Australia's new transfer pricing regime

Articles Written by Prashanth Kainthaje (Partner)

On 13 February 2013, the Federal Government introduced Tax Laws Amendment (Countering a Tax Avoidance and Multinational Profit Shifting) Bill 2013 (Bill) into Parliament. The Bill, if enacted, will significantly expand the ability of the Commissioner of Taxation (Commissioner) to amend assessments on transfer pricing grounds.

Background to Transfer Pricing Amendments

In Roche Products Limited v Federal Commissioner of Taxation [2008] AATA 639; (2008) 70 ATR 703 and Federal Commissioner of Taxation v SNF (Australia) Pty Ltd (2011) 193 FCR 149, the Commissioner was unsuccessful in applying profit-based methods for the purpose of determining arm's length consideration for intra-group transactions. Rather, the Administrative Appeals Tribunal (AAT) and the Federal Court of Australia, respectively, preferring transaction-based methods. In addition, the Federal Court of Australia in SNFAustraliacast doubt on the ability of the Commissioner and taxpayers to rely upon the Organisation for Economic Cooperation and Development's Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (Guidelines).

In Roche and SNF Australia the Commissioner also argued that Australia's double tax treaties as incorporated into Australian law contained a power to assess a taxpayer independently and separately from the domestic transfer pricing provisions in Division 13 of Part III of the Income Tax Assessment Act 1936 (Cth) (the 1936 Act). Whilst the AAT and the Federal Court of Australia did not make a definitive statement on this point, the Federal Government in 2012 introduced a retrospective, treaty equivalent cross-border transfer pricing regime, being Subdivision 815-A of the Income Tax Assessment Act 1997 (Cth) (the 1997 Act).

A significant limitation of Subdivision 815-A is that it only applies where a relevant double tax treaty applies to the entity. The Bill, if enacted, amends the 1997 Act by introducing Subdivisions 815-B, 815-C and 815-D into the 1997 Act. The new provisions will apply to treaty and non-treaty contexts.

The new provisions will replace the current Division 13 of Part III of the 1936 Act from the earlier of 1 July 2013 and the date of Royal Assent, assuming it is passed by both Houses of Parliament.

Proposed changes

Self-executing provisions

Unlike the provisions in Division 13 and Subdivision 815-A, the new provisions will be self-executing. That is to say, they will not require the Commissioner to make a determination before they apply. The Explanatory Memorandum (EM) to the Bill rationalises this on the basis that it 'better aligns Australia's domestic transfer pricing rules with the design of Australia's overall tax system which generally operates on a self-assessment basis' (EM at paragraph 2.17).

Transfer pricing benefit

The critical provision in Subdivision 815-B is proposed section 815-115. That provision provides that if an entity gets a transfer pricing benefit from conditions that operate between the entity and another entity in connection with their commercial financial relations, those conditions are taken not to operate and instead, the arm's length conditions are taken to operate. The conditions that operate include, but are not limited to, such things as price, gross margin, net profit, and the division of profits between the entities.

The provision only applies for certain purposes, namely, computing the amount of:

  • an entity's taxable income;
  • an entity's loss of a particular sort;
  • an entity's tax offsets; and
  • withholding tax payable by the entity in respect of interest or royalties.

A transfer pricing benefit arises from conditions that operate between the entity and another entity in connection with the commercial or financial relations if:

  • the actual conditions differ from arm's length conditions (proposed paragraph (a) of subsection 815-120(1));
  • the actual conditions satisfy the cross-border test (proposed paragraph (b) of subsection 815-120(1)); and
  • had the arm's length conditions operated instead of the actual conditions, one or more of the following would, apart from Subdivision 815-B, apply:
  • the amount of the entity's taxable income would be greater;
  • the amount of the entity's loss of a particular sort would be less;
  • the amount of the entity's tax offsets for an income year would be less; and
  • an amount of withholding tax payable in respect of interest or royalties would be greater (proposed paragraph (c) of subsection 815-120(1)).

Determination of whether actual conditions differ from arm's length conditions

For the purpose of determining if the actual conditions differ from the arm's length conditions, there is taken to be a difference between the actual conditions and the arm's length conditions if an actual condition exists that is not one of the arm's length conditions or a condition does not exist in the actual conditions but is one of the arm's length conditions.1 Thus, it would seem that a slight variation between the actual conditions and the supposed arm's length conditions would result in the application of proposed paragraph (a) of subsection 815-120(1).

