Overview and Background
The Australian federal 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 passed by the Australian Federal Parliament on August 20, 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 has been concerned with ensuring that Australia's Transfer Pricing Rules—both under the Domestic Law, Division 13 of the Income Tax Assessment Act 1936 (Cth) (ITAA 36), and under DTAs—are interpreted as consistently as possible with the Organization 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 November 1, 2011 announcement regarding proposed reforms to the 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. The rules will particularly affect global technology companies, banks and other financial services providers, funds managers, distributors and those involved in e-commerce.
It is expected further changes dealing with prescriptive documentation requirements, transfer pricing methodologies and penalties will be part of a second set of amendments to the Transfer Pricing Rules.
Highlights of Amendments
The TP Bill as enacted contains 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 the Domestic Law, rather than the Treaty itself, for the purpose of negating a "Transfer Pricing Benefit."
More changes are expected that will deal with documentation requirements, TP methodologies and penalties.
- 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 Thin Capitalization Provisions, Division 820 of the ITAA 97; i.e., impacting on costs that are debt deductions.
- Subdivision 815-A applies retrospectively from income tax years starting on or after July 1, 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.
These expanded Transfer Pricing rules will have a significant impact on all global businesses—including both inbound and outbound investors.
- 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 the Thin Capitalization 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, i.e., 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 with 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 to 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 know-how on the application of Transfer Pricing Rules.
Accordingly, both for first establishing whether an entity gets a Transfer Pricing Benefit, and second, 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 July 22, 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 devoted considerable attention to the legitimacy of the DTA's assessment powers, particularly with respect to the associated enterprises article and the business profits article. Recognizing some uncertainty around the legitimacy of the purported assessing powers contained in the 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 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 the 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 said 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, however, is the government's rationale for retrospectively introducing applicable legislation (from July 1, 2004) on the basis that it is the long-standing legislative intent that the law operates in this way, i.e., to provide an assessing power in the DTAs. While recognizing that there might be different views on the merits of the DTA power to assess, the government justified the introduction of retrospective legislation on the basis that first, these amendments ensured the law operated as the Parliament intended and second, there was a significant risk to revenue if the law were to apply in a manner that was inconsistent with the intention of Parliament.
This justification for retrospective legislation is consistent with the speech of May 18, 2012 by the Assistant Treasurer, the Honorable 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 was noted in the Second Reading Speech accompanying the TP Bill.
Thin Capitalization Provisions—Division 820
While preserving Division 820 as the comprehensive regime dealing with thin capitalization, Subdivision 815-A now applies to modify a Transfer Pricing Benefit related to profits, or referable 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 suggested that in working out the costs that are debt deductions, taxpayers need to first 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 of each other.
Although arguably supported by OECD guidance, the Explanatory Memorandum flagged that in some exceptional cases the arms length rate that applies to a debt interest may only be effectively determined by reference to the amount of debt a taxpayer would reasonably be expected to have if dealing at arm's length; irrespective of compliance with the safe harbor or other thin capitalization limits. This approach is not only controversial, but reflects the position adopted by the ATO in Taxation Ruling TR 2010/7 Transfer Pricing and Thin Capitalization. Most important, it is questionable whether this approach is supported by the plain words of the section—given the primacy of the language of the statute.
Some of the changes are retroactive to July 2004.
Once the arm's 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 capitalization rules can further apply to reduce the taxpayer's otherwise allowable debt deductions, e.g., under the safe harbor test. The Explanatory Memorandum, which provided examples to support the proposed interaction of Subdivision 815- A and the thin capitalization rules, refers particularly to example 1.6 dealing with the arm's length amount of debt interest.
Despite our concerns about several key aspects of the TP Bill, we expect that the Commissioner will actively seek to apply new Subdivision 815-A along with, in certain circumstances, Division 13. The Australian Transfer Pricing enforcement environment has forever changed with the passing into law of Subdivision 815-A.
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