreement allocate all or most of the purchase price to the tangible assets to be acquired, thus reducing or eliminating any element of the purchase price assigned to goodwill. However, the lower price paid for goodwill also represents its cost base for CGT purposes, so this may increase the CGT exposure of the buyer in any subsequent sale. The impact on stamp duty liabilities should also be considered.
Most tangible assets may be depreciated for tax purposes, provided they are used, or installed ready for use, to produce assessable income. Rates of depreciation vary depending on the effective life of the asset concerned.
Capital expenditure incurred in the construction, extension or alteration of a building that is to be used to produce income may be depreciated for tax purposes using the straight-line method, normally at the rate of 2.5 percent per year. Entitlement to this capital allowance deduction usually accrues to the building’s current owner or, in certain cases, a lessee or quasi-ownership right holder, even though the they
may not be the taxpayer that incurred the construction costs. The entitled party continues to write off the unexpired balance of the construction cost.
An important consideration in any acquisition of Australian assets or shares in an Australian company that joins a pre-existing tax consolidated group is that, as part of the pushdown of the purchase price, depreciable assets can have their tax cost base reset to a maximum of their market value. In this scenario, any buildings acquired do not have their amortizable cost base increased, even though the tax cost base of the asset may be reset to a higher value. Capital allowances for expenditure on these assets are generally capped at 2.5 percent per year of the original construction
cost, regardless of the market value of the asset. The reset tax cost base of these assets is only relevant on a future disposal of the asset.
On the disposal of depreciable plant and equipment, the excess of the market value over the tax written-down value for each item is included in the seller’s assessable income. Conversely, where the purchase price is less than the tax written-down value, the difference is an allowable deduction to the seller.
Relatively few payments giving rise to intangible assets may be amortized or deducted for tax purposes. Currently, the main types of intangible assets that may be deducted or amortized are:
In this context, a ‘taxable purpose’ broadly means for the purpose of producing assessable income in Australia. For example, expenditure incurred in setting up a new foreign subsidiary that will produce dividend income that is exempt from Australian tax would not be considered as related to carrying on a business for a taxable purpose.
The R&D tax incentive allows a 40 percent R&D tax offset for companies with turnover of AUD20 million or more. A 45 percent refundable tax offset applies for smaller companies/groups.
Tax losses and franking (imputation credits) are not transferred as a result of an asset acquisition. The cost of depreciable assets is generally allocated as discussed earlier. However, a number of other matters must be considered:
Foreign resident capital gains withholding tax
A buyer that acquires certain Australian assets from a seller that is a relevant foreign resident may pay up to 12.5 percent of the purchase price to the Commissioner of Taxation. The buyer must withhold this amount from the purchase price paid to the seller. This is a non-final withholding tax and is available as a refundable tax offset to the seller.
The obligation applies to the acquisition of an asset that is:
Certain transactions are exempt from the withholding obligations, including transactions involving TARP (and certain indirect Australian real property interests) valued at less
than AUD750,000 and transactions conducted through an approved stock exchange.
Further, no obligation is imposed where the seller obtains a clearance certificate from the Commissioner of Taxation or for indirect interests only where the seller has made a declaration about their residency status or the nature of the interest in their asset. The amount withheld may be varied, including to nil, where the seller makes appropriate applications to the Commissioner by the seller.
Foreign resident capital gains withholding tax applies in relation to acquisitions on or after 1 July 2016.
Value added tax
Goods and services tax, the Australian equivalent of valued added tax (VAT), applies to ‘taxable supplies’ (both goods and services), currently at a rate of 10 percent.
Disposals of assets have varying GST implications, depending on the nature of the transaction. If the sale of assets does not fall within the GST-free going concern exemption, the GST implications arising on the disposal of each asset need to be determined. A sale of assets is likely to be taxable, depending on the assets’ nature.
For example, the disposal of trading stock, goodwill and intellectual property is normally treated as a taxable supply.
A transfer of debtors is an input taxed (i.e. exempt) supply, and the GST treatment on the transfer of real property depends on the nature of the property. Commercial property is generally a taxable supply (but may be GST-free subject to meeting certain criteria), while residential property depends on whether it is ‘new’ (taxable) or second-hand (input taxed). Farmland is taxable but may be GST-free, subject to satisfying certain criteria.
The availability of input tax credits (GST credits) to the buyer of a taxable supply of assets depends on how the buyer intends or actually uses those assets. Generally, full credits are available where the buyer intends to use the assets to make taxable or GST-free supplies. However, such credits may not be available where the assets are to be used to make input- taxed supplies (e.g. financial supplies or residential leasing supplies). Where full credits are not available, reduced credits (equivalent to 75 or 55 percent) may be available subject to certain criteria.
The stamp duty implications of a transfer of assets depend on the nature and location (by Australian state and territory) of the assets transferred. Stamp duty is imposed by each state and territory of Australia on the transfer of certain assets. Each jurisdiction has its own revenue authority and stamp duty legislation. Exemptions, concessions and stamp duty rates differ substantially among the Australian states and territories.
