Practical Compliance Guideline on Intangibles by Australia – Lessons for India

In the absence of proper guidelines controversies keep on arising between taxpayers and tax authorities. When seen from this perspective, Practical Compliance Guidelines (PCG) issued by the Australian Taxation Office (ATO) on 19 May 2021 clarifying tax-compliance approach and associated risks for intangible arrangements is a welcome step. In this article the growing importance of intangibles, salient features of the PCG and lessons for India are discussed.

Growing Importance of Intangible Assets

In 1912, among the world’s 10 largest companies were the likes of US Steel, Jersey Standard, Pullman and American Tobacco. Their success rested with their physical assets: oil fields, railroads and factories. A century on, oil companies still dominate the top 10, but there have been new entrants: IBM, Microsoft and Apple, with Apple vying the top spot. Unlike the old industrial giants, these three tech companies rely not on physical assets for their prosperity, but on ideas and innovation – in short, their intellectual properties.¹

Studies do support and suggest that intangible assets are the fundamental source of competitive advantages for firms in most industries. Technology in the firm, brand of the firm, etc. are some of the intangibles whose value often get unlocked during mergers and acquisitions, which has itself have increased in recent times. Intangible assets could cover a wide array of human accomplishments, covering inventions, works of authorship, software, data, expertise, know-how, experimental designs, technical information, trade secrets, publicity rights, domain names and documentation; anything for which one can anticipate future value.

As a result, in recent times, investment in intangible assets is surpassing investment in tangible assets. In some business intangible assets have become the key driver of value, innovation, and growth. In 2018 intangible assets made 84% of all enterprise value on the S&P 500 companies, a massive increase from just 17% in 1975.² Surprisingly, the current set of accounting standards do not capture the value of intangible assets unless purchased. As a result, a substantial portion of enterprise value may not be evident on the face of a balance sheet.

Companies are now spending millions of dollars in developing, enhancement, maintenance, protection, and exploitation (DEMPE) of intangible assets. Given the recent importance of intangibles for businesses, there have been considerable work by the OECD & G20 on determining arm’s length price of such transfers or uses. It is also that often payment for these assets is considered tax base eroding. BEPS Action Plan 8-10 has given detailed guidance on how to tackle these erosions of taxable base.

In a Multinational Enterprise (MNE) set-up where companies distribute among companies in different jurisdictions responsibilities for developing and maintaining intangibles in one jurisdiction, exploitation in other, protection and ownership in other, DEMPE is designed to ensure that allocation of costs for functions like development, enhancement, maintenance and protection and enjoyment of returns from exploitation does not erode the tax base of the jurisdiction. Not only OECD, tax authorities around the globe are cognisant of DEMPE with respect to intangibles and are taking steps to protect their respective tax bases.

Initiative by ATO – Practical Compliance Guideline 2021/D4

In order to provide a road map to taxpayers and Tax authorities for dealing with various issues connected to intangibles the ATO on May 19, 2021 released a draft Practical Compliance Guideline (PCG) 2021/D4 for public comment – thereby continuing the trend by ATO to provide a framework to assist taxpayers in assessing the level of risk in their transactions of intangible assets with international related parties.

ATO issues practical compliance guidelines on tax issues. Seen from Indian perspective these are a mix of Circular and Instructions. They also address some relevant questions. These provide broad law administration guidance, addressing the practical implications of tax laws and outlining ATO’s administrative approach. For example, they might set out:

• How ATO assesses tax compliance risk across a range of activities or arrangements in relation to a certain area of the law – an activity or arrangement is considered low risk (unlikely to require scrutiny) and where an activity or arrangement is considered high risk (likely to attract scrutiny).
• Practical compliance solutions where tax laws are creating a heavy administrative or compliance burden, or where the tax law might be uncertain in its application.

Draft PCG 2021/D4 outlines the approach which ATO is going to take with respect to compliance and risk factors connected with Intangible Arrangements including DEMPE of intangible assets or where intangible assets are migrated offshore. In particular, the ATO is concerned with whether the functions performed by Australian entities (in connection with the DEMPE of intangible assets) are properly recognized and remunerated in accordance with the arm’s-length principle embodied in Australia’s transfer pricing rules. For these guidelines the definition of intangible assets and the DEMPE framework are sourced from the OECD Transfer Pricing Guidelines.

Draft PCG focuses on identifying Intangible Arrangements that mischaracterise Australian activities connected with DEMPE of intangible assets. Such arrangements may be non-arm’s length or structured to avoid tax obligations, resulting in inappropriate outcomes for Australian tax purposes. As such it covers a wide breadth of arrangements from licensing intangibles, research and development (R&D) activities, cost contribution arrangements, and intangibles migrations.

