By Manuel Makas, Managing Partner, Julian Pinson, Partner and Professor Graeme Cooper, Consultant, Greenwoods and Herbert Smith Freehills Pty Ltd
As expected, this year’s Budget was dominated by spending measures directed toward social programs, with only a few, very specific, tax changes. This “light-touch approach” to tax was not surprising. The Treasurer said in a speech last year that “the pathway to recovery is not through higher taxes…”, ruling out significant tax increases.
The 2020-21 Budget had already delivered $30 billion of tax cuts for business (by expanding the immediate deduction for capital equipment and reviving loss carry backs), suggesting another round of business tax cuts in 2021 might be unlikely, and so the decision to spend another $20 billion by extending both measures for another year came as a surprise. They are 2 of the more expensive measures in the Budget.
But it seems, with the spot price of iron ore currently hovering around US$230 per tonne, the revenue needs of government are being well looked after without the need for major changes to policy settings. Treasury has estimated that a movement of US$10 in the price of a tonne of iron ore is worth about $1 billion in revenue – the Budget in October last year was based on the assumption that the spot price of iron ore would fall to US$55 per tonne by the end of the June 21 quarter!
Many of the specific tax announcements in the Budget bring to fruition projects that have been in the pipeline for several years, such as:
- changing the test of residence for individuals was mooted by the Board of Taxation in 2016;
- the rules dealing with employee share schemes have been controversial since the major reform in 1995, and while amendments in 2009 and 2015 addressed some problems, the issue of taxation on leaving employment has been the subject of ongoing lobbying for at least a decade;
- the proposal for a collective investment vehicle formed as a corporation rather than a trust dates back to the Johnson report (Australia as a Financial Centre) in 2009, with draft legislation already circulated by Treasury in early 2019;
- proposals to solve problems in the TOFA hedging regime were first announced in the 2011-12 Budget, re-announced in the 2016-17 Budget, and then deferred in December 2017; and
- the proposal to allow taxpayers to self-assess the effective life of certain depreciating intangible assets re-announces a measure from Malcolm Turnbull’s National Innovation and Science Agenda in November 2015.
Of course, there are many more items on the Government’s “Tax: To Do” list (eg the reforms to the demerger rules did not make it into this year’s Budget list), but the Budget demonstrates some progress toward reducing the backlog.
A final question worth pondering is whether some of the new elements in the Government’s program – particularly, the Digital Economy Strategy – will evolve to include more tax elements. The tax offset for Digital Games and the Patent Box regime for medical IP are a first step, but tax measures could form part of a wider suite of policies directed at attracting specialist staff, training and re-training staff, business investments in new equipment and software, retaining successful businesses and their staff in Australia, and so on.
This article looks at several Budget measures: extension of full expensing of depreciable assets; extension of loss carry-back; Patent box; Taxation of financial arrangements (TOFA) changes; digital economy measures; Employee Share Scheme measures announced.
Extension of full expensing of depreciable assets
The Government proposes to extend by one year to 30 June 2023 the 2020-21 Budget measure providing for the full expensing of eligible depreciating assets by businesses with an aggregated turnover of less than $5 billion. The extended measure, which is designed to work in conjunction with the similarly extended loss carry-back rule, should provide a welcome opportunity to undertake more strategic and significant investment in qualifying plant and equipment.
The one-year extension, which has no cap on the cost of an eligible depreciating asset, applies to:
- new or second-hand depreciating assets (however if second hand, the aggregated turnover of the business must be below $50 million);
- held on or after 7:30pm on 6 October 2020; and
- first used or installed, ready for use by 30 June 2023.
Eligible assets exclude:
- assets allocated to a low-value pool or a software development pool;
- certain primary production assets;
- buildings and other capital improvements subject to deduction under Division 43; and
- assets never to be located in Australia or which will not principally be used for the purpose of carrying on a business.
For a corporate tax entity whose aggregated income exceeds $5 billion, an alternative income test is available where:
- the total of its ordinary and statutory income (excluding NANE income) is less than $5 billion for the 2018-19 income year (or the 2019-20 income, where that year ends before 6 October 2020); and
- the total cost of depreciating assets (excluding intangible assets and assets that are or will not principally be used in Australia) for the 2016-17 to 2018-19 income years exceeds $100 million.
However, if an entity only qualifies for temporary full expensing under the alternative income test, the following assets are also not eligible for the measure:
- intangible assets; and
- assets previously held by an associate.