The assets to which stamp duty may apply in a typical acquisition of an Australian business include land and buildings (including leasehold land and improvements), chattels, debts, statutory licenses, goodwill and intellectual property. The specific types of assets subject to duty differ among the jurisdictions.
All states and territories, except Queensland, Western Australia and the Northern Territory, have abolished stamp duty on the transfer of non-real business assets, such as goodwill and intellectual property.
The maximum rates of duty range from 4.5 to 5.95 percent on the greater of the GST-inclusive consideration and the gross market value of the dutiable property. Additional foreign buyer surcharge duty applies for acquisitions of residential land in some jurisdictions.The buyer generally is liable to pay this duty.
Stamp duty can make reorganizations expensive. For this reason, it is often important to establish the optimum structuring of asset ownership at the outset to avoid further payments of duty on subsequent transfers.
However, most jurisdictions provide relief from duty for certain reconstructions within at least 90 percent-owned corporate groups. Such relief is subject to a number of conditions that vary among the jurisdictions, including certain pre-transaction and post-transaction association requirements for group members.
The exemption is not automatic. A formal application is required to be lodged with the relevant revenue authorities.
Purchase of shares
Non-residents are not subject to CGT on the disposal of shares in Australian companies unless the company is considered to have predominantly invested in real property.
This exemption does not protect non-resident investors who hold their investments in Australian shares on revenue account. Broadly, the acquisition of shares with the primary intention of future re-sale, whether by trade sale or initial public offering (IPO), could be characterized as a revenue
transaction, even though the sale would occur several years in the future. In this respect, the ATO has made determinations that affect Australian investments by resident and non- resident private equity funds.
Australia’s tax treaties usually apply so that non-residents disposing of shares on revenue account are not subject to Australian tax if they do not have a PE in Australia. However, this can be overridden by Australia’s general anti-avoidance rule (GAAR; also known as ‘Part IVA’).
As noted earlier in this report, a 12.5 percent, non-final WHT applies to disposals by non-residents of certain Australian real property interests, which includes indirect real property interests.
Tax indemnities and warranties
In the case of negotiated acquisitions, it is usual practice in Australia for the buyer to request and the seller to provide indemnities or warranties as to any undisclosed taxation liabilities of the company to be acquired. The extent of the indemnities or warranties is a matter for negotiation.
Where the target company is a standalone company or the head company of an Australian tax consolidated group, carried forward tax losses may transfer along with the company, subject to transfer and utilization rules.
Where an Australian target company has carried forward tax losses, these generally continue to be available for recoupment only if there is greater than 50 percent continuity (with respect to dividends, capital and voting rights) in the beneficial ownership of the company. If this primary test is failed, as is usually the case in a takeover, the pre-acquisition losses are available for recoupment only if the Australian company, at all times during the year of recoupment, carries on the same business as it did immediately before the change in beneficial ownership of its shares.
This test is difficult to pass because it requires more than mere similarity in the businesses carried on. Its effect is that no new types of businesses or transactions may be entered into without the likely forfeiture of the losses, particularly in the case of an income tax consolidated group. As noted earlier in this report, the Australian government has proposed a second test in addition to the same business test. For losses incurred after 1 July 2015, the current same business test is expected to be relaxed to allow businesses to access past year losses where it has been conducting a ‘similar’ business at the relevant test times.
However, provided the transfer tests are satisfied, same business losses may be refreshed on acquisition by an income tax consolidated group. Given the potential uncertainty in this area, often a ruling is obtained from the tax authorities and/or detailed written tax advice is sought to confirm that the same- business test has historically been satisfied.
Similarly, no deduction for bad debts is available to the Australian company after its acquisition by the foreign entity unless there is either:
When the target company becomes a member of the buyer’s income tax consolidated group as a result of the transaction, the tax attributes of the company transfer the head company of the income tax consolidated group (i.e. tax losses, net capital losses, franking credits and foreign tax credits).
Broadly, these losses may be transferable to the acquirer where the target has satisfied the modified same business test for the 12 months prior to the acquisition.
Limitation of loss rules restrict the rate at which such losses can be deducted against the taxable income of the consolidated group, based on the market value of the loss- making company as a proportion of the market value of the consolidated group as a whole. This is often a complex area.
By contrast, where the target company is a subsidiary member of an Australian income tax consolidated group, the tax attributes of the company leaving the group are retained by the head company of the group and do not pass to the buyer with the entity transferred.
Crystallization of tax charges
Under the self-assessment tax regime, the ATO generally is subject to a limited review period of 4 years following the lodgment of the income tax return or business activity statement (except in the case of tax evasion or fraud).
To prevent pre-sale dividends from being distributed to reduce capital gains arising on sale of shares, the ATO has ruled that a pre-sale dividend paid by a target company to the seller shareholder is part of the seller shareholder’s capital proceeds for the share disposal (thereby increasing capital gain or reducing capital loss arising on the share sale), if the seller shareholder has bargained for the dividend in return for selling the shares.
