The Australian Taxation Office (the "ATO") recently released a Decision Impact Statement ("DIS") in response to the decision of the Full Federal Court of Australia in Commissioner of Taxation v SNF (Australia) Pty Ltd (2011) FCAFC 74. The Court ruled in favour of the taxpayer.
At the outset, it is noted that the Government has announced a proposal to 'reform' Australia's transfer pricing legislation and the DIS reflects present written law. The ATO, in the DIS, notes that the legal position will probably be materially different if Parliament (backdates to 2004) amending legislation along the lines proposed (refer transfer pricing insights article Click here to read).
SNF is a wholly owned subsidiary of a French company. SNF is a distributor of polyacrylamide (chemical) products acquired from overseas related party manufacturers. SNF incurred trading losses since its incorporation in 1990 until 2004. The ATO conducted a transfer pricing audit of SNF and made adjustments to prices paid to "...reflect an arm's length amount'.
SNF attributed the losses to a combination of factors including: intense competition, poor management, defalcations by an employee, excessive stock levels, an insufficiently high level of sales per sales person, a series of bad debts and a market penetration strategy. In other words, the poor performance resulted from factors other than the transfer pricing policies of the group.
A key question arising is: does the existence of a period of prolonged losses (indirectly) imply that the consideration agreed with related parties is not arm's length, especially if the related party transactions form a substantial part of the taxpayer's business?
In the earlier single Judge decision of the Federal Court, Justice Middleton explained that: "Genuine losses may occur for many reasons, including the ones relied upon by the taxpayer in this proceeding. It is not to be assumed that losses, even over a lengthy period, are necessarily artificial.
"The Full Federal Court broadly agreed with Justice Middleton and questioned the utility and significance of the debate as to why SNF incurred sustained losses.
In the DIS, the ATO states that it accepts that "...the mere fact that the consideration a taxpayer actually paid for property would leave a hypothetical independent party in the exact same circumstances as the actual taxpayer in a commercially unsustainable position does not by itself entail that the consideration actually paid was more than the arm's length consideration." This is a valuable acknowledgement by the ATO and a controversial area about which transfer pricing professionals have historically found themselves in conflict with the ATO.
Interestingly, the Commissioner of Taxation in the DIS also warns that "...how a court would approach the task required by Division 13 if the circumstances had been that, because of its nature, a particular transaction probably would not have taken place at all between unrelated parties remains to be tested in future cases." An arrangement that arm's length parties might not enter into, presumably, includes one where one party to the arrangement incurs sustained losses (or is in a commercially unsustainable position).
Further the ATO highlighted an alternative position that it may seek to argue in future cases, The Commissioner may argue that "...instead of seeking lower prices for the goods it bought, the taxpayer, had it been dealing at arm's length, would have sought separate compensation for the special costs and risks it incurred in prosecuting for the chief long-term benefit of the SNF Group the strategy of building market share in Australia." In other words, the Commissioner may argue for a fee to be paid by the relevant group company (e.g. parent company) for "services" that the Australian entity provides for the benefit of other group members. This is a theoretical position that the ATO has raised in the past, the so called 'representative services' view; that is the subsidiary is performing a 'service' of representing the parent in Australia and should receive a payment therefore. A similar argument is also potentially possible in relation to a market penetration strategy where the parent is seen as the potential beneficiary thereof.
Implications for Comparability Analysis
We have discussed the implications of the SNF case for comparability analysis in our previous transfer pricing insights article. Click here to read the article.
In the SNF case, the ATO was said to have submitted that when applying the CUP method, the Australian Transfer Pricing rules require the hypothesis of an arm's length taxpayer that had the very same characteristics of the taxpayer (i.e. a very high/strict level of comparability). Indeed, in the DIS the ATO agrees that this is a misrepresentation of their submission. The Court however interpreted the rules as requiring no more than the parties to the hypothetical transaction in question be independent of each other.
The DIS does not touch on the level or degree of comparability required between the taxpayer and the independent companies that are subject of the CUP analysis. For example, do the taxpayer and the independent companies need to be of the same size, at the same level or point on the supply chain etc? The Commissioner appears to provide a generic discussion on the topic and explained that the transactions being compared must be comparable in terms of the five comparability factors (discussed in our previous article) and that sufficiently reliable adjustments can be made for material differences identified in the analysis. Fundamentally, however, the consideration: "...must ultimately make style="font-weight: bold;">commercial sense for the actual taxpayer..." (our emphasis)
Further the Commissioner argued that SNF was undertaking a market penetration strategy and that this was a material factor which is relevant to the comparability analysis. The Full Federal Court questioned the need for this stating "...the taxpayer's burden of proof did not require it to tender proof positive of every fact no matter how mundane or pedestrian; ...there was no reason to think that the businesses of the [the independent companies] were conducted on other than the ordinary basis of seeking to make profits from their distribution activities or that they were pursuing any out-of-the-ordinary strategy, which might have affected the prices paid by them". In response, the Commissioner explains that: "The basis for the rejection of the Commissioner's argument on this point does not, with respect, emerge clearly from the judgement. If a similar situation arises in a future case, the ATO will seek clarification of the point." (our emphasis).
Relevance of the OECD Guidelines
The Commissioner intends to continue to apply its public rulings on transfer pricing which the ATO argues are consistent with the OECD Guidelines. In the DIS the ATO explains that it will highlight in future cases that Australia's tax treaty partners have adopted the practice of applying the OECD Guidelines in interpreting the Associate Enterprises article in the relevant Tax Treaty. The Associated Enterprises article generally applies the arm's length principle to transactions entered into by associated enterprises. However, it is noted that the wording used in the Associated Enterprises Article in the OECD Model Tax Convention/Treaty (which is adopted in most of Australia's tax treaties) are very different from the Australian transfer pricing legislation. To be fair, the Commissioner does appear to highlight this uncertainty in the DIS. However, going forward, the Assistant Treasurer, Bill Shorten has confirmed that this issue will be addressed by the proposed 'reform' of Australia's transfer pricing rules.
Other practice issues raised in the DIS that can be expected to be addressed by the proposed changes to the transfer pricing rules include:
- The use of the profits approach to test the arm's length nature of the transfer price paid/received;
- The use of an arm's length 'range' of amounts; and
- Whether the tax treaties provides a separate taxing mechanism for the ATO to make transfer pricing assessments.
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