Cross-border test

In so far as the cross-border test is concerned, conditions that operate between an entity and another entity in connection with their commercial or financial relations will satisfy the cross-border test if:

  • an Australian resident, an Australian resident trust estate or a partnership in which all the partners are, directly or indirectly, through one or more interposed partnerships, Australian residents or resident trust estates, operates at or through an overseas permanent establishment (PE) of the entity;
  • an entity not covered by the preceding point does not operate solely at or through an Australian permanent establishment of the entity;
  • the conditions operate in connection with a business that the entity carries on in an area covered by a tax treaty.

Arm's length conditions

Arm's length conditions, in relation to conditions that operate between an entity and another entity, are conditions that might be expected to operate between independent entities dealing wholly and independently with one other in comparable circumstances.

In identifying arm's length conditions, it is necessary to use the method, or combination of methods, that is appropriate and reliable, having regard to all relevant factors, including the following:

  • the respective strengths and weaknesses of the possible methods in their application to the actual conditions;
  • the circumstances, including the functions performed, assets used and risks borne by the entities;
  • the availability of reliable information required to apply a particular method;
  • the degree of comparability between the actual circumstances and the comparable circumstances, including the reliability of any adjustments to eliminate the effect of material differences between those circumstances (proposed subsection 815-215(3)).

The new provisions require that the arm's length conditions to be ascertained by reference to the methods specified in the Guidelines.

In analysing the degree of comparability, regard must be had to all relevant factors, including the following:

  • the functions performed, assets used and risks borne by the entities;
  • the characteristics of any property or services transferred;
  • the terms of any relevant contracts between the entities;
  • the economic circumstances;
  • the business strategies of the entities (proposed subsection 815-215(4)).

For the purposes of the new provisions, circumstances are comparable to actual circumstances if, to the extent (if any) that the circumstances differ from the actual circumstances:

  • the differences do not materially affect a condition that is relevant to the methods; or
  • a reasonably accurate adjustment can be made to eliminate the effect of the difference on a condition that is relevant to the method (proposed subsection 815-215(4)).

Relevance of actual commercial or financial relations

The new provisions provide that the identification of the arm's length conditions must:

  • be based on the commercial or financial relations in connection with which the actual conditions operate; and
  • have regard to both the form and substance of those relations (proposed subsection 815-130(1)). 

This is referred to as the 'basic rule' in the new provisions. However, there are three exceptions to the basic rule in proposed subsection 815-130(1). 

First, it is necessary to disregard the form of the actual commercial or financial relations to the extent, if any, that the commercial or financial relations are inconsistent with the substance of those commercial or financial relations (proposed subsection 815-130(2)).

The second exception to the basic rule provides that arm's length conditions must be based on other commercial or financial relations rather than the actual commercial or financial relations if:

  • independent entities dealing wholly or independently with one another in comparable circumstances would not have entered into the actual commercial or financial relations;
  • independent entities dealing wholly or independently with one another in comparable circumstances would have entered into other commercial or financial relations; and
  • those other commercial or financial relations differ in substance from the actual commercial or financial relations (proposed subsection 815-130(3)).

The EM (at paragraph 3.100) explains that this exception applies where, having regard to their own economic interest, wholly independent entities would not have entered into the actual commercial or financial relations, but would have instead entered into alternative commercial or financial relations that differ in substance from the actual commercial and financial relations. The EM (at paragraphs 3.101-3.103) provides:

As each element of this test must be positively satisfied, it is not of itself sufficient to propose that independent entities might have dealt with one another in an alternative manner. Moreover, the mere fact that actual independent entities have not been observed to have dealt with one another in a particular way (or that information on such independent dealings is not available) will not necessarily mean that independent entities would not have entered into the commercial or financial relations that the entities actually did.  The relevant question is instead whether independent entities behaving in a commercially rational manner and acting in their own best commercial and economic interests would have dealt with one another in the same way, given the options that are realistically available to them. Without detracting from the relevance of actually observed dealings, nothing prevents each aspect of the test from being established hypothetically.

The requirement that independent entities 'would' have done something different to the actual entities imposes a higher standard of proof than simply demonstrating that independent entities 'might' or 'might be expected to' have entered into alternative commercial or financial relations.

