Australian Financial Markets Association Liaison Group key messages 23 November 2023

Welcome and introductions

Fiona Knight has joined Public Groups (PG) as Deputy Commissioner, taking over from Faith Harako. Rebecca Saint will continue to lead client experience and manage the PG strategy whilst Fiona Knight will be responsible for the Engagement and Assurance interactions, and the Banking and Finance (B&F) strategy.

The new Australian Taxation Office (ATO) Commissioner is expected to be announced shortly. An initial increase in external engagements is anticipated, along with potential organisational changes.

Banking and Finance strategy 2023-24

Discussion was had the B&F strategy slide deck for 2023–24 which was released in August 2023, prior to the last Australian Financial Markets Association (AFMA) Liaison Group meeting. The strategy has since been presented and discussed via an extensive roadshow with advisory firms and discussed with several individual taxpayers.

Formal industry ‘strategies’ are typically implemented for certain industries, for example, B&F, Investment Income (insurance and super) and the Energy and Resources due to population size, materiality and coverage of the top 20 taxpayer groups. These strategies are supported by risk clusters such as IP migration, and inbound supply chain which focus more on tax issues related to a specific type of transaction or arrangement. Some issues are also addressed through a compliance program which may run for a finite period. AFMA members noted that the expertise of the Common Reporting Standard risk cluster has been particularly valuable.

Top 100 population and low risk sign-off letter

The focus for Top 100 B&F taxpayers this calendar year has been a transition from annual compliance arrangements (ACA) and into pre-lodgment compliance reviews (PCR). In the B&F space, the ATO has developed a PCR product tailored to the B&F industry. Under the PCR framework, pre-lodgment low risk signoff may be requested from the ATO for transactions with uncertain tax outcomes. Where a low-risk rating is provided, this rating will generally translate to a high assurance rating post ITR lodgment, subject to the relevant position being adopted. It was confirmed that lodgment of the return constitutes evidence that relevant position has been adopted.

AFMA expressed that its members would be interested in the possibility and pathway for a low-risk signoff for the Top 1,000 population, for material/complex transactions. The ATO advised that resourcing constraints meant this offering would not be feasible for Top 1,000 taxpayers. Relevantly, the ATO’s ability to provide this offering is based on a continual engagement with Top 100 taxpayers which has facilitated a deep understanding of their business operations. Another mechanism certainty could be obtained by Top 1,000 taxpayers is via advice and guidance’s early engagement process, which may assist taxpayers to determine whether the issues presented are appropriate for a ruling.

Islamic finance

The ATO acknowledged while this is not a new product offering, the ATO has seen increased activity in Islamic finance, triggered by several new entrants to the market. This has led to some desire for potential law reform, and/or guidance from the ATO to confirm tax treatment both from a bank and client’s perspective. The ATO may issue web-based guidance on the issue in the next year.

Franked distributions funded by capital raisings

In relation to recent legislative measures to address franked distributions funded by capital raisings, the ATO is undertaking external consultation to ascertain if ATO public advice and guidance is required in relation to the measure. For B&F, clarification may be required around recent amendments to include specific wording to exempt equity interests issued as a direct response to meet a requirement, direction or recommendation from Australian Prudential Regulation Authority (APRA) or Australian Securities and Investments Commission (ASIC).

Justified Trust / Combined Assurance Review Update (including GST led reviews)

The ATO has recently released annual Top 100 and Top 1,000 findings reports, which outlines key observations and findings at a program level. The Top 100 report includes some commentary on various industry subgroups. B&F has been included as part of 'banking, finance and investment, superfunds and insurance'.

Top 100

Within the Top 100 population, 52% have obtained an overall high assurance rating. For B&F, 6 of the 7 major banks are at high assurance, with the 7th on track to attain high assurance by 30 June 2024.

The report also outlines the consequences of high assurance for taxpayers, and the expectations for the Monitoring & Maintenance (M&M) and refresh year engagements. The ATO noted that several taxpayers are moving into refresh years. For these taxpayers, many tax topic issues are at high assurance.