Extension of loss carry-back measure
The Government proposes to extend by one year to include the 2022-23 income year the existing temporary loss carry-back measure for eligible companies which was introduced last year.
Companies with aggregated annual turnover of up to $5 billion in the loss year can choose to apply tax losses incurred during the 2019-20, 2020-21, 2021-22 and now the 2022-23 income years to offset tax paid in 2018-19 or later years, to generate a refundable tax offset.
The amount of the loss carry-back tax offset is limited by requiring that the amount carried back is not more than the earlier taxed profits and that the carry-back does not generate a franking account deficit. Companies that do not elect to carry back losses under this measure can still carry losses forward as normal.
There is no change proposed to other aspects of the current loss carry-back rules. For instance:
- capital losses cannot be carried back;
- consolidated groups cannot access the loss carry back in relation to losses brought into the group by a joining entity;
- companies looking to claim the loss carry back must have lodged their tax returns for the 5 preceding income years (unless there was no requirement to lodge a tax return); and
- there is a specific integrity rule which denies a loss carry back where there has been a change in control of the company under a scheme to obtain the loss carry back tax offset.
Patent box regime
From 1 July 2022, a patent box regime will apply to income derived from Australian medical and biotech patents. Where the regime applies, the income will be taxed at the concessional rate of 17% (as compared to 30%). The Government will also consult on extending the regime to the clean energy sector.
The regime is designed to incentivise R&D activities in Australia and encourage companies to retain ownership of patents in Australia.
The concessional rate will only apply to income from the patent itself rather than income from manufacturing, branding and other attributes.
Such regimes have come under scrutiny as part of the OECD’s BEPS project, in particular “Action 5 – harmful tax practices”. Many of the regimes in place prior to the BEPS project have either been abolished or amended to comply with the OECD’s guidelines. The OECD’s guidelines generally require a nexus between the income receiving the benefits and the activity contributing to that income, meaning the benefit can only apply where the R&D is undertaken by the company itself and in the country giving the concession.
In many cases, the rate applicable to patent boxes in other jurisdictions is 0 – 10%, leaving Australia’s 17% still well above its competitors.
Depending on the final design of the patent box regime, it can be expected to raise various transfer pricing issues such as:
- the concessional patent box tax rate will apply to income from certain patents. If this income is generated by the sale of goods or services using IP protected by the patent, it will be necessary to determine the share of that income which is attributable to the patent. This may require the application of transfer pricing principles; and
- foreign tax authorities may be concerned that income is being diverted to Australia to take advantage of the patent box regime. This could lead to additional scrutiny of related cross border transactions.
The measure has a start date of 1 July 2022 and will apply to income from patents applied for after 7:30pm 11 May 2021, once those patents are granted.
The Government has announced that technical changes will be made to the TOFA provisions in Div 230 of the ITAA 1997.
Changes to the TOFA rules were originally announced in the 2011-12 Budget with further more holistic changes announced in the 2016-17 Budget. The 2016 announcement foreshadowed a fundamental rewrite of the TOFA rules in a more simplified form. The 2021-22 Budget announcement makes clear that this ambitious approach has been dropped and the amendments will be of a more minor and technical nature. Although the full scope of the technical amendments is unclear, the 2 specifically noted areas are:
- amendments to the TOFA hedging rules to allow taxpayers to enter into tax effective hedges on a portfolio basis. This has been a significant issue for managed funds and super funds for many years as the operation of the accounting and tax hedging rules has been unclear when items are being hedged on a portfolio basis. This change will hopefully provide certainty for taxpayers; and
- amendments to ensure that taxpayers are only taxed on realised foreign currency exchange gains and losses, unless they have elected to be taxed on unrealised foreign currency exchange gains and losses.
One disappointing aspect of the announcement is that the changes will only apply to transactions entered into on or after 1 July 2022. If the changes are intended to be revenue neutral and to largely correct unintended outcomes, it is disappointing that the changes will not have immediate effect.
Digital economy tax incentives
The Government has announced a number of measures designed to grow the digital economy. Most are spending announcements, such as investment in aviation and artificial intelligence, but there are also some tax incentives.
Allowing taxpayers to self-assess the effective life of depreciating intangible assets
The Government will allow taxpayers to self-assess for tax purposes the effective lives of eligible intangible depreciating assets, such as patents, registered designs, copyrights and in-house software.
The rate at which in-house software declines in value will be of particular interest, given that a code base is typically constantly being re-written and upgraded.