This follows the High Court of Australia decision in Dick Smith.
In this case, the share acquisition agreement stipulated that a dividend would be declared on shares prior to transfer and the buyer was to fund the dividend (with the purchase price
calculated by deducting the dividend amount). The court found the value of the dividend formed part of the consideration for the dutiable transaction for stamp duty purposes.
Complex anti-avoidance provisions also apply in this area.
GST (VAT) does not apply to the sale of shares. The supply of shares is a ‘financial supply’ and input taxed if sold by a seller in Australia to a buyer in Australia. However, if the shares are sold to, or bought from, a non-resident that is not present in Australia, the sale may be a GST-free supply (i.e. zero rated).
While GST should not apply in either event, the distinction between an input taxed supply and a GST-free supply is important from an input tax credit-recovery perspective. Generally, full credits are not available for GST incurred on costs associated with making input taxed supplies, but full credits should be available for GST-free supplies.
All states and territories impose landholder duty on ‘relevant acquisitions’ of interests in companies or unit trusts that are ‘landholders’. The tests for whether an entity is a landholder differ among the jurisdictions. In some jurisdictions, landholder duty is also imposed on certain takeovers of listed landholders.
Landholder duty is imposed at rates of up to 5.95 percent of the value of the land (land and goods in some states) held by the landholder. A concessional rate of duty applies to takeovers of listed landholders in some states (the concessional rate is 10 percent of the duty otherwise payable). Additional foreign buyer surcharge duty applies on acquisitions of interests in companies or unit trusts which directly or indirectly hold residential land.
The acquirer generally is liable to pay stamp duty, but in some jurisdictions the landholder and acquirer are jointly and severally liable for stamp duty.
It is not possible to obtain a clearance from the ATO giving assurances that a potential target company has no arrears of tax or advising as to whether or not it is involved in a tax dispute.
Where the target company is a member of an existing income tax consolidated group or GST group, the buyer should ensure the target company is no longer liable for any outstanding tax liabilities of the existing group (e.g. if the head company of that group defaults). The buyer should ensure that the target company:
The ATO has a detailed law administration practice statement that sets out its approach to recovering outstanding group tax liabilities from an exiting company. The buyer should bear this in mind when assessing the tax position of the target company.
After the choice between the purchase of shares or assets has been made, the second decision concerns the vehicle to be used to make the acquisition and, as a consequence, the position of the Australian operations in the overall group structure. The following vehicles may be used to acquire the shares or assets of the target:
The structural issues in selecting the acquisition vehicle can usually be divided into two categories:
Local holding company
It is common to interpose an Australian holding company between a foreign company (or third-country subsidiary) and an Australian subsidiary. The Australian holding company may act as a dividend pool because it can receive dividends free of further Australian tax and re-invest these funds
in other group-wide operations. It is common to have an Australian holding company act as the head entity of an income tax consolidated group.
Foreign parent company
Where the foreign country of the parent does not tax capital gains, the foreign parent may wish to make the investment directly. Non-residents are not subject to CGT on the disposal of shares in Australian companies unless the company is considered to have predominantly invested in real property (as discussed earlier). However, while Australian withholding tax (WHT) on interest is generally 10 percent for treaty and non- treaty countries, the WHT on dividends is commonly limited to 15 percent on profits that have not been previously taxed (referred to as ‘unfranked’ or ‘partly franked’ dividends; see ‘Dividend imputation rules’ below), but only when remitted to treaty countries. (Australia’s more recent treaties may reduce this rate further if certain conditions are satisfied).
The dividend WHT rate is 30 percent for unfranked dividends paid to non-treaty countries. The tax on royalties paid from Australia is commonly limited to 10 percent for treaty countries (30 percent for non-treaty countries). Therefore,
an intermediate holding company in a treaty jurisdiction with lower WHT rates may be preferred, particularly if the foreign parent is unable to fully use the WHT as a foreign tax credit in its home jurisdiction (subject to limitation on benefit clauses in tax treaties and the application of the Australian GAAR).
Non-resident intermediate holding company
If the foreign country imposes tax on capital gains, locating the subsidiary in a third country may be preferable. The
third-country subsidiary may also sometimes achieve a WHT advantage if the foreign country does not have a tax treaty with Australia.
However, some treaties contain anti-treaty shopping rules. As noted, the ATO has ruled in a taxation determination that the Australian domestic GAAR would apply to inward investment private equity structures designed with the dominant purpose of accessing treaty benefits. The taxation determination demonstrates the ATO’s enhanced focus on whether investment structures (e.g. the interposition of holding companies in particular countries) have true commercial substance and were not designed primarily for tax benefits.
A key consideration in this regard is to ensure the payee beneficially owns the dividends or royalties. Beneficial entitlement is a requirement in most of Australia’s treaties.
