Explainer: the ATO plan to deter corporate tax avoidance

The Senate enquiry into corporate tax avoidance has been successful in disclosing some difficult-to-find information about corporate groups as well as the Australian Taxation Office. Out of it has come news of an important detection tool developed by the tax office to identify corporate groups for investigation.

The detection tool is basically a formula to compute the effective tax rates (“ETRs”) of corporate groups. The concept of ETR is not new, but what’s interesting about the ATO formula is it adopts an economic perspective, effectively overriding the legal structure of a corporate group. This approach is critically important in the context of the battle against corporate tax avoidance.

It is well known that corporate groups can create artificial subsidiaries in low-tax jurisdictions – such as Ireland and Singapore – for tax avoidance purposes. The current international tax regime generally respects the legal structure of a group, as well as intra-group transactions that may not have real economic substance.

The case of Apple

When Apple appeared before the Senate economics committee last month it claimed that broadly its effective tax rate in Australia was 30%, equal to the corporate tax rate in Australia. The claim is true in the sense that Apple Australia does pay 30 cents in the dollar on profits that it reports in its tax return.

However, the claim ignores the fact that the reported profit figure is the result of an international tax avoidance structure. For example, assume Apple Australia makes a net profit of A$300 million in a year. It would presumably have no objection to paying A$90 million tax on the amount, and therefore it can claim an ETR of 30%.

What’s missing in that claim is that the $300 million profit is the product of its tax avoidance arrangement. The profit looks tiny when considering its made from sales totalling about $6 billion a year. The company achieves this low net profit margin of 5% by paying $5.5 billion to its group company in Ireland (via Singapore) for the products it sells in Australia.

To rub salt into the wound, out of the $5.5 billion, research suggests about $2.2 billion profits booked in Ireland may have never been taxed anywhere in the world.

The ATO’s plan

The ATO should be applauded for striving to achieve two goals in response to this type of activity. First, it is identifying corporate groups that are engaging in aggressive tax avoidance structures. Second, it is challenging those arrangements aiming to collect the “fair” amount of tax.

The detection tool recently disclosed by the ATO is designed to achieve the first goal. In particular, the ETR formula:

…is intended to identify an economic group’s total worldwide profit from Australian linked business activities.

The keyword here is “economic”: it highlights the economic perspective the ATO adopts in designing the formula. In the ATO’s words, by “including the entire economic group’s profits from Australian linked activities, international related party dealings are effectively ignored”. This is the correct approach to deal with modern corporate groups, as most of them are highly integrated globally.

The formula basically computes the ETR of a corporate group by dividing the amount of corporate tax paid in Australia with the “total economic group profit from business activities which are linked to Australia”. In particular, if a company purchases goods from offshore group companies, the formula dictates that “the entire supply chain profit … arising from Australian business activities” would be included in the computation of the ETR.

Back to the Apple example, the amount of corporate tax paid is $90 million. The amount of “total economic group profit” attributable to the sales to Australian customers would likely be the reported profit of $300 million, plus the never-taxed profit of $2.2 billion booked in Ireland.

The ETR computed under the ATO formula would therefore be $90 million divided by $2.5 billion, or 4%. This is much lower than Australia’s corporate tax rate of 30%, and should therefore raise the red flag in the ATO system for further investigation.

Ready for a fight

Besides detection, the ATO ETR formula also serves another useful function: deterrence. The disclosure of the formula by the ATO sends a loud and clear signal to corporate groups that aggressive tax avoidance structures will not escape scrutiny. Multinational enterprises now have one more factor to consider before engaging in this kind of activity, namely, it is highly likely an aggressive tax avoidance structure would be detected by the ATO and subject to challenge. It is possible that some corporate groups may prefer not to have a fight with the ATO in the first place.

Of course, detection is just the first goal of the ATO in the battle against corporate tax avoidance. The second goal of successfully challenging tax avoidance structures and collecting additional tax revenue is easier said than done.