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Support Payments on ATO Radar

Are they deductible?

It has not been uncommon for parent companies to provide financial assistance to subsidiaries that are commencing operations, which are seeking to expand into new markets or are experiencing financial stress or difficulties. Under Australian and international transfer pricing regulations a parent may even be required to make such support payments

On 24 April 2013, the Australian Taxation Office (ATO) released a controversial draft tax determination TD 2013/D3, which expresses the ATO’s preliminary view that support payments made by a parent to its subsidiary are capital in nature and not deductible under section 8-1 of the Income Tax Assessment Act 1997. Furthermore, they are included in the cost base of the parent’s investment in the subsidiary.

The draft TD only considers the deductibility of support payments to the parent, not the assessability of such payments to the subsidiary entity. Also, transfer pricing considerations are not addressed in the draft TD.

This draft TD appears to have broad application. However, the examples in the TD are only based on one fact pattern and, therefore, the draft TD may not be necessarily applicable to all support payments. Taxpayers must consider their own facts when determining the TD’s applicability.

The key features of the TD are summarised below.

What is a support payment?

In broad terms, the draft TD defines a support payment as a payment, however described, that is objectively made by a parent to a subsidiary because all or part of the subsidiary has made a loss or losses, or is not sufficiently profitable (for example, by reference to an agreed benchmark.

The definition potentially covers a broad range of payments. For instance, the draft TD indicates that a reimbursement of a portion of a subsidiary’s advertising and promotional expenditure, which is calculated so that the subsidiary receives an arm’s length return, is considered a support payment on the basis that it is objectively made to ensure that the subsidiary is sufficiently profitable and its effect is to maintain the capital value of the parent’s investment in the subsidiary.

It is not uncommon for intercompany agreements to contain clauses that specify or guarantee a certain margin or profit level to the subsidiary for the functions, assets and risks that it carries out in relation to a transaction with its parent. Also, Advance Pricing Arrangements (APAs), agreed with the ATO in order to obtain certainty on the arm’s length nature of international related party transactions, can contain clauses requiring compensating adjustments to achieve an agreed profit result for the subsidiary. Payments made between parent and subsidiary companies to give effect to such agreements appear to be within the broad definition of a support payment to which the draft TD applies.

The exact meaning of the term ‘payment’ is unclear. It is noted that the issue of whether a payment is on capital account is considered after it is concluded that the payment is a “loss or outgoing incurred”. Therefore, this could, for instance, exclude charging a discounted price for products or services provided by the parent to the subsidiary, to allow that subsidiary to achieve a target margin, on a go-forward basis. If, on the other hand, the parent adjusts previously charged prices by issuing a credit note to the subsidiary, there is potentially a ‘payment’ so that the draft TD applies.

Section 8-1

The draft TD expresses the view that support payments are capital in nature because the character of the advantage sought is the maintenance or enhancement of the value of the parent’s investment in a subsidiary.

Also, the ATO considers a support payment is capital in nature where its objective purpose is to secure the subsidiary as a source of future income, whether in the form of fees, royalties, dividends or other amounts. In that case, in the view of the ATO, the purpose of the payment is to create or maintain a profit yielding asset as opposed to the process of operating it. This view could potentially have implications beyond the context of a parent and subsidiary relationship. However, we would expect, given the restriction of the draft TD to support payments made by a parent to a subsidiary, that this statement could be read down in the context of those scenarios.

The draft TD states that although support payments may secure a future source of income their character differs from payments made to secure exclusive trading rights, which are not a means of propping up a subsidiary. By including this comment the ATO seems to be attempting to limit the potential application of the TD to situations where the support payment’s purpose is primarily to prop up its subsidiary as distinct from situations where this is incidental to the main objective of earning future income.

Further, the draft TD distinguishes between a scenario where the payment from the parent to the subsidiary is required because the subsidiary suffers losses or makes insufficient profits, and one where the subsidiary supplies an asset or service to its parent and is paid for that asset or service. In practice, payments made by a parent to its subsidiary may be for a service (marketing service) or asset (trading right) provided by the subsidiary or an arm’s length recharge of a third party service, and should not automatically be regarded as the maintenance or enhancement of the value of an investment in a subsidiary.

Section 40-880

According to the draft TD, the objective purpose and effect of a support payment is to increase or preserve the value of a parent’s investment in a subsidiary. A support payment is therefore considered to be capital expenditure incurred for the purpose or expected effect of increasing or preserving the value of the CGT asset (parent’s direct or indirect investment in the subsidiary), and not deductible under the ‘blackhole’ provision in section 40-880.

Examples

The crux of the draft TD is contained in three examples. Each is based on the same fact pattern, involving a resident parent company and its wholly-owned subsidiary which has been established in order to commence business in a foreign jurisdiction.

In these examples, the ATO considers that the relevant payment is not deductible under section 8-1 on the basis that it is capital in nature. This is because the payment is considered by the ATO to have been objectively made because the subsidiary incurred a loss or insufficient profit and its effect is to maintain the capital value of the parent’s investment.

This raises the question of when payments made from a parent to a subsidiary are made with this objective. To answer this question all aspects of the context in which the support payment is made must be considered, and it may come down to questions of emphasis and degree. It is noted that there are situations where the support payment is to support the actual earning of revenue. The ATO’s fact pattern for its three examples may assist its conclusion that the payments in those examples are capital in nature. Taxpayers must consider their own fact pattern carefully before interpreting the draft TD’s applicability to their circumstances.

Final comments

Given the wide range of payments this draft TD may be applicable to, and the limited range of examples in the draft TD (which are all based on the one set of facts), it is likely the draft TD will create significant uncertainty in respect of the treatment of support payments.

The draft TD has significant implications for parent entities that have entered into support arrangements with subsidiary entities, even if the payment is made to comply with the arm’s length principle or pursuant to an APA. The draft TD also raises questions concerning the tax treatment of the payment at the level of the subsidiary entity and the possibility of double taxation, even in purely domestic situations.

Even though the TD is currently in draft form, once it is finalised it will have prospective and retrospective effect. Accordingly, we consider that it would be prudent for affected clients to review any existing and proposed support arrangements, and their transfer pricing policies generally, in order to assess the implications of the ATO’s preliminary view and, where appropriate, provide comments on the draft TD to the ATO. Comments are due on 24 May 2013.

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