The ATO’s approach to refresh years will be to apply a lighter touch, more risk-based approach. This means that where the ATO can reasonably rely on the assurance attained previously, for example, there is a thorough understanding of particular tax topics and comfort around relevant governance, arrangements and tax outcomes that the ATO will not review these topics fresh but instead focus on identifying and verifying any significant new transactions or events, changes in the economic activity, and new tax positions undertaken.

The onus will be on the taxpayer to advise of any changes to the business and fact patterns, and how the business is dealing with changes in law, where applicable. Where the ATO has issued new guidance such as tax determinations, tax rulings and practical compliance guidelines (PCG), the ATO wants to understand how the taxpayer has understood, self-assessed and applied the guidance.

Top 1,000

Only 24% of the Top 1,000 population have obtained overall high assurance. Many taxpayers have achieved medium assurance. Given the diversity of the overall Top 1,000 population, it is difficult to draw conclusions because the findings of the Top 1,000 findings report is at a whole of market level.

The B&F Top 1,000 population is broad comprising of a number of regional banks, foreign retail and institutional banks, credit unions and mutuals, fintech and non-bank financial institutions. Approximately 25% have obtained high assurance which is consistent with the overall Top 1,000 population.

B&F Top 1,000 taxpayers should refer to the letter dated 1 April 2021 regarding ‘Justified Trust Top 1,000 Program, Banking and Finance: Key Observations – Income Tax’ which provided detail on technical issues which are relevant to AFMA members and our intended compliance approach. The issues and approaches discussed in this letter remain relevant. The letter represents a feasible pathway for taxpayers who wish to obtain an overall high level of assurance. The ATO hopes that with the messaging in the letter, half of the foreign banks population reviewed in the next round can obtain high assurance. Additionally, taxpayers should focus on any identified concerns and recommendations in the tax assurance report on how to obtain a higher level of assurance. If an issue has been flagged by the ATO previously and recommendations provided, there is an expectation that taxpayers action and adopt the recommendations. If there is a situation where changes haven’t been adopted, the ATO encourages taxpayers to reach out to discuss their circumstances before the next review commences.

Discussion was had around any blockers that the ATO is seeing to achieving high assurance. The ATO noted that transfer pricing (TP) and branch attribution remain key issues in which taxpayers struggle to achieve overall high assurance. This is due to the globally integrated nature of banking businesses which present challenges under the shorter timeframes in the Top 1,000 review product. There is less opportunity for the ATO to work with the taxpayer to obtain documentation and conduct functional interviews for the purposes of obtaining high assurance. Given these practical challenges, we are adopting an approach which does not require the ATO to evidence and review every individual cross border related party dealing and internal dealing. Instead, the ATO will seek to establish a comprehensive factual understanding of all categories of cross border related party/internal dealings (for example, loans, trading and hedging, head office service charges), and undertake a targeted functional analysis and sampling of transactions to assess and validate the methodologies adopted by the taxpayer. The findings from undertaking this approach will dictate the overall assurance rating for transfer pricing and branch attribution. AFMA agreed that the TP requirement early on with Justified Trust was time consuming and difficult to satisfy in a timely manner.

GST

It was noted that GST has been subsumed into the PCR framework, and thus is included in the Top 100 point in time and annual disclosures and approach to M&M year reviews. The main difference is the M&M for GST which is 3 years instead of the 2 years for income tax, with a Refresh occurring in the 4th year.

The ATO acknowledged the challenges posed by the joint Combined Assurance Review process particularly for smaller businesses who may only have one or two staff in Australia. The ATO is open to feedback on how to improve the program to assist with the evolution of the Top 1,000 approach.

Medium and emerging population – tax performance programs

Page 2 of the Strategy slide deck outlines the medium and emerging (M&E) population. The current threshold for this population is annual turnover of less than $250 million. In the B&F space there are approximately 1,500 taxpayers. The population is diverse with foreign bank branches (no ADI licence), non-bank lenders, investment groups, fintech, technology service providers and Buy Now Pay Later providers.

