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 be tightened to prevent a multinational from shifting profits from Australia by claiming excess interest expense deductions.
This tax avoidance technique is known as thin capitalisation. 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.
For instance, it was reported recently that Glencore, Australia’s largest coalminer, paid almost zero income tax 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.
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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.
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%.
Effectiveness of measures
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.
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 separate entity principles embedded in the tax law and the economic reality that a multinational operates as one single enterprise.
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.
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.
Hockey said “we need a global solution to a global problem”. 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.
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 even declared in the hearing 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 an award” (emphasis added).
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.
Antony Ting is a Senior Lecturer of Taxation Law at University of Sydney.