Draft PCG is designed to focus on ‘tax risks’ associated with the potential application of Australia’s provisions regarding:

These guidelines have been divided by ATO into two parts, viz:

• Part One – Compliance Approach: Provides an outline of ATO’s compliance approach for Intangible Arrangements.
• Part Two – Risk Assessment Framework: Provides an outline of ATO’s risk assessment framework, which explains how ATO assesses the compliance risks of Intangible Arrangements.

Part One – Compliance Approach

Maintenance of adequate documentation and self-assessing the risk is at first the responsibility of the taxpayers. Part One outlines documentation and evidence which ATO would generally expect when assessing the level of compliance risk posed by the Intangible Arrangements according to the ATO’s risk assessment framework set out in Part Two.

ATO has provided a preliminary list of information which ATO will examine whether taxpayers have relevant international related party dealings, are a Significant Global Entity (SGE) and/or have disclosed a relevant Category C reportable tax position:

The Documentation and Evidence Expectations outlined are categorised as:

1. Understanding and evidencing the commercial considerations and taxpayer’s decision making
2. Understanding the legal form of Intangible Arrangements
3. Identifying and evidencing the intangible assets and connected DEMPE activities
4. Analysing the tax and profit outcomes of Intangible Arrangements.

It is clarified in the guidelines that the documents list outlined is intended to serve as a general guide and should not be treated as an exhaustive list. Depending upon the business complexities, governance processes and systems, documentation requirements might vary.

Part Two – Risk Assessment Framework

This part is designed to explain how ATO assesses the compliance risks of Intangible Arrangements. This will act as a guide for taxpayers to assess the Risk Factors as they relate to their Intangible Arrangements. The risk assessment framework includes an assessment of the risk based on:

• Risk Factors (Appendix 1): Outline features and Examples of Arrangements that ATO will use to inform assessment of compliance risks.
• Documentation and Evidence Expectations: Including the level of evidence that ATO will have regard to when assessing Intangible Arrangements against Risk Factors.

The Risk Factors focus on five parameters:

1. Understanding and evidencing the commercial considerations and decision making, in particular where taxpayer has restructured or had a change associated with Intangible Arrangements;
2. Understanding the form of Intangible Arrangements;
3. Identifying and evidencing the intangible assets and connected DEMPE activities of Intangible Arrangements;
4. Analysing the tax and profit outcomes of Intangible Arrangements; and
5. Understanding the type of example arrangements ATO consider to be High, Medium or Low risk (Appendix 2).

Leanings for India

The draft PCG 2021/D4, in a very elaborate manner, lays down the way tax authorities in Australia will perceive and peruse the Intangible Arrangements of taxpayers. It is a commendable step towards establishing a taxpayer-friendly environment. For the tax authorities as well, it will bring discipline and focus in their approach towards Intangible Arrangements. It will be very helpful for taxpayers as they will know in advance as to how their Intangible Arrangements will be looked at by the authorities. This will help taxpayers in planning in a better way. The downside is that the guidelines will put very heavy compliance burden on taxpayers towards documentation and audit, especially since there is no minimum threshold proposed in the guidelines for audit and documentation.

In India, there is a plethora of litigation on taxation of royalty on intangible assets. Latest is the landmark ruling of the Supreme Court in February 2021 in Engineering Analysis Centre of Excellence Private Limited vs. CIT (Civil Appeal Nos. 8733-8734 of 2018) on the difference between use of the copyright and the acquisition or use of the copyrighted article. The apex court ruled that any sum paid by resident end-users as consideration for the resale/use of computer software cannot be typically branded as royalty under the tax treaties – it amounts to procurement of goods.

Apart from this, there are controversies in many cases regarding valuation for transfer pricing purposes. The Indian tax authorities, in many cases, have held the value of intangibles received by Indian companies from their group companies as “NIL”. In most of such cases, this approach has not found favour with courts. This results in uncertainty for taxpayers and unnecessary costs for taxpayers as well as government. To minimise both, government should come out with detailed guidelines for taxpayers and tax auditors. For this, the draft guidelines issued by ATO would be immensely helpful.

Annexure: Summary of Risk Factors (ATO PCG 2021/D4)

Appendix 2: Classification of Example Intangibles Arrangements

Examples of High Risk, Medium Risk, and Low Risk Factors as given in Appendix 2 to PCG 2021/D4: