OVERVIEW AND BACKGROUND
The Australian Federal Government (Government) has introduced tough new Transfer Pricing Rules in the form of a new Subdivision 815-A of the Income Tax Assessment Act 1997 (Cth) (ITAA 97).
Subdivision 815-A was contained in Taxation Laws Amendment (Cross-Border Transfer Pricing) Bill (No.1) 2012 (TP Bill), which was introduced into Federal Parliament on 24 May 2012. The Assistant Treasurer introduced the TP Bill principally to clarify the assessing authority of the Transfer Pricing Articles contained in Australia's Double Tax Agreements (DTAs) and because of perceived concerns about the potential risk of revenue leakage.
The Government is concerned with ensuring that Australia's Transfer Pricing Rules - both under our Domestic Law, Division 13 of the Income Tax Assessment Act 1936 (Cth) (ITAA 36), and under our DTAs - are interpreted as consistently as possible with the Organisation for Economic Cooperation and Development (OECD) guidance, particularly the OECD Transfer Pricing Guidelines.
These guidelines had previously been held in Commissioner of Taxation v SNF (Australia) Pty Limited (2011) FCAFC 74 (SNF decision) not to be a legitimate aid to the construction of the DTAs or Division 13.
The Government has moved swiftly to fix perceived deficiencies in the law following the SNF decision in June 2011 and follows upon the Assistant Treasurer's 1 November 2011 announcement regarding proposed reforms to our Transfer Pricing Rules.
It is anticipated these expanded Transfer Pricing Rules will have a significant impact on all global businesses - including both inbound and outbound investors. They will particularly affect global technology companies, banks and other financial services providers, funds managers, distributors and those increasingly involved in e-commerce.
It is expected further changes dealing with prescriptive documentation requirements, Transfer Pricing Methodologies and Penalties may be part of a second tranche of amendments to our Transfer Pricing Rules.
HIGHLIGHTS OF AMENDMENTS
There are several significant amendments to the Transfer Pricing Rules, most particularly the following:
- The introduction of new Subdivision 815-A,which is equivalent to, but independent of the Transfer Pricing Rules contained in Australia's DTAs. This Subdivision will enable the Commissioner of Taxation to determine a liability to tax under our Domestic Law, rather than the Treaty itself, for the purpose of negating a "Transfer Pricing Benefit".
- A determination can be made by the Commissioner to negate a "Transfer Pricing Benefit" whereby the profits or taxable income of the taxpayer are increased, or the tax loss or net capital loss decreased. It should be noted that no tax avoidance purpose is required and that either the Associated Enterprises Article (for entities) or the Business Profits Article (for permanent establishments) of the relevant DTA must apply.
- Reference should be made to the OECD Model Tax Convention and its commentaries as well as the OECD Transfer Pricing Guidelines in determining whether an entity gets a "Transfer Pricing Benefit", or more broadly in interpreting a provision of the DTAs.
- The introduction of specific and controversial rules on the interaction of Subdivision 815-A with the existing Thin Capitalisation Provisions, Division 820 of the ITAA 97; ie impacting on costs that are debt deductions.
- Subdivision 815-A applies retrospectively from income tax years starting on or after 1 July 2004.
- Division 13 is made subject to new Subdivision 815-A.
- An unlimited amendment period is provided for determinations by the Commissioner under Subdivision 815-A, similar to that provided for under Division 13.
- Consequential adjustments - for example to interest or royalty withholding taxes - can be made to disadvantaged entities where the Commissioner considers it is fair and reasonable.
- A safety net is provided to ensure that there is no double taxation to further increase an entity's assessable income and/or reduce allowable deductions including capital losses. However, it is noted that further reductions in debt deductions for purposes of our Thin Capitalisation Rules can be made in addition to amendments under Subdivision 815-A.
- Transitional provisions apply to the imposition of penalties related to years 2004/5 through to 2011/12.
DETAILS OF NEW SUBDIVISION 815-A
Three conditions for Subdivision 815-A to apply
In order for the Commissioner to make a determination increasing the taxable income or reducing the tax loss or net capital loss of the taxpayer, each of the three following conditions must be satisfied:
- The entity gets a Transfer Pricing Benefit
- An International Tax Agreement ie DTA applies
- The DTA contains an Associated Enterprises Article or a Business Profits Article.
Transfer Pricing Benefit
A Transfer Pricing Benefit essentially arises where the amount of profits an entity would have made having regard to the arms length conditions and the amount actually made are different. The amount of the Transfer Pricing Benefit is the difference between the actual amount of taxable income (or tax loss or net capital loss) for the income year and the expected profits that should have accrued.
Similar approaches apply depending on whether the entity is an Australian resident or a permanent establishment in Australia. In forecasting the amount of profits that might be expected to accrue under the arms length principle, taxpayers should make reference to the activities and functions performed, assets used and risks assumed by the entity or the enterprise through the permanent establishment.
Where appropriate in light of the above information, the Commissioner may make a determination to negate a Transfer Pricing Benefit and effectively increase the taxable income, or reduce the tax loss or net capital loss of the entity.
An entity may be taken to receive multiple Transfer Pricing Benefits - where the impact is on more than one aspect of the entity's tax position - and the Commissioner must give a copy of the determination negating the Transfer Pricing Benefit(s) to the entity.
The OECD is the primary international tax forum and provides authoritative international knowhow on the application of Transfer Pricing Rules.
Accordingly, both for firstly establishing whether an entity gets a Transfer Pricing Benefit, and secondly, for more broadly interpreting a provision of a DTA, guidance is provided by the OECD Model Tax Convention, its commentaries and the OECD Transfer Pricing Guidelines, the latest of which were issued on 22 July 2010. Certain exclusions will apply and regulations may be introduced to prescribe different documents or parts of documents providing further guidance to taxpayers and the Australian Taxation Office (ATO).
The OECD guidance materials applicable are those last approved by the OECD Council (and amended) before the start of the relevant year of income.
These amendments will override the Full Federal Court's view expressed in the SNF decision that the OECD Transfer Pricing Guidelines were not a legitimate aid to the construction of Australia's DTAs or Domestic Transfer Pricing provisions.
RETROSPECTIVE APPLICATION AND LEGITIMACY OF THE DTA'S ASSESSING POWER
The Second Reading Speech and the Explanatory Memorandum (Accompanying Aids) accompanying the TP Bill devote considerable attention to the legitimacy of the DTA's assessment powers, particularly with respect to the associated enterprises article and the business profits article.
Recognising some uncertainty around the legitimacy of the purported assessing powers contained in our DTAs, including by reference to recent cases, Downes J in Roche Products Pty Limited (2008) and Middleton J in SNF Australia Pty Limited (2010), the Government has outlined in detail in the Accompanying Aids its reasons why, in its view, the Parliament intended that the DTA Transfer Pricing Rules provided additional assessing powers to our Domestic Transfer Pricing Rules, Division 13. It is noteworthy that the Accompanying Aids do not refer to Lindgren J's comments in Undershaft (No. 1) Limited (2009), where he stated at paragraphs 45 and 46 that "The DTA does not give a Contracting State power to tax...", but rather allocates the right to tax between contracting states; albeit with respect to capital gains.
More significant though is the Government's rationale for introducing retrospectively applicable legislation (from 1 July 2004) on the basis that it is the longstanding legislative intent that the law operated in this way, ie to provide an assessing power in the DTAs. While recognising that there might be different views on the merits of the DTA power to assess, the Government has justified the introduction of retrospective legislation on the basis that firstly, these amendments ensure the law can operate as the Parliament intended and secondly, there is significant risk to revenue if the law were to apply in a manner that is inconsistent with the Parliament's intention.
This justification for retrospective legislation is consistent with the speech of 18 May 2012 by the Assistant Treasurer, the Honourable David Bradbury MP, on retrospective legislation and related matters. While disappointing and increasingly burdensome for taxpayers, this approach to retrospectivity may herald a new era of statutory interpretation and/or increase the risk that future Governments will more often retrospectively amend the tax law based on comments in Parliament, including those of the Shadow Treasurer as noted in the Second Reading Speech accompanying this TP Bill.
THIN CAPITALISATION PROVISIONS - DIVISION 820
While preserving Division 820 as the comprehensive regime dealing with thin capitalisation, Subdivision 815-A potentially applies to modify a Transfer Pricing Benefit related to profits, or referrable to costs that are debt deductions of the relevant entity for taxation purposes.
While not clear from the wording of proposed Section 815 - 25, the Explanatory Memorandum suggests that in working out the costs that are debt deductions, taxpayers need to firstly determine the arms length rate applying to a debt interest, having regard to the conditions that could be expected to operate between entities dealing wholly independently with each other.
Although arguably supported by OECD guidance, the Explanatory Memorandum flags that in some exceptional cases the arms length rate applying to a debt interest may only be determined effectively by reference to the amount of debt a taxpayer would reasonably be expected to have if dealing at arm's length; irrespective of otherwise compliance with the safe harbour or other thin capitalisation limits.
This approach is not only controversial, but reflective of the position adopted by the ATO in Taxation Ruling TR 2010/7 Transfer Pricing and Thin Capitalisation. Further and most importantly, it is questionable whether this approach is supported by the plain words of the section - given the primacy of the language of the statute.
Once the arms length rate is determined, it is applied to the taxpayer's actual amount of debt to determine the amount of the Transfer Pricing Benefit.
Finally, the thin capitalisation rules can further apply to reduce the taxpayer's otherwise allowable debt deductions, eg under the safe harbour test. The Explanatory Memorandum provides examples to support the proposed interaction of Subdivision 815-A and the thin capitalisation rules - refer particularly to example 1.6 dealing with the arms length amount of debt interest.
Although only recently introduced into the House of Representatives and despite our concerns about several key aspects of the TP Bill, we would expect that Subdivision 815-A will be passed by both Houses of Parliament and enter into law in the coming months.
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