Australia has signed the multilateral instrument (MLI) and will adopt the principal purpose test (PPT) within its tax treaties where the treaty partner jurisdiction has also elected to adopt the PPT.
Forming a branch may not seem to be an option where shares rather than assets are acquired. This is because, in effect,
the foreign entity has acquired a subsidiary. However, if the branch structure is desired but the direct acquisition of assets is not possible, the assets of the newly acquired company may be transferred to the foreign company post-acquisition, effectively creating a branch. Great care needs to be taken when creating a branch from a subsidiary in this way, including consideration of the availability of CGT rollover relief, potential stamp duties and the presence of tax losses.
However, a branch is not usually the preferred structure for the Australian operations. Many of the usual advantages of a branch do not exist in Australia:
The branch structure has one main potential advantage. Where the Australian operations are likely to incur losses, in some countries, these may be offset against domestic profits. However, the foreign acquirer should consider that deductions for royalties and interest paid from branches to the foreign head office, and for foreign exchange gains and losses on transactions between the branch and head office, are much more doubtful than the equivalents for subsidiaries, except where it can be shown that the payments are effectively being made to third parties.
The only provisions that might restrict the deduction for a subsidiary are the arm’s length pricing rules applicable to international transactions and the thin capitalization provisions.
Reorganizations and expansions in Australia are usually simpler where an Australian subsidiary is already present.
An Australian subsidiary would probably have a much better local image and profile and gain better access to local finance than a branch. The repatriation of profits may be more flexible for a subsidiary, as it may be achieved either by dividends
or by eventual capital gain on sale or liquidation. This can be especially useful where the foreign country tax rate is greater than 30 percent; in such cases, the Australian subsidiary may be able to act as a dividend trap. Finally, although Australian CGT on the sale of the subsidiary’s shares might be avoided, this is not possible on the sale of assets by a branch, which is, by definition, a PE.
Two other frequently mentioned advantages of subsidiaries are limited liability (i.e. inaccessibility of the foreign company’s funds to the Australian subsidiary’s creditors) and possible requirements for less disclosure of foreign operations than
in the branch structure. However, both these advantages can also be achieved in Australia through the use of a branch, by interposing a special-purpose subsidiary in the foreign country as the head office of the branch.
Where the acquisition is to be made together with another party, the parties must determine the most appropriate vehicle for this joint venture. In most cases, a limited liability company is preferred, as it offers the advantages of incorporation (separate legal identity from that of its
members) and limited liability (lack of recourse by creditors of the Australian operations to the other resources of the foreign company and the other party). Where the foreign company has, or proposes to have, other Australian operations, its shareholding in the joint venture company is usually held by
a separate wholly owned Australian subsidiary, which can be consolidated with the other operations.
It is common for large Australian development projects to be operated as joint ventures, especially in the mining industry. Where the foreign company proposes to make an acquisition in this area, it usually must decide whether to acquire an interest in the joint venture (assets) or one of the shares of the joint ventures (usually, a special-purpose subsidiary).
This decision and decisions relating to the structuring of the acquisition can usually be made in accordance with the preceding analysis.
Trusts, particularly Australian unit trusts, are popular investment structures in Australia. Under a trust arrangement, the legal owner (the trustee) holds the property ‘in trust’
for the benefit of the beneficial owners (the unit holders). In essence, the trust separates the legal and beneficial ownership of the property.
Depending on the objectives for entering into the arrangement, trusts can be established in a number of different forms, including discretionary trusts and unit trusts.
In a discretionary trust (or family trust), the beneficiaries do not have a fixed entitlement or interest in the trust funds. The trustee has the discretion to determine which of the beneficiaries are to receive the capital and income of the trust and how much each beneficiary is to receive. The trustee does not have a complete discretion. The trustee can only distribute to beneficiaries within a nominated class as set out in the terms of the trust deed.
A unit trust is a trust in which the trust property is divided into a number of defined shares, or ‘units’. The beneficiaries subscribe for the units in much the same way as shareholders in a company subscribe for shares. Some benefits on the use of a unit trust over a discretionary trust and company include:
To the extent an Australian trust’s income is sourced in Australia, corresponding distributions to non-resident unit holders are generally subject to WHT. The rate of tax and method of payment depends on whether the income represents:
Certain managed investment trusts are able to elect into the attribution MITs (AMIT) regime. The AMIT regime: allows AMITs to use a simplified attribution method of tax in relation to distribution of income
The AMIT rules have effect from 1 July 2016, with the option of early adoption from 1 July 2015.
Where a buyer uses an Australian holding company in an acquisition, the form of this investment must be considered. Funding may be by way of debt or equity. A buyer should be aware that Australia has a codified regime for determining the debt or equity classification of an instrument for tax purposes. This is, broadly, determined on a substance over form basis.
In the context of equity funding, it will also need to be considered whether the issue of shares or units in a landholder may trigger landholder duty (see ‘Stamp duty’ above).
