Posts Tagged ‘reconstruction’

Featured Article – Changes to Australia’s Transfer Pricing Rules

December 18, 2012

Australian-flag-waving

Transfer Pricing NEWS:

An exposure draft of legislation was released on November 22, 2012, “Tax Laws Amendment (Cross-Border Transfer Pricing) Bill 2013: Modernisation of transfer pricing rules—proposing changes to Australia’s domestic transfer pricing rules,” to introduce new Australian transfer pricing rules with significant self assessment and documentation requirements. The start date for these new rules has not been announced, but it is expected to be the date of Royal Assent of the amending legislation.

Apparently, these new rules are a response by the Australian Commissioner of Taxation (Commissioner) to recent losses in tax court. The most prominent example is the SNF case last year. In that case the Commissioner unsuccessfully argued for the use of the transactional net margin method of adjusting transfer prices over the comparable uncontrolled price method. It looks like the Commissioner is convincing the Federal Government to legislate the Commissioner’s interpretation of the old rules as the new rules.

The Exposure Draft proposes the repeal of Australia’s existing transfer pricing rules in Division 13 of Part III of the Income Tax Assessment Act 1936 and the insertion of their replacements, as Subdivisions 815-B to 815-E of the Income Tax Assessment Act 1997. Specifically:

  • 815-B: Arm’s length principle for cross-border conditions between entities
  • 815-C: Arm’s length principle for permanent establishments
  • 815-D: Record keeping requirements (Documentation)
  • 815-E: Special rules for trusts and partnerships.

This blog post will only focus on Subdivisions 815-B and 815-D. Of the four, I see these two as having relatively more consequence for taxpayers. For more information on 815-C and 815-E, please refer to the Exposure Draft (link to Exposure Draft at end of posting).

The new transfer pricing rules will operate on a self-assessment basis, unlike the old rules, which required the Commissioner to make a determination of an assessment. This burden has shifted to the taxpayer, who will need to assess its own transfer pricing arrangements to determine whether they comply with the new rules. If a taxpayer identifies that it has a non arm’s-length arrangement creating a ‘tax benefit’ in Australia, it should self-assess a transfer pricing adjustment to increase Australian taxable income to reflect an arm’s-length result (downward adjustments are not permitted under the proposed rules).

Arm’s Length Conditions

The draft legislation focuses on the ‘conditions’ that exist between entities and whether these are consistent with the ‘arm’s length conditions’. Arm’s length conditions are the conditions that may be expected between independent entities dealing wholly independently with one another in comparable circumstances. In identifying arm’s length conditions, regard must be had to the economic substance of what was actually done. Where the economic substance of what was done does not match the legal form, it is the economic substance that determines the ‘arm’s length conditions’.

The arm’s length conditions are to be determined using the most appropriate and reliable method. The method must be selected based on the comparable data available, and a comparability analysis must be performed. Five comparability factors (the comparability factors in the OECD Transfer Pricing Guidelines) must be considered in this analysis. The five comparability factors are:

  1. Characteristics of property or services
  2. Functional analysis
  3. Contractual terms
  4. Economic circumstances
  5. Business strategies

An arrangement could be considered non-arm’s length if it does not contain a condition that third parties would have normally included in a comparable arrangement. Likewise, if a related party arrangement contains a condition that third parties would not normally agree to, this may also constitute a non-arm’s length arrangement. Note: There is great uncertainty as to how the Commissioner will apply this test in practice.

Transfer Pricing Benefit

There will be a ‘transfer pricing benefit’ where arm’s length conditions are applied and one of the following three outcomes would arise:

  1. The Australian entity’s taxable income for the income year is greater than actual conditions
  2. The Australian entity’s loss is less than actual conditions
  3. The Australian entity’s tax offsets are less than actual conditions

 Reconstruction

The draft Explanatory Memorandum states that the Commissioner can substitute actual dealings or arrangements if “independent entities would not have done what was actually done given the options that are realistically available to them.” Basically, the Commissioner is granted broad power to reconstruct transactions when the arrangements are not considered “substantially similar” to what would have occurred between independent parties, given the options realistically available to the Australian taxpayer. This statement in the Explanatory Memorandum is somewhat of a departure from the OECD Guidelines, which state:

“[r]estructuring of legitimate business transactions would be a wholly arbitrary exercise the inequity of which could be compounded by double taxation created where the other tax administration does not share the same views as to how the transaction should be structured.”