This standard is intended to reduce the number of possible alternatives that can be hypothesised under the exception. In the event that more than one alternative set of commercial or financial relations would have been entered into by independent entities (for example, because the overall effect of each alternative is similar enough that independent entities would be indifferent about which one operated), the substituted commercial or financial arrangements under this exception should comport as closely as possible with the facts and economic substance of what actually occurred. This approach is consistent with both the OECD Guidelines (see for example paragraph 9.187 of the OECD Guidelines) and the requirement in the exception that in the course of identifying arm's length conditions, the independent entities must be in comparable circumstances to the actual entities. (Emphasis added)

The third exception to the basic rule requires that the identification of the arm's length condition is to be based on the absence of commercial or financial relations if independent entities dealing wholly independently with one another in comparable circumstances would not have entered into commercial or financial relations (proposed subsection 815-130(4)).

The identification of arm's length conditions is to be determined in accordance with the Guidelines. There is provision for regulations to specify a document, or part of a document, which determines arm's length conditions. The identification of arm's length conditions is therefore not an easy task. In particular, one would expect the Commissioner to rely upon the three exceptions in the case of intra-group transactions involving unique property or services or in circumstances where there are intra-group allocations of risks.

Interaction with thin capitalisation

Where the thin capitalisation rules in relation to an entity's 'debt deductions' apply, a special rule modifies the way in which the new transfer pricing regime applies to that entity (proposed section 815-140). The purpose of the rule is to preserve the role of the thin capitalisation rules in determining the maximum allowable debt under Division 820 of the 1997 Act. The proposed provision is consistent with the administrative approach of the Commissioner as stated in Taxation Ruling TR 2010/7.

If, under the arm's length conditions, working out an entity's debt deductions involves applying an interest rate to debt interest, the rule requires the interest rate to be worked out as if the arm's length conditions had operated. The arm's length rate may need to be determined by having regard to conditions which could be expected to operate between entities dealing wholly and independently with each other. For example, in some exceptional cases, it may be appropriate to determine the arm's length rate having regard to the amount of debt the entity is likely to have had, had the conditions operating between it and the associate been consistent with what would have been if the entities had been independent of each other. The EM is silent on the issue of parental affiliation. Presumably it is a factor in determining the arm's length interest rate2, although this is by no means uncontentious.3

It is this interest rate that is applied to the debt interests the entity has actually issued instead of the debt interests that would have been issued had the arm's length conditions operated (in the event that there is a difference between these amounts).

Consequential assessments

In addition to the ability to amend assessments on transfer pricing grounds to the primary entity, the Commissioner is permitted to make consequential adjustments to another entity if that other entity might have been expected to have less taxable income than was actually the case, greater deductions than was actually the case, greater tax offsets than was actually the case or a lower liability to Australian withholding tax than was actually the case (proposed section 845-145).

Arm's length principles for permanent establishments

There are new provisions dealing with transfer pricing and permanent establishments. These provisions are contained in proposed Subdivision 815-C. Subdivision 815-C applies when an entity obtains a transfer pricing benefit in an income year for the attribution of profits to a PE of the entity. In such a case, the amount of profits actually attributed to the PE is not taken to be attributed to the PE. Rather, the arm's length profits are taken to have been attributed to the PE for the purposes of calculating the transfer pricing benefit obtained by the entity.

Subdivision 815-C does not apply in respect of amounts of withholding tax payable. This is because Subdivision 815-C applies in respect of intra-entity allocation of income and expenses and as such its effect does not have any implications for withholding tax.

Time limits for amending assessments

Under the current Division 13 and Subdivision 815-A, the Commissioner has an unlimited period in which to make or amend an assessment in relation to a transfer pricing adjustment. This period is subject to certain limitations in some, but not all, of Australia's double tax treaties.4

In contrast, Sub-divisions 815-B and 815-C allows the Commissioner to amend an assessment 7 years after the day on which the Commissioner gives notice of the assessment to the entity for the purpose of giving effect to proposed sections 815-115 or 815-215, respectively. In addition, there is an unlimited period of time to make consequential assessments.

Penalties

The new provisions into Subdivision 284-C in Schedule 1 of the Taxation Administration Act 1953 (Cth) (TAA) imposes a liability to an administrative penalty where the Commissioner takes certain actions to give effect to Subdivisions 815-B or 815-C that result in a liability to additional amount of income tax or withholding tax.