A central team in the ATO leads the strategy for the M&E market, who may seek advice from specialist teams such as B&F strategy where required.

The team is developing a letter campaign focusing on foreign banks, credit unions, and mutuals which will address the tax requirements around selected issues like Part IIIB, TP, branch attribution, and standard issues like capital allowances, blackhole expenses, thin capitalisation and taxation of financial arrangements (TOFA).

The focus of the campaign is on ensuring that taxpayers have a basic understanding of fundamental tax issues and their obligations, rather than obtaining assurance. As such:

• The ATO may not require taxpayers to respond but may merely advise of issues we have identified so that if the taxpayer is selected for a review, they should ensure that these issues are addressed.
• The campaign itself will be tailored to the market, and depending on the nature of the risk there may be different types of approaches taken. The exact product used will likely depend on the type of engagement that occurs. For example, it may be a PAG (information sheet) with no formal review product which simply draws attention to key risks around particular arrangements, tax topics, or conversely there may be a project where certain key risks have been identified and there will be a review. It is expected that this campaign will commence in the first half of 2024.

AFMA advised that while credit unions and mutuals typically engage through customer owned banking associations, some are AFMA members, and AFMA also does operate an outreach program aimed at smaller members.

Pillar Two – latest developments

Pillar Two will be an ongoing agenda item going forward. Internally, the ATO has been doing work in terms of system design, process mapping, administrative lodgment and compliance, data processing and information exchange with other jurisdictions. The B&F strategy team attends some of the discussions as a stakeholder.

In terms of the extent of potential compliance work coming out of Pillar Two:

• AFMA noted Australia has a headline tax rate of 30% while the Pillar Two minimum effective tax rate is 15%.
• The ATO advised that Pillar Two is primarily an information collection regime, so whilst there is scope for income inclusion and top-up tax, the success of regime should mean that this is an exception rather than the rule.

The ATO has emailed entities that will be subject to Pillar Two reporting requirements. There is an emphasis to commence preparations around systems and capability, for smaller corporate entities where there may be lower levels of sophistication. For example, M&E taxpayers which may have a significant global presence but a small Australian presence. A webpage for Pillar Two has also been set up on ato.gov.au.

The timing of the Pillar Two legislative framework is currently unclear. The ATO is operating on the basis that finalisation will occur in early 2024.

Thin cap – proposed debt deduction creation rules

The following discussion was had around the proposed debt deduction creation rules and repeal of section 25-90:

• AFMA noted its engagement throughout the consultation process on the proposed repeal of section 25-90, raising concerns in relation to the higher compliance burden that would eventuate from the repeal, especially in relation to taxpayers who operate a pool of funds, with a minimal benefit to revenue. It was noted that the proposed repeal of section 25-90 had been deferred and not abandoned. The ATO noted that section 25-90 was listed on the strategy document as it had been finalised prior to the announcement that the repeal would be deferred.
• AFMA has been heavily involved in providing feedback on the proposed debt deduction creation rules. Pleasingly, in the latest amendment to the bill there is a carveout aimed at ADIs and securitisation arrangements from the debt deduction creation rules. It has also made further submissions regarding extending the carveout to 'financial entities', and an extension of grandfathering rules as the rules may not become law until next year. AFMA expressed that a PCG would be useful in providing guidance to taxpayers once the law is enacted.
• AFMA noted the expanded definition of 'debt deduction' based on the Organisation for Economic Co-operation and Development (OECD) guidance, appears to capture costs that are considered to be economically equivalent to interest, for example, payments on interest rate swaps. This creates a risk that any interest on derivatives could be brought into scope of the thin cap rules, even if not linked to a debt interest. This could potentially require the market to bifurcate arrangements, resulting in substantial compliance costs.

In terms of the policy intent behind the debt deduction rules, the ATO stated that it had not identified any arrangements in the B&F space, and it was likely that the identified schemes this measure was targeting were outside of the B&F market.