Unlike the OECD guidelines, the proposed rules do not require the existence of ‘exceptional circumstances’ before undertaking a reconstruction.

‘Optional’ Transfer Pricing Record Keeping (aka Documentation)

While the Exposure Draft does not make “transfer pricing ‘record keeping’” mandatory, it is in effect mandatory if the taxpayer wants to have a reasonably arguable position. Subdivision 815-D imposes burdensome self-assessment documentation requirements in order for a taxpayer to obtain a RAP. A RAP limits penalties to 10% (non deductible) versus 25% or more otherwise.

Where Taxpayers prepare robust transfer pricing documentation in accordance with the prescribed process, they should be deemed to have a RAP.

Records to satisfy 815-D:

  • Must be contemporaneous
  • Must explain how 815-B applied or did not apply to the entity
  • Must explain why applying 815-B best achieves consistency with the OECD Guidelines
  • Must identify both the ‘actual conditions’ and the ‘arm’s length conditions’
  • Must detail the method used and comparable circumstances relevant to identifying the ‘arm’s length conditions’
  • Must detail the difference, if any, between the ‘arm’s length conditions’ and the ‘actual conditions’

If documentation does not meet the RAP, taxpayers would be subject to a minimum penalty of 25% of the tax shortfall if the Commissioner makes an adjustment, subject to de minimis thresholds (generally $10,000 or 1% of taxable income). The potential penalty with a RAP is 10%.

Transfer Pricing INSIGHTS:

  1. Taxpayers should review their intercompany legal agreements to assess whether legal form and economic substance are aligned, and whether the terms and conditions are consistent with third party agreements.
  2. The Exposure Draft implies that a single set of arm’s-length conditions will exist. In practice, there is rarely a single arm’s-length price or outcome; taxpayers and tax authorities typically seek to identify a range of arm’s-length outcomes. The use of a range is not directly acknowledged in the Exposure Draft. While this is an area of uncertainty, taxpayers could attempt to refer to the OECD Guidelines to support the use of a range.
  3. Subdivision 815-B applies whether the entities are related or not, allowing the Commissioner to attack collusive behavior between unrelated parties, and potentially requiring the taxpayer who wants a Reasonably Arguable Position to document unrelated party transactions to show they are indeed unrelated party transactions.
  4. The Exposure draft gives the Commissioner great power with regard whether or not to make, and how to make, consequential adjustments. Although Subdivision 815-B operates on a self-assessment basis for the primary taxpayer, it does not operate on a self-assessment basis for any other ‘disadvantaged entity’ taxpayer that might be affected by ‘arm’s length conditions’ replacing the ‘actual conditions’. In such cases, the disadvantaged entity will need to ask the Commissioner to make a determination such as reducing its taxable income, increasing its loss, increasing a tax offset, or reducing the withholding tax payable in respect of interest or royalties. The Commissioner is only required to make such a determination where the Commissioner considers it is fair and reasonable to do so.
  5. The proposed de minimis rule does not provide much relief for taxpayers, since it will be necessary for taxpayers to calculate the value of potential transfer pricing adjustment exposures before they can identify whether their dealings fall below the threshold. A simpler approach – which would have been less onerous to the taxpayer – would have been to provide an exemption from penalties for transactions that fall below a certain threshold.
  6. In future transfer pricing cases, the Commissioner may be able to argue that a significant difference between results produced by a transactional method used by the taxpayer (e.g., the comparable uncontrolled price method), and a profit-based method (e.g., the transactional net margin method), suggests there are factors specific to the taxpayer’s situation that are not taken into account by the transactional method. Then, the Commissioner could rely on a profit-based method to defend an assessment of a ‘transfer pricing benefit’ even where the taxpayer is able to use a transactional method to establish that no such benefit exists (as the Commissioner attempted to do in the SNF case).
  7. For certain large and complex intercompany arrangements, I think the added uncertainty for taxpayers resulting from the Exposure Draft, and the additional documentation burden, increases the appeal of APAs.

Links to the Exposure Draft and Explanatory Memorandum:

Exposure Draft

Explanatory Memorandum

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