This measure will apply to assets acquired from 1 July 2023, after the temporary full expensing regime has concluded. Taxpayers will continue to have the option of applying the existing statutory effective life to depreciate these assets.
Venture capital tax incentives review
Australia’s venture capital industry is currently supported by 3 regimes:
- the Venture Capital Limited Partnership (VCLP) regime which provides tax incentives to offshore investors;
- the Early Stage Venture Capital Limited Partnership (ESVCLP) regime which provides a tax exemption for all investors and a 10% tax offset on drawn capital; and
- the Early Stage Innovation Company (ESIC) regime which provides a 10-year CGT exemption and a 20% tax offset (capped at $200,000 per annum) for investments in very early stage companies.
The Government has announced that it will undertake a review of these programs to “ensure current arrangements are fit-for purpose and support genuine early stage Australian start-ups”.
There is a long list of technical and interpretational issues with these programs that have been raised with Treasury over the last few years.
While some industry participants have welcomed the review, by using terms such as “fit for purpose” and “genuine early stage start-ups”, the Government may well be flagging that the incentives will be tightened.
There has been a view that the VCLP regime is unnecessary as it is often used by mid-market private equity funds rather than for “true” venture capital. However, Australia’s VC fund ecosystem is still nascent and has very limited capacity to participate, let alone lead, large growth stage funding rounds beyond Series A. This is evident by the recent funding rounds in SafetyCulture ($99 million) and Octopus Deploy ($221 million) both led by Insight Partners out of New York. Killing off the VCLP structure may further delay the ability of the Australian VC industry to participate meaningfully in these growth rounds.
Digital games tax offset
The Government will introduce a 30% refundable tax offset for eligible Australian businesses that spend a minimum of $500,000 on qualifying Australian games expenditure after 1 July 2022.
The definition of qualifying expenditure to support the development of digital games has yet to be revealed.
The Government considers that the skills developed in digital game software will be transferrable to other sectors including defence innovation, medical technology, education technology, emergency planning, construction (for example, the “digital twins” software developed by Sydney company WillowTwin), AgTech, and modern manufacturing.
The offset will be available in the year when the qualifying expenditure has ceased on a game. The maximum offset a developer will be able to claim in each year is $20 million.
- Self-assessing the effective life of intangibles is expected to bring forward deductions, particularly in respect of in-house software.
- The venture capital and mid-market private equity fund structures are to be reviewed to ensure they are “fit for purpose”. This is expected to focus structures towards early stage venture capital, rather than growth capital.
Employee Share Schemes
The Government has announced that cessation of employment will no longer trigger a taxing point under the employee share scheme (ESS) provisions in Div 83A.
Division 83A is the regime that ensures that any discount on shares, rights and options (ESS interests) given to employees in respect of their employment is taxed at their marginal tax rate, either at the time of grant or on a deferred basis. The proposed amendment is relevant to ESS interests subject to tax deferral.
The proposed amendment will overcome 2 key issues that arise with a cessation of employment taxing point:
- the employee has a tax liability even if their ESS interests were unable to be monetised, eg because the vesting conditions had not been met or disposal restrictions continued to apply;
- the market value of the ESS interest (which determines how much is assessable under the ESS provisions) is determined at the time employment ceased, notwithstanding the ESS interests could only be sold at a later time, and might be sold for a lower price.
The proposed change should make it more manageable to grant shares to employees where vesting is subject to performance hurdles that apply after the cessation of employment. Further, the proposed change will ensure that there is no longer an inadvertent taxing point arising where employees have changed employers within a corporate group prior to the demerger or sale of a subsidiary.
The removal of the cessation of employment as a taxing point is a welcome change, but it is unfortunate that it will only apply for ESS interests issued in the first income year after the amendments receive assent. It would have been preferable for the change to apply with effect from Budget night so that business can factor this change into their next grant of ESS interests.
Other irritants in the ESS provisions still remain:
- the $5,000 cap for salary sacrifice into shares;
- the 3-year disposal restriction for start-up options;
- the requirement that a start-up cannot be a company older than 10 years; and
- the 10% ownership limit for employees who can benefit from the start-up concession and deferred taxation.
Amendments are also proposed in respect of Corporations Act disclosure requirements and exemptions from licensing, anti-hawking and advertising prohibitions that are relevant for the issue of ESS interests, in particular for unlisted companies.
This article was first published in Thomson Reuters’ Weekly Tax Bulletin.