Generally, interest is deductible for income tax purposes (subject to commentary below), but dividends are not. Additionally, the non-interest costs incurred in borrowing money for business purposes, such as the costs of underwriting, brokering, legal fees and procurement fees, may be generally written-off and deducted over the lesser of 5 years or the term of the borrowing.
Whether an instrument is debt or equity for tax purposes is a key consideration in implementing a hybrid financing structure, discussed later.
Deductibility of interest
Interest payable on debt financing is generally deductible in Australia, provided the borrowed funds are used in the assessable income-producing activities of the borrower or to fund the capitalization of foreign subsidiaries. No distinction is made between funds used as working capital and funds used to purchase capital assets.
The major exceptions to this general rule are as follows:
The thin capitalization rules apply to inbound investing entities with respect to all debt that gives rise to tax deductions.These rules deny interest deductions where the average amount
of debt of a company exceeds the safe harbor debt amount, the alternative arm’s length debt amount and, in certain circumstances, the worldwide debt amount of the company.
The safe harbor debt amount is essentially 60 percent of the value of the assets of the Australian company, which is a debt-to-equity ratio of 1.5:1. For financial institutions, this
ratio is increased to 16:1. The arm’s length debt amount is the amount of debt that the Australian company could reasonably be expected to have borrowed from a commercial lending institution dealing at arm’s length.
The thin capitalization rules, subject to additional safe harbors, apply to Australian groups operating overseas (outbound investing entities) in addition to Australian entities that
are foreign-controlled and Australian operations of foreign multinationals.
As the thin capitalization rules apply regarding all debt that gives rise to tax deductions, no distinction is made between connected and third-party financing or between local and foreign financing.
Withholding tax on debt
Australia generally imposes WHT at 10 percent on all payments of interest, including amounts in the nature of interest (e.g. deemed interest under hire purchase agreements or discounts on bills of exchange). The 10 percent rate applies to countries whether or not Australia has concluded a tax treaty with the country in question. However, the applicable interest WHT rate may be reduced to 0 percent on certain interest payments to financial institutions by some of Australia’s more recent tax treaties (including those with the US, UK, France and Japan). Few techniques to eliminate WHT on interest are available.
Interest paid on widely held debentures issued outside Australia for the purpose of raising a loan outside Australia is exempt from WHT where the interest is paid outside Australia. As Australian WHT cannot usually be avoided, the acquisition should be planned to ensure that credit is available in the country of receipt.
Australia does not impose WHT on franked dividends. Australia imposes WHT on the unfranked part of a dividend at a rate that varies from 15 percent, the usual rate in Australia’s treaties, to 30 percent for all non-treaty countries. In the case of the US and UK treaties, the rate of dividend withholding may be as low as 0 percent.
Australia is renegotiating its tax agreements with its preferred trading partners with a view to extending the 0 percent concessional WHT rate.
Checklist for debt funding
Equity is another alternative for funding an acquisition. This may take the form of a scrip-for-scrip exchange whereby the seller may be able to defer any gain, although detailed conditions must be satisfied.
The main conditions for rollover relief include:
Additional conditions apply where both the target company and the buyer are not widely held companies or where the selling shareholder, target company and buyer are commonly controlled.
Where the selling shareholders receive only shares from the acquiring company (the replacement shares) in exchange for the shares in the target company (the original shares) and elect for scrip-for-scrip rollover relief, they are not assessed on any capital gain on the disposal of their original shares at the time of the acquisition. Any capital gain on the shares is taxed when they dispose of their replacement shares in the acquiring company. Where the sellers receive both shares and other consideration (e.g. cash), only partial CGT rollover is available. The cost base of the original shares is apportioned on a reasonable basis between the replacement shares and the other consideration, and the selling shareholders are
subject to CGT at the time of the share exchange to the extent that the value of the other consideration received exceeds the allocated portion of the original cost base of the original shares.
Where the selling shareholders acquired their original shares prior to 20 September 1985 (pre-CGT shareholders), subject to transitional provisions, the selling shareholders are not subject to CGT on the disposal of the original shares, so they do not require rollover relief. However, such shareholders lose their pre-CGT status, so they are subject to CGT on any increase in the value of the replacement shares between
the acquisition and subsequent disposal of the replacement shares. The cost base of the replacement shares that a pre- CGT shareholder receives is the market value of those shares at the time of issue.
Provided the target company or buyer is a widely held company, the cost base of the shares in the target company that are acquired by the buyer is the market value of the target company at the date of acquisition. The CGT cost base of the target shares acquired by the buyer is limited if the selling shareholders’ cost base in the target company (i.e. no step-up to market value is available) if:
Generally, a company is widely held if it has at least 300 members. Special rules prevent a company from being treated as widely held if interests are concentrated in the hands of 20 or fewer individuals.
Demerger relief rules are also available to companies and trusts where the underlying ownership (at least 80 percent) of the divested membership interests in a company is maintained on a totally proportionate basis. These rules are not available to membership interests held on revenue account. In an M&A context, safeguards in the anti-avoidance provisions prevent demergers from occurring where transactions have been pre-arranged to effect change in control.