Discussion was then had around amendments relating to the tax treatment of off-market share buybacks to align with the tax treatment of on-market share buybacks. The ATO noted that it has seen a shift from off-market share buybacks to on-market share buybacks. It was flagged that there may be more focus from the ATO on the application of section 45B, in the context of any significant and/or unusual transactions which impact the balance sheet or are out of ordinary course of capital management / dividend policy.

Technical issues

Bail-in

The ATO has made a further submission to advocate for law change with Treasury. There has been no traction on the issue to date. The ATO re-confirmed that it is not currently pursuing any compliance action on bail-in arrangements. AFMA agreed that they are aligned with the ATO on this issue. The ATO encouraged AFMA to continue to advocate on this issue with Treasury so that it is seen as higher priority.

Head Office Expense Allocation and MAPs/PEs

ATO confirmed that there is no pathway through the Mutual Agreement Procedure (MAP) program for relief from double taxation on mark-ups on expenses for general management and administrative expenses attributable to branch operations. The only relief from double taxation would be alignment as to the calculation of profits under the business profits article, which would require Australia to move towards the authorised OECD approach.

Discussion was had around the framework/approach of the ATO to penalties and interest in relation to marks-ups on head office expense allocation. The ATO noted that penalty and interest will be considered on a case-by-case basis, however the following general considerations are relevant:

• There has been no change in ATO view. The ATO had a clear view for many years on how the relevant business approach applies under the TP rules or treaties. Relevantly, approach does not allow the cost base of expenses attributable to branch operations to be inflated with a margin. This approach applies to both domestic and foreign entities.
• It will be relevant if the taxpayer has previously been subject to review, and recommendations have been provided on this issue. Where this is the case, it is likely remission of any applicable penalties and interest will prove difficult.
• The extent to which it is reasonably arguable that higher value functions are being rewarded is also relevant. Where the ATO considers it clear that routine low value functions are being rewarded, there will likely be a strong recommendation to amend tax returns. If it is unclear, the recommendation may ask the taxpayer to conduct further analysis to justify the basis for adopting a mark-up on other expenses as a method for attributing income offshore. AFMA noted that whether a function is perceived as routine or ‘value add’ can often be a grey area. The ATO advised that the key observations letter clearly acknowledges that a mark-up may be appropriate in some circumstances, but taxpayers must be able to evidence this.

AFMA members were encouraged to contact the B&F team if they are not currently under review and want to discuss their circumstances in relation to this matter.

Thin capitalisation risk-weighted assets

This issue originated from a few Justified Trust reviews where it became apparent banks were applying different approaches in deciding when a particular asset should be booked in an Australian branch or an offshore branch. In some cases, taxpayers could not explain what their decision-making process was when deciding where to book an asset for thin capitalisation purposes.

To establish some consistency in this area, the ATO is working on a technical discussion paper outlining the ATO’s current thinking in relation to an acceptable approach in attributing risk-weighted assets to Australian branches. The paper will be in the form of a consultation paper which will be circulated to industry for comment.

The proposed approach will be based on OECD principles on asset attribution, focusing on the location of where the significant people functions are performed.

The ATO is aware that APRA has guidelines in respect of when foreign banks should book assets in Australia and we expect that in most cases, our proposed approach should not be inconsistent with APRA’s expectations.

The paper will also contain some illustrative examples and address other tax issues that may be impacted by where assets are booked, for example, interest withholding tax arising on funding costs associated with funding those assets that should have been booked in Australia.

The paper is currently undergoing internal review with our Tax Counsel Network.

Where a taxpayer has a current review underway and information is sought on thin capitalisation, any information provided in relation to their tax decision making process will not disadvantage the taxpayer. The ATO acknowledged that there has not historically been a published view or guidance on risk-weighted assets attribution.

Hybrid mismatch

The ATO has received enquiries around what constitutes a ‘payment’ under the hybrid mismatch rules.

For taxpayers that have elected out of Part IIIB, the technical view is that internal payments made on notional dealings are not payments for purposes of the hybrid mismatch rules. That is, the hybrid mismatch rules are not triggered by notional internal dealings.

