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Lending a helping hand

Tax Telegraph, July 2013

Lending a helping handParent Co is a company resident of Australia and owns a business manufacturing widgets.

Parent Co wishes to expand its operations and thus sets up a subsidiary company, Sub Co, in Singapore. Sub Co is set up with much enthusiasm, however, it is soon realised that due to the volatile economy, Sub Co is struggling in Singapore. Parent Co makes a payment to Sub Co in the amount of $1 million to help its subsidiary stay afloat. In providing this “help” Parent Co expects to get a deduction in the amount of $1 million.

It is natural to expect companies to support their subsidiaries financially in times when they might be starting up or struggling.

Such “help” generally comes in the form of a “market support payment” and has been very common practice for a long time. The payments are supposed to reflect the risk that a subsidiary faces when operating in new markets or existing ones while implementing the methods and strategies of the parent company. The struggling subsidiary receives “help” to stay afloat and the company providing the help gets a tax deduction for it.

It’s a win-win situation right?

The ATO seems to have a different view.

Take a step back

Market support payment is a payment 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.

The definition potentially covers a broad range of payments. For instance, a reimbursement of a portion of a subsidiary’s advertising and promotional expenditure, which is calculated such that it ensures that the subsidiary is sufficiently profitable.

It is also not uncommon for intercompany agreements to contain clauses that specify or guarantee a certain margin or profit level to the subsidiary for the activities carried out in relation to a transaction with its parent. This could potentially result in the subsidiary paying some fees to the parent company during profitable years, but also receiving a payment from the parent company during difficult times.

The normal position for most parent companies making such payments to subsidiaries is to claim the amounts as tax deductions. This can be justified on the basis that the payments are outgoings related to the ordinary course of their business.

However, the ATO has recently released a draft Tax Determination (TD) 2013/D3 which purports to change this treatment.

The draft determination is based on the fact pattern in the latter example given above. It is a scenario where a parent shares its resources, such as trademarks or systems, with a foreign subsidiary in exchange for a variable fee. This “license fee” is calculated based on the subsidiary’s performance in various measures during a profitable year. However, in an unprofitable year, the subsidiary will receive a market support payment which covers the amount of the loss made. It is this type of transfer from parent to subsidiary which the ATO is examining.

It is important to note upfront that the rules proposed in this draft determination don’t apply to companies within the same tax consolidated group. Similarly, a bona fide loan from a parent to a subsidiary is not considered to be a market support payment.

Proposed changes

So what is it that the ATO is proposing to change?

Put simply, it’s the ability for a company to claim these market support payments as deductions. The ATO has specified that they would now adopt the position that market support payments are no longer deductible under either the “general” or “black-hole” provisions in the Income Tax Assessment Act 1997.

General deductions is a category of allowed deduction which covers the vast majority of the outgoings that you can think of when it comes to the day to day operation of a business. So long as it is considered necessary and is made in relation to the production of income, an expense will usually fall under this category. There is always a strong link between general deductions and the earning of income.

A black-hole deduction is named as such because it is where “black-hole expenditure” or expenditure which doesn’t fall under any other category in the legislation is claimed. This would include items such as business commencement expenses that wouldn’t be allowed under general or other deduction provisions. A business may claim a deduction for the amount of the outgoing in equal amounts split over five years.

The essential exception to deductibility rules are expenses or outgoings “of a capital nature”. Whether something is or isn’t of a capital nature generally comes down to principles established in judgements handed down in court cases over the years.

Broadly, it’s useful to think of capital as the “tree” and income as the “fruit” and in such a sense market support payments to a subsidiary are akin to maintaining the health and value of the tree, in this instance the shares held in the subsidiary. It comes down to a concept known as “enduring benefit” which means that the value in making market support payments is more similar to longer term investments than the simple day to day transactions characterising general deductions.

The ATO view is that market support payments possess the character of capital rather than income. Accordingly, instead of allowing a deduction, the value of market support payments should be added to the cost base of the shares in the subsidiary. Cost base is essentially just a value representing the cost of acquiring and maintaining an asset, such as shares.

So what does it all mean?

There are several issues with the stance that the ATO has taken.

For one, it is intended to apply regardless of how a parent-subsidiary arrangement may operate in practice. The ATO suggests that the objective view of any such payment is capital.

This would apply in any situation where the payments between parent and subsidiary are determined with relation to the profits or losses of the subsidiary as judged and agreed to between the two.

However, the ATO’s view that these payments are capital would run afoul of some transfer pricing rules and could be challenged both at home and abroad.

The ATO has also allowed TD2013/D3 a broad scope, applying to any parent company that has entered into a market support arrangement or has made plans to do so. However, the example scenario in the draft is too narrow to support a blanket application to all parent-subsidiary arrangements. When examining issues of whether a transaction should be treated as capital or revenue, the courts have always taken particular care to examine the specific facts and circumstances of the individual scenario.

If the draft progresses to become a public ruling, these changes are likely to be applied retrospectively. Given the uncertainty and lack of clarity on the actual application, this would not provide much time for taxpayers to review their arrangements.

Contact your local Deloitte Private advisor to get an understanding of how these changes may affect you or your clients.

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