The demerger relief available is as follows:
Dividend imputation rules
Australia operates an imputation system of company taxation through which shareholders of a company gain relief against their own tax liability for taxes paid by the company.
Resident companies must maintain a record of the amount of their franking credits and franking debits to enable them to ascertain the franking account balance at any point in time, particularly when paying dividends. This franking account is a notional account maintained for tax purposes and reflects the amount of company profits that may be distributed as franked dividends.
Detailed rules determine the extent to which a dividend should be regarded as franked. A dividend may be partly franked and partly unfranked. Generally, a dividend is franked where the distributing company has sufficient taxed profits from which to make the dividend payment and the dividend is not sourced from the company’s share capital.
Dividends paid to Australian resident shareholders carry an imputation rebate that may reduce the taxes payable on other income received by the shareholder. Additionally, shareholders who are Australian resident individuals and complying superannuation funds can obtain a refund of excess franking credits.
For non-resident shareholders, however, franked dividends do not result in a rebate or credit but instead are free of dividend WHT (to the extent to which the dividend is franked).
No dividend WHT is levied on dividends paid by a resident company to its resident shareholders. Income tax assessed to an Australian-resident company generally results in a credit to that company’s franking account equivalent to the amount of taxable income less tax paid thereon.
The franking account balance is not affected by changes in the ownership of the Australian company. As non-resident companies do not obtain franking credits for tax paid, an Australian branch has no franking account or capacity to frank amounts remitted to a head office.
Due to Australia’s thin capitalization regime, a buyer usually finances through a mix of debt and equity and may consider certain hybrid instruments. Australia does not impose stamp duty on the issue of new shares in any state, and there is no capital duty. However, it should be considered whether landholder duty may be triggered on the issue of shares in a landholder.
As noted earlier in this report, the characterization of hybrids (e.g. convertible instruments, preferred equity instruments and other structured securities) as either debt or equity is governed by detailed legislative provisions that have the overriding purpose of aligning tax outcomes to the economic substance of the arrangement.
These provisions contain complex, interrelated tests that, in practice, enable these instruments to be structured such that subtle differences in terms can decisively alter the tax characterization in some cases. Examples of terms that can
affect the categorization of an instrument include the term of the instrument, the net present value of the future obligations under the instrument and the degree of contingency/certainty surrounding those obligations.
Additionally, the debt/equity characterization of hybrid instruments under the Australian taxation law and that under foreign taxation regimes have been subject to enhanced scrutiny by the ATO and foreign revenue authorities. In this context, consideration should be given to the application of the proposed hybrid mismatch tax regime and an integrity provision that deems an interest from an arrangement that funds a return through connected entities to be an equity interest under certain circumstances (and thus causes returns to be non-deductible).
The careful structuring of hybrid instruments is a common focus in Australian business finance. In some cases, this focus extends to cross-border hybrids, which are characterized differently in different jurisdictions. The proposed changes for hybrid mismatches discussed above may remove the previous benefits from the differences in classifications between jurisdictions.
Historically, a complex specific statutory regime has applied that, broadly, seeks to tax discounted securities on an accruals basis. This treatment is essentially preserved under the Taxation of Financial Arrangements (TOFA) provisions, which aim to align the tax and accounting treatment of financial arrangements. Note that interest WHT at 10 percent may apply when such a security is transferred for more than its issue price.
Where settlement is deferred on an interest-free basis, any CGT liability accruing to the seller continues to be calculated from the original disposal date and on the entire sale proceeds. Furthermore, where interest is payable under the settlement arrangement, it does not form part of the cost base. Rather, it is assessable to the seller and deductible to the buyer to the extent that the assets or shares are capable of producing assessable income, other than the prospective capital gain on resale. See ‘Recent developments’ for discussion of recent changes affecting earn-outs.
Concerns of the seller
Non-residents generally are exempt from CGT on the disposal of Australian assets held on capital account, including a disposal of shares in a company or interests in a trust. The
key exception is where a non-resident has a direct or indirect interest in real property, which is defined broadly to include leasehold interests, fixtures on land and mining rights. The provisions that seek to apply CGT in these circumstances
are extremely broad and carry an extraterritorial application in that non-residents disposing of interests in upstream entities that are not residents of Australia may also be subject to CGT. Similarly, stamp duty is potentially payable by a buyer in these circumstances.
The CGT exemption for non-residents does not apply to assets used by a non-resident in carrying on a trade or business wholly or partly at or through a PE in Australia.
The ATO has also historically argued that disposals by overseas private equity funds may have an Australian source and be taxable on revenue account and therefore not benefit from the exemption for non-residents on capital gains on Australian shares in such cases, the source of the gain will be critical in determining Australian taxing rights.
Where a purchase of assets is contemplated, the seller’s main concern is likely to be the CGT liability arising on assets acquired after 19 September 1985. Where the sale is of a whole business or a business segment that was commenced prior to CGT, the seller normally seeks to allocate as much
of the price as possible to goodwill. Payment for goodwill in these circumstances is generally free from Australian income tax, unless there has been a majority change in underlying ownership of the assets.
