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The 2023–24 financial year has seen several tax developments with important structuring implications for cross-border mergers and acquisitions.
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Recent tax developments in the M&A landscape
04 October 2024
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Here we’ll cover those changes including the expanded scope of CGT on disposals by foreign residents, the removal of the de minimis threshold on the application of the foreign resident capital gains withholding tax, and the associated new ATO notification. We’ll also touch on Australia’s new thin capitalisation rules, which move from assets-based tests to earnings-based tests, and new developments and guidance on royalties, royalty withholding tax, and the diverted profits tax.
CGT on disposals by foreign residents
Under the current CGT regime, foreign residents are generally only taxed on disposals of direct and indirect interests in Australian real property, mining, quarrying and prospecting rights where the minerals, petroleum or quarry materials are located in Australia, and assets used in carrying on a business in Australia through a permanent establishment in Australia. Disposals of rights or options to acquire any of the above by foreign residents are also taxed.
From 1 July 2025, disposals of assets with a close economic connection to Australian land will be subject to CGT. Moreover, the principal asset test – which determines whether the value of the membership interests are primarily driven by Australian real property interests – will shift from a point-in-time test (being the time of disposal) to a test that covers a 365-day period. These changes mean that foreign residents planning to sell membership interests can no longer avoid CGT by selling down real property interests in advance.
The expanded CGT base will now capture, among other things, indirect interests in leases or licences to use land in Australia, Australian water entitlements, and infrastructure and machinery installed on Australian land such as energy, telecommunications and transport infrastructure. Foreign residents will need to account for Australian CGT exposure when planning disposals of both existing and future investments in Australia.
Changes to foreign resident capital gains withholding tax
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The rate of foreign resident capital gains withholding tax (FRCGWHT) will increase from 12.5 per cent to 15 per cent while the de minimis threshold will be reduced from $750,000 to $0. The change will apply to transactions on and from 1 January 2025.
Foreign residents disposing of shares and other membership interests exceeding $20 million will be required to notify the ATO before the transaction. The policy objective is to improve oversight and compliance with the FRCGWHT rules.
For investors, these changes mean the removal of the de minimis threshold, with the consequence that any time a foreign resident disposes of shares or other membership interests, the purchaser will be required to withhold 15 per cent of the sale proceeds if more than 50 per cent of the value of these interests are driven by Australian real property interests. In combination with the expanded CGT base for foreign residents, a much greater number of sales by foreign residents will now be subject to Australia’s CGT regime. The immediate tax burden will impact the cash flow of foreign residents, particularly where that capital was expected to be deployed elsewhere shortly after the sale.
Failure by a foreign vendor to notify the ATO, and obtain a receipt confirming the same, could result in the purchaser refusing to complete or delaying settlement. Sale contracts should contain new clauses to mitigate the risk of sales being delayed or abandoned.
New thin capitalisation rules
Australia’s new thin capitalisation rules will apply to income years commencing on or after 1 July 2023 for entities other than Australian deposit-taking institutions (ADIs) and other financial institutions. Under the new rules, these investors will have to apply earnings-based, rather than assets-based, tests to determine the maximum level of debt that they can carry.
The design of the new tests can further constrain the maximum amount of debt permissible for entities that are not part of a consolidated group. Under the fixed ratio test, an upstream entity cannot include dividends and franking credits in calculating its tax-EBITDA unless it held less than 10 per cent in the downstream entity. The upstream entity also cannot access the excess thin capitalisation capacity of a downstream entity (including any excess capacity of that entity carried forward up to 15 years) unless at least a 50 per cent interest is held directly. There is no ability to use excess thin capitalisation capacity if either entity applies the group ratio test.
The repeal of a provision that enabled deductions for interest incurred in capitalising or acquiring foreign entities has also been announced.
As of 1 July 2024, a new debt deduction creation rule applies before the new fixed ratio and group ratio tests. However, this rule does not apply where the third-party debt test is used. This rule denies deductions for debt expenses incurred in paying dividends to, returning capital to, and acquiring trading stock from, a related entity.
The rule will not apply to debt expenses incurred in subscribing for new shares issued by a company, in acquiring new tangible depreciating assets subject to satisfying certain conditions, in funding related party lending where only one entity has borrowed funds under a commercial arrangement and on-lends to an associate, or by ADIs, securitisation vehicles and certain qualifying insolvency remote special purpose entities.
For investors, these changes mean that related party financing used to fund Australian acquisitions by foreign residents will be curtailed under the new thin capitalisation rules. The new earnings-based ratios are likely to result in lower permissible debt capacities in the Australian market as earnings cannot be adjusted upwards as easily as assets, which may be revalued higher.
Entities in sectors that are likely to have carry-forward losses will also suffer from constraints on their debt capacity such as those in research and development, and capital-intensive industries. Furthermore, earnings-based ratios are likely to be subject to greater volatility year-on-year than assets-based ratios. Foreign investors would need to be extra diligent in managing their thin capitalisation exposure each year.
Acquisitions of less than 50 per cent of shares or other membership interests would be limited in their ability to be debt funded. Acquisitions of less than 50 per cent but greater than or equal to 10 per cent would be subject to even greater constraints.
The new debt deduction creation rule will impede common post-acquisition strategies, such as using related party debt to fund distributions or restructure the business.
Developments in royalties
A measure announced in the 2022-23 Commonwealth Budget to introduce an anti-avoidance rule preventing significant global entities (i.e., entities part of a group with annual global turnover of at least A$1 billion) that claim deductions for intangibles in low or no tax jurisdictions will be discontinued because the issue will be addressed by the Global Minimum Tax and Domestic Minimum Tax to be implemented by the Commonwealth government.
From 1 July 2026, significant global entities that have mischaracterised or undervalued royalty payments will be subject to new penalties.
In PepsiCo, Inc. v Commissioner of Taxation [2024] FCAFC 86, the Full Federal Court of Australian (FCAFC) ruled that payments made by the taxpayers under a contract for the supply of concentrate did not contain an embedded royalty and therefore were not subject to royalty withholding tax (RWHT), nor did the diverted profits tax (DPT) apply. However, the Commissioner has applied for special leave to appeal to the High Court of Australia (HCA).
The decision of the HCA in PepsiCo will set an important precedent in cross-border acquisitions where part of the purchase price may be seen as a payment for the use of intangible property (referred to as embedded royalty). The position of the FCAFC is that if the purchase price does not allocate an amount to royalties, RWHT and DPT will not apply. Investors should closely observe whether the HCA will take a different position.
Dhanushka Jayawardena, partner, Holding Redlich
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