The administrative penalty for transfer pricing related schemes shortfall amounts is the sum of:

  • 25% of the scheme shortfall amount subject to the reasonably arguable position point noted immediately below; and
  • 10% of the scheme shortfall amount to the extent that it is attributable to the taxpayer (or their agent) having treated the transfer pricing rules as applying or not applying to a matter in a way that was reasonably arguable.

Where however, it is reasonable to conclude that the entity entered into a scheme with the sole or dominant purpose of obtaining a transfer pricing benefit (for themselves of another entity), the base penalty amount is the sum of:

  • 50% of the scheme shortfall amount subject to the reasonably arguable position point noted immediately below; and
  • 25% of the scheme shortfall amount to the extent that it is attributable to the taxpayer (or their agent) having treated the transfer pricing rules as applying or not applying to a matter in a way that was reasonably arguable.

Transfer Pricing Records

Section 284-250 of Schedule 1 of the TAA provides that an entity cannot have a reasonably arguable position where an entity has treated Subdivision 815-B or 815-C as applying or not applying to a matter in a certain way (or made a statement about the way those Subdivisions apply to a matter), in circumstances where the entity does not have records that meet the requirements of Subdivision 284-E. That is to say, an undocumented transfer pricing position is not reasonably arguable and hence subject to greater penalties.

The records kept by an entity meet the requirement of Subdivision 284-E of Schedule of the TAA if the records:

  • are prepared before the time by which the entity lodges its income tax return for the income year relevant to the matter (or matters); and
  • are in English, or readily accessible and convertible into English; and
  • explain the particular way in which Subdivision 815-B or 815-C applies (or does not apply) to the matter (or matters); and
  • explain why the application of Subdivision 815-B or 815-C applies to the matter (or matters) in the best way that achieves consistency with the Guidance.

Furthermore, the records must allow each of the following to be readily ascertained:

  • the arm's length conditions relevant to the matter (or matters);
  • the particulars of the methods used in comparable circumstances relevant to identifying those arm's length conditions;
  • unless the records are for the non-application of the Subdivision to a matter (or matters) - the result that the application of the Subdivision in that particular way, as compared to the non-application of the Subdivision, has for the operation of the tax legislation in relation to the entity;
  • for Subdivision 815-B, the actual conditions relevant to the matter (or matters);
  • for Subdivision 815-C:
  • the actual profits mentioned in paragraph 815-220(1)(a) of the 1997 Act and the arm's length profits, to the extent that they are relevant to the matter (or matters); and
  • the particulars of the activities and circumstances mentioned in subsection 815-225(1) of the 1997 Act, to the extent that they are relevant to the matter (or matters).

As can be seen, the record keeping requirements are onerous and it can be readily envisaged that substantial penalties will be levied. The documentation requirements should be considered in the light of the relatively new International Dealings Schedule5, which comprises part of the Australian tax return and with the requirement to disclose Reportable Tax Positions.6

Concluding comments

It will be essential for taxpayers with cross-border dealings to review their transfer pricing compliance strategies to ensure compliance with the new provisions. In particular, dealings involving unique items of property, non-standard distributions arrangements and intra-group financing arrangements should be scrutinised with a view to ensuring compliance with the Guidelines and the new provisions. In appropriate circumstances, thought should be given to obtain Advance Pricing Arrangements.



1 Proposed section 815-120(2).

2 See paragraphs 49-52 of Taxation Ruling TR 2010/7, and footnote 43 of Taxation Ruling TR 2010/7.

3 See for example, Peter Blessing, "Divergence of Third Party Pricing from Arm's Length Results" in Tax Polymath: A Life in International Taxation: Essays in Honour of John F. Avery Jones, IBFD, 2010 at 153-185.

4 See for example Article 9(4) of the Convention between Australia and Canada for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Article 9(4) of the Convention between Australia and Japan for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income.

5 The International Dealings Schedule has replaced the former Schedule 25A. See http://www.ato.gov.au/content/00298236.htm for further information.

6 See http://www.ato.gov.au/content/00322539.htm for further information.

 
Important Disclaimer: The material contained in this article is comment of a general nature only and is not and nor is it intended to be advice on any specific professional matter. In that the effectiveness or accuracy of any professional advice depends upon the particular circumstances of each case, neither the firm nor any individual author accepts any responsibility whatsoever for any acts or omissions resulting from reliance upon the content of any articles. Before acting on the basis of any material contained in this publication, we recommend that you consult your professional adviser. Liability limited by a scheme approved under Professional Standards Legislation (Australia-wide except in Tasmania).

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