The CGT liability may also be minimized by favorably spreading the overall sale price of the assets in such a way that above-market prices are obtained for pre-CGT assets and below-market prices obtained for post-CGT assets. Such an allocation may be acceptable to the buyer because it may not substantially alter the CGT on sales.
However, the prices for all assets should be justifiable; otherwise, the ATO may attack the allocation as tax avoidance or non-arm’s length. The buyer would also be keen to review the allocation, with particular reference to those assets that have the best prospects for future capital gains.
The seller is concerned about the ability to assess the amount of depreciation recouped where depreciable assets (other than buildings) are sold for more than their tax written-down value.
The excess of consideration over the tax written-down value is included in assessable income in the year of sale as a balancing adjustment and taxed according to the normal income tax rules. Where a depreciable building is sold, no such balancing adjustment is generally made. Where a depreciable asset (other than a building) is sold for less than its tax written-down value, the loss is deductible as a balancing deduction in the year of sale. This balancing deduction is not treated as a capital loss.
Strictly speaking, the seller is also required to include as assessable income the market value of any trading stock sold, even though a different sale price may be specified in the sale agreement. As noted earlier, the ATO’s usual practice is to accept the price paid as the market value.
Stamp duty is payable by the buyer but inevitably affects the price received by the seller.
GST considerations are also relevant to the seller. As noted above, the sale of assets may be a taxable supply unless the sale qualifies as a GST-free supply of a going concern. Where the going concern exemption is not available, the types of assets being transferred need to be considered individually to determine the applicable GST treatment. While the sale and purchase of shares does not attract GST, full input tax credits may not be available for GST incurred on transaction costs associated with the sale or purchase. For some
costs, a reduced input tax credit may be available for certain prescribed transaction costs.
Where the seller company has carried forward losses, the sale of business assets does not ordinarily jeopardize its entitlement to recoup those losses. However, the seller company may be relying on satisfaction of the same business test (see ‘Tax losses’ above) to recoup the losses (e.g. due
to changes in the ownership of the seller since the year(s) of loss). Care is then required, as the sale of substantial business assets could jeopardize satisfaction of this test and lead to forfeiture of the losses.
Where a purchase of shares is contemplated, the seller may have several concerns, depending on the seller’s situation. Potential concerns include the following:
Corporations Act 2001 and IFRS
The Australian Corporations Act 2001 (Corporations Act) governs the types of company that can be formed, ongoing financial reporting and external audit requirements, and the repatriation of earnings (either as dividends or returns of capital).
Australian accounting standards issued by the Australian Accounting Standards Board (AASBs) are effectively the equivalent of International Financial Reporting Standards (IFRS). The acquisition of a business, regardless of whether it is structured as a share acquisition or asset acquisition, is accounted for using purchase under business combination accounting in accordance with AASB 3 Business Combinations (AASB 3).
Under purchase business combination accounting, all identifiable assets and liabilities are recognized at their respective fair values on the date that control of the business is obtained. Identifiable assets may include intangible assets that are not recognized on the target’s balance sheet. These intangible assets may have limited lives and require amortization.
In a business combination, liabilities assumed include contingent liabilities, which are also recognized on the balance sheet at their estimated fair value.
The difference between consideration paid (plus the balance of non-controlling interest at acquisition date and the acquisition date fair value of the acquirer’s previous interest in the acquire) and the ownership interest in the fair value of acquired net assets represents goodwill. Goodwill is not amortized but is tested for impairment annually. Any negative goodwill impairment is recognized immediately in the income statement.
Transaction costs associated with business combinations occurring in fiscal years commencing on or after 1 July 2009 are expensed as incurred. Acquisition-related costs are generally expensed as incurred with the exception of costs relating to the costs of issuing debt or equity securities.
The reorganization of businesses under the control of the same parent entity is outside the scope of AASB 3 accounting standards. Typically, these such restructurings occur at book values, with no change in the carrying value of reported assets and liabilities and no new goodwill. Again, transaction costs associated with these common control transactions are generally expensed as incurred.
Generally, all substantial Australian companies have an obligation to file audited financial statements with the Australian Securities and Investments Commission (ASIC). ASIC monitors compliance with the Corporations Act. These financial statements are publicly available.
Filing relief may be available for certain registered foreign companies and Australian entities by taking advantage of class order relief granted by ASIC.
Payment of dividends
The payment of dividends by companies to their shareholders is governed by the Corporations Act and the relevant company’s constitution in conjunction with the accounting standards and taxation law.
Under the Corporations Act, a company currently cannot pay a dividend to its shareholders unless its assets exceed its liabilities immediately before the dividend is declared and the excess is sufficient for the payment of the dividend. The dividend payment must also be fair and reasonable to shareholders as a whole and must not materially prejudice the company’s ability to pay its creditors.