However, it was noted that where internal dealings are observed, the ATO may view this as an indication of risk that the hybrid mismatch rules may apply, and seek to further understand the relevant arrangement globally, including payments to external parties.

In respect of Assurance Reviews:

• The ATO noted that a few banks have now undergone first time reviews on their application of the hybrid mismatch rules. A general observation from these reviews across the entire market, including B&F, has been an insufficient level of enquiry to self-assessment whether the rules apply, and inadequate evidence of processes to ensure compliance with the imported hybrid mismatch rules. Relevantly, in relation to the approach set out in PCG 2021/5, a key blocker to obtaining high assurance has been insufficient documentation and processes to evidence substantial effort made by taxpayers to comply with the imported hybrid mismatch rules.
• The ATO acknowledged that the current level of enquiry may have been adopted because the hybrid rules are relatively new, and uncertainties still exist. However, in the next round of reviews, it is expected that the taxpayers provide more detailed analysis on the hybrid mismatch rules and detail reasons the rules should or should not apply, including any neutralisation methods used where applicable.
• Issuing questionnaires from counterparties in other jurisdictions and requesting responses would meet the expected level of enquiry expected to be undertaken by taxpayers per PCG 2021/5.

The ATO agreed that the introduction of Pillar Two is expected to alleviate some concerns around the application of the hybrid mismatch rules given the increased transparency that will occur, however noted a baseline level of due diligence will still be required from taxpayers in terms of documentation and evidence.

Offshore banking unit transition

The ATO issued guidance in December 2022 regarding offshore banking unit (OBU) transitional issues. The application of the guidance will differ depending on the type of OB activities conducted by the taxpayer. The key issue around transitioning is the viability for taxpayers to continue OB activities at a 30% tax rate, or whether they will need to shut down the OBU entirely by selling contracts and moving offshore.

This year most taxpayers should have moved to the 30% tax treatment, depending on when their year-end is. The OBU interest withholding tax exemption will cease from 1 January 2024. Review on OBU activity however will continue as reviews are generally backward looking. There will be a focus on the issues outlined in our OBU letter in respect of the transition years.

The ATO noted there have been some large OBU claims in the years approaching the cessation of the regime, with respect to FX trading. Other taxpayers have continued trading at 30%, due to the complexity of shutting down operations and the potential for further announcements from movement. The ATO has not seen a significant deregistration of OBUs.

Calculation of PAYG(I) Commissioners rate – TOFA label fields

The calculation of The Commissioner of Taxations PAYG instalment rate relies on some of the labels of the income tax return, including some labels in Section 8 which are statistical and do not feed into the calculation of taxable income.

The ATO has identified an issue where some taxpayers have reported incorrectly resulting in TOFA gains disclosed in Label 8T being higher than the total income as disclosed in Label 6S, and PAYG withholding instalment rate is then incorrectly calculated even if the taxpayer has a tax payable in their most recent lodged income tax return. In some cases, a nil PAG(I) rate can occur, which raises concerns about an inappropriate deferral of payment of tax.

Where taxpayers are reporting certain TOFA gains and losses on a net basis, they need to do this in all the relevant label fields. Label 8T should just be summing up these amounts from the other TOFA label fields in the tax return. This is because:

• Issues can arise when reporting certain TOFA items on a gross basis, as it can produce some very large turnover figures which can become problematic as the data then feeds into the corporate tax transparency report. It was noted that there was no consultation period for the 2022–23 Corporate Tax Transparency report.
• Amending the tax return itself (either by Commissioner initiated or taxpayer submission to the ATO) does not result in immediate amendment of corporate tax transparency data. It requires a discretion to be exercised by the Commissioner.

AFMA members noted that for many taxpayers, it was not possible to report the figures as suggested using existing software.

Other business

The structure and frequency of ATO/AFMA meetings going forward was discussed. In the new year, the ATO is proposing to hold a meeting for foreign banking representatives and AFMA which coincides with the launch of the B&F Strategy document for 2024–25. Representatives from other areas of the office, for example, the Pillar Two team would be invited to directly engage.