On Friday 16 March 2012, the Assistant Treasurer released Exposure Draft legislation containing proposed legislative amendments implementing the first stage of the transfer pricing reforms announced on 1 November 2011. Regrettably the most egregious element of the 1 November announcement, the backdating to 1 July 2004 of the incorporation of Australia's tax treaty transfer pricing articles into our legislation, has been captured in the 'Exposure Draft'. A further disappointment is that new provisions have been drafted to apply an arm's length test to the cost of debt capital. These new 'debt deduction' provisions have also been written into the draft law to operate from 1 July 2004. A link to the Exposure Draft and Explanatory Memorandum can be accessed here.
Despite the very significant criticism of the Government reforms and a forthright submission by Moore Stephens (along with other firms) in relation to the backdating of legislation, our Government has pursued the backdating 'policy' that can arguably be described as 'third world' in its genesis.
We note that further transfer pricing legislation reform will follow in due course.
Tax Treaty Articles
The ATO has long held the view that the 'business profits' and 'associated enterprises' articles of our tax treaties provided a separate taxing power to that which it holds under Division 13 of the Income Tax Assessment Act, 1936 (ITAA1936). In the wake of increasing uncertainty around this question, the Assistant Treasurer has sought to "clarify" this issue. In short, the concern was that Division 13 of ITAA1936 dealt with the "pricing" of transactions whilst the tax treaty provisions dealt with "profits".
The reform has been 'marketed' by Government as having been designed with the view to ensuring that the transfer pricing provisions enshrined within Australia's tax treaties "are able to be applied and operate independently of Australia's unilateral transfer pricing rules". The legislative change will be achieved by the explicit incorporation of the transfer pricing treaty rules into the Income Tax Assessment Act 1997 (ITAA1997) with attendant changes also made to ITAA1936.
The original Treasury consultation paper proposed a broadening of the current transfer pricing rules in Division 13 by incorporating the OECD arm's length principle into the operative rules. This has progressed such that Phase One of the legislative process now captures a consideration of relevant OECD Transfer Pricing Guidelines and the OECD Model Tax Convention.
The proposed amendments, to be made under Division 815 of ITAA1997, are designed to make certain two aspects of the operation of Australia's transfer pricing rules:
- To ensure that the transfer pricing articles contained in Australia's tax treaties are able to be applied and operate to provide assessment authority independent of Division 13 through explicit incorporation into ITAA1997
- To require the arm's length principle to be interpreted as consistently as possible with relevant OECD guidance.
The ATO can be expected to pursue a number of transfer pricing audits with increased vigour whereby they will seek significant adjustments to taxpayers' profits (as and from 1 July, 2004) where those profits are deemed by the ATO to be less than commercially realistic. Clearly taxpayers with multiple years of losses should have the greatest cause for concern.
The Arm's Length Debt Test
Section 815-22(4) and (5) of the proposed legislation gives effect to the ATO's more recent approach in relation to the interaction of the thin capitalisation and transfer pricing rules.
Whether or not the Thin Capitalisation rules within Division 820 of the ITAA1997 apply to an entity, new rules will first apply (from 1 July 2004) in evaluating whether an entity has derived a "transfer pricing benefit" for the income year having regard, inter alia, to what is an arm's length amount of debt.
This otherwise allowable debt deduction is then subject to the operation of Division 820. That is Division 820 operates as a secondary test and would deny debt deductions to the extent that an entity's debt exceeds its allowable debt.
Submissions are invited by Treasury in relation to the Exposure Draft. The closing date for submissions is Friday 13 April 2012.
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