The above requirements replaced the former profits-based test, which provided that a company could only pay a dividend out of profits. Currently, however, it is ambiguous whether
a dividend declared other than out of profits (e.g. by relying on the net assets test only) would constitute an unlawful reduction of capital (as the Corporations Act prescribes a
procedure that must be followed to effect a capital reduction). As a result, companies need to ensure all legal requirements are met and avoid dividend traps (i.e. the inability to stream profits to the ultimate shareholder due to insufficient profits and assets within a chain of companies). Note that for income tax purposes, the ATO’s view is that a dividend needs to be paid out of profits in order for a shareholder to obtain a credit for the tax paid by the company.
The assessment of whether the applicable requirements have been met (including in relation to available profits) for the declaration of a dividend is determined on a standalone,
legal-entity-by-legal-entity basis, not the consolidated position of the corporate group. This entity-by-entity assessment requires planning to avoid dividend traps. Appropriate pre- acquisition structuring helps minimize this risk. Australian law does not have a concept of par value for shares. As mentioned above, the Corporations Act prescribes how share capital
can be reduced, including restrictions on the redemption of redeemable preference shares.
Where the buyer owns other Australian companies and has elected to form an Australian income tax consolidated group, the target company becomes a subsidiary member on acquisition. Only wholly owned subsidiaries can join an Australian tax consolidated group.
Issues that arise as a result of the tax-consolidation regime for share acquisitions are as follows:
Australia has a complex regime for the taxation of international related-party transactions. These provisions specify significant contemporaneous documentation and record-keeping requirements.
The transfer pricing rules focus on determining an arm’s length profit allocation and provide the Commissioner of Taxation with broad powers of reconstruction in respect of international related-party dealings.
General anti-avoidance rule
The GAAR (Part IVA) can apply where:
If the GAAR applies to a scheme, the Commissioner may cancel the tax benefit, make compensating adjustments and impose substantial penalties.
Dual residency is unlikely to give rise to any material Australian tax benefits and could significantly increase the complexity of any transaction.
Foreign investments of a local target company
Where an Australian target company holds foreign investments, the question arises as to whether those investments should continue to be held by the Australian target company or whether it would be advantageous for a sister or subsidiary company of the foreign acquirer to hold the foreign investments.
Australia has a comprehensive international tax regime that applies to income derived by controlled foreign companies (CFC). The objective of the regime is to place residents who undertake certain passive or related-party income earning activities offshore on the same tax footing as residents who invest domestically.
Under the current CFC regime, an Australian resident is taxed on certain categories of income derived by a CFC if the taxpayer has an interest in the CFC of 10 percent or more. A CFC is broadly defined as a foreign company that is controlled by a group of not more than five Australian residents whose aggregate controlling interest in the CFC is not less than 50 percent. However, a company may also be a CFC in certain circumstances where this strict control test is not met but the foreign company effectively is controlled by five or fewer Australian residents.
Taxpayers subject to the current CFC regime must calculate their income by reference to their interest in the CFC.The income is then attributed to the residents holding the interest in the CFC in proportion to their interests in the company — that is, the Australian resident shareholders are subject to tax in Australia on their share of the attributable earnings of the CFC.
Any income of a CFC that has been subjected to foreign or Australian tax can offset that amount with a credit against Australian tax payable. Excess credits may be carried forward for up to 5 income years. The income of a CFC generally is not attributed where the company is predominantly involved in actively earning income.
Given the comprehensive nature of the CFC regime and the few exemptions available, the Australian target company may not be the most tax-efficient vehicle for holding international investments. However, due to a recent series of reforms relating to conduit relief, Australia is now a favorable intermediary holding jurisdiction. In particular, Australia
now has broad participation exemption rules that enable dividend income sourced from offshore subsidiaries and capital profits on realization of those subsidiaries to be paid to non-resident shareholders free from domestic income tax or non-resident WHT.
Foreign investment into Australia
Australia has a foreign investment review framework that requires certain proposals by foreign persons to be approved by Australia’s Foreign Investment Review Board (FIRB) before they are implemented. The package of legislative reforms
that commenced on 1 December 2015 represents the most significant changes to Australia’s foreign investment regime since it was introduced over 40 years ago. The primary objectives of the reforms are to provide stronger enforcement and a better-resourced system with clearer rules for foreign investors. Some of the key changes include stricter penalties for contravening the foreign investment framework, new fees on foreign investment applications and the ATO’s enlistment in ensuring compliance and enforcement of critical aspects of the regime.
Determining whether an application for approval is required to be made to FIRB depends on a range of factors that must be carefully assessed case-by-case. These factors include the type of investor, the type of investment, the industry sector in which the investment will be made and the value of the investment.
To avoid delays, it is crucial for foreign investors to consider at an early stage of any transaction whether approval under Australia’s foreign investment regime will be required.
Advantages of asset purchases
Disadvantages of asset purchases
Advantages of share purchases
Disadvantages of share purchases
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