The first tranche of the reform of Australia's transfer pricing rules have been passed unamended by the Senate and received Royal Assent on 8 September, 2012.
The legislation remains substantially unchanged from the original Exposure Draft released earlier this year and upon which we wrote on 23 March, 2012.
Australia's transfer pricing rules will now operate under two distinct sets of provisions: namely, the existing laws enshrined in Division 13 of the Income Tax Assessment Act, 1936 [ITAA1936] (that, for the time being at least will apply to non-treaty countries) and the new Division 815 of the Income Tax Assessment Act 1997 [ITAA1997] provisions that essentially enshrine the OECD Transfer Pricing Guidelines into our legislation. Whilst both sets of provisions rely on the widely accepted 'arm's length principle', the methods of establishing an 'arm's length' outcome for a taxpayer's international related party dealings are significantly broadened for our tax treaty country trading partners. In future, for this group of taxpayers, wherever necessary, the ATO can now be expected to refer to the "profitability" of an enterprise (or lack thereof) rather than the "pricing" of its related party dealings to support an adverse transfer pricing adjustment.
Regrettably, the most egregious element of the original proposed legislation, the backdating of the new legislation (to 1 July 2004) has remained based upon some flimsy, spurious and, in part at least, false premises.
Despite vociferous criticism of the Government reforms and several forthright submissions by Moore Stephens (along with other firms) in relation to the legislation, our Government has pursued the backdating 'policy' that, we submitted, is 'third world' in its genesis.
To recap the key concepts and outcomes of this reform and its application to taxpayers, the ATO's long held 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 ITAA1936 has now been firmly established as law. Concerns that Division 13 of ITAA1936 dealt with the "pricing" of transactions whilst the tax treaty provisions dealt with "profits" have been 'clarified' by the creation of the new transfer pricing provisions. The new provisions provide, inter alia, that the extent of a taxpayer's economic activity conducted in Australia will by and large dictate the "profitability" that should be attributed to Australia "...consistent with the provisions that might be expected to have operated between independent parties in comparable circumstances..."
- Further changes to our transfer pricing legislation have been foreshadowed and are expected before year-end and are expected to deal with non-treaty country trading partners and possibly mandatory documentation requirements.
- The reform, 'marketed' previously by Government as having been designed to ensure 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", is now achieved through the explicit incorporation of the transfer pricing treaty rules into the ITAA1997 with attendant changes also made to ITAA1936.
The amendments under Division 815 of ITAA1997, broaden the current transfer pricing rules in Division 13 by incorporating into those rules, inter alia, the OECD Guidelines, thereby making certain two aspects of the operation of Australia's transfer pricing rules:
- Ensuring 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 the ITAA1997 ; and
- Requiring the arm's length principle to be interpreted as consistently as possible with relevant OECD guidance.
The new provisions operate to enshrine the OECD Guidelines within our law; in this regard it is noteworthy that in the period since these new provisions have been deemed to have become operative, the OECD Guidelines have been updated and both versions may need to be referred to depending upon the time period that a taxpayer is evaluating from a transfer pricing perspective.
The ATO can now 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 less than robust operating results or trading losses have cause for concern. Whilst there may be an arm's length basis for their pricing they are now well advised to also address their operating performance particularly if they suspect that the ATO is likely to regard their performance as less than commercially realistic. In short, those taxpayers in losses or with low profitability for years ending on or after 30 June 2005 should consider documenting the commercial reasons as to why they have under-performed.
These reasons, in our experience may include:
- Loss of major contract(s)
- Loss of key staff
- New competitors entering the market
- Fallout from and post the GFC etc
Not content with the 'clarification' measures taken to align Division 13 with the OECD Guidelines, Section 815-22(4) and (5) of the new legislation also 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, the new rules will first apply (from 1 July 2004) in evaluating whether an entity has derived a "transfer pricing benefit" for the income year in question having regard, inter alia, to what is an arm's length amount of debt.
The otherwise allowable debt deduction is only subject to the operation of Division 820 if and to the extent that an entity's debt exceeds its allowable debt (under Division 820).
- Australian taxpayers are now well advised to assess the potential implications of the new legislation when engaging with international related parties located in treaty countries and for the intervening period since 2004.
- An increased focus on record-keeping and the maintenance of contemporaneous transfer pricing documentation will be the best course of action to protect a taxpayer from a potential minefield of costs and penalties, particularly where a cocksure Revenue Authority will now be looking to re-assert its authority following its poor performance in recent transfer pricing litigation.
- Whilst the ATO has publicly announced that it won't be changing its approach to transfer pricing audits or re-examining previously settled cases, including APAs, there is no guarantee that a minority Government willing to impose draconian legislative measures (such as the backdating of legislation), challenged by the want of a 'surplus' budget will not be driving the ATO to achieve challenging revenue targets.
- Taxpayers that have considered or may be considering entry into an Advance Pricing Arrangement should reassess this approach to addressing tax risk management associated with transfer pricing.
As noted above, a second tranche of transfer pricing reform provisions will be issued shortly, likely before year end.
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