On 22 November, 2012 the Federal Government released a further Exposure Draft of proposed amendments to Australia's transfer pricing rules.
This Exposure Draft forms Phase II of the proposed changes to Australia's transfer pricing rules.
The Exposure Draft is titled: Tax Laws Amendment (Cross-Border Transfer Pricing) Bill 2013: Modernisation of transfer pricing rules.
In many respects the new provisions have many similarities to Subdivision 815-A, given Royal Assent on 8 September, 2012 as part of Phase I of the reform process.
Subdivision 815-A will have a very short life as the new proposed provisions will have no operation from the date of implementation of the new subdivisions into our law. The new provisions will also replace Division 13.
Clearly the Government has had no regard whatsoever for the burden cast upon affected taxpayers that must deal with layers of complex legislation.
The new subdivisions included in this Exposure Draft are:
- Subdivision 815-B - Deals with separate legal entities to ensure arm's length principle operates in the totality of its commercial or financial dealings with related parties and unrelated parties.
- Subdivision 815-C - Deals with permanent establishments to ensure the arm's length principle attributes an entity's actual income and expenses between its parts
- Subdivision 815-D - Details the "optional" documentation requirements and benefits of maintaining documentation; namely a reduced base penalty amount on the basis that one has a reasonably arguable position
- Subdivision 815-E – Details that Subdivisions 815-B, 815-C and 815-D also applies to trusts and partnerships.
The application of the provisions is on a self assessment basis and their success, like Division 13, does not rely on the presumption of a tax avoidance motive. The provisions operate irrespective of whether the dealings are between related parties purportedly to prevent "...collusive behaviour..."
In essence the Exposure Draft introduces into our domestic law the requirement that arm's length conditions apply between an entity's totality of international commercial or financial dealings and these arm's length conditions are substituted where they do not so operate. That is, an entity gets a "transfer pricing benefit" where the "actual conditions" differ to the arm's length conditions and the entity's "taxable income" should have been greater or tax loss (and/or tax offsets) less.
Arm's length conditions are defined, as the "... conditions that operate between an entity and another entity ...that might be expected to operate between independent entities dealing wholly independently with one another in comparable circumstances".
In identifying the "arm's length conditions", the Exposure Draft directs one to use the transfer pricing "...method, or the combination of methods, that is the most appropriate and reliable..." One is then directed to a number of "relevant factors" including the relative merits of each possible method and the functional profile of the taxpayer. We believe the focus on the "most appropriate method" coupled with the direction to refer to OECD guidance is a positive step in potentially tempering the Taxation Office enthusiasm for use of the profit methods. We say this as the OECD guidance makes clear the fact that where it is possible to apply one or other of the traditional transaction methods (the "comparable uncontrolled price method" or the "resale price" or "cost plus methods") in an equally reliable manner to the profit methods "...the traditional transaction method is preferable..." Accordingly, the profit methods, whilst unquestionably now having legislative "life" will only be the "most appropriate" method where they are more appropriate than the traditional transaction methods. Having said that, the comment must be subject to the fact that the Exposure Draft provides for documents (including OECD guidance) to be prescribed to apply or prescribed not to apply. Just what documents may be "prescribed" not to apply remains to be seen.
The "arm's length conditions" that are referred in the Exposure draft are stated to include:
- The price
- The gross margin
- The net profit
- The division of profit between entities
Presently, the Commissioner may amend an assessment to give effect to a transfer pricing adjustment unfettered by time limits. One bright spot on the horizon is that the Exposure Draft proposes an 8 year time limit, within which the Commissioner must issue such a notice of assessment.
Forecast mandatory transfer pricing documentation has not come to bear in this Exposure Draft, however the application of significant penalties with regard to adverse transfer pricing adjustments where documentation has not been prepared or maintained on a contemporaneous basis, remains.
This exposes taxpayers who have not addressed their documentation requirements to penalties and interest that may, in our experience, potentially exceed 100% of the revenue subject to adjustment.
Where Taxpayers prepare robust transfer pricing documentation in accordance with the ATO's prescribed "four-step" process, they should be deemed to have a Reasonably Arguable Position (RAP) and potential penalties are effectively halved to a range of 10% to 25% (non deductible).
The Exposure Draft also treats PE's as "distinct and separate" but dealing wholly independently when determining the amount to be brought to tax. The "arm's length profits" are worked out by "allocating the actual income and expenses of the 'entity' between the PE so that the PE's profits are those one would expect it to make as a separate and distinct entity. We are concerned that presently the Exposure Draft refers to substituting the profits of a PE with "arm's length profits" rather than referring, for example, to the "arm's length outcome" or "arm's length result" of a PE.
Interestingly, any new legislation dealing with PE's is likely to require change in the near term as the Government has arranged for the Board of Taxation to examine the implications of Australia adopting the OECD recently adopted 'functionally separate entity' approach in determining the profits to be attributed to a PE. Australia's present approach, an approach included in all our Tax Treaties, "allocates" income and expenses to the PE rather than hypothesise a 'separate enterprise'. This creates conflict with the concept of 'arm's length' insofar as internal charges for services, loans etc should essentially be a 'cost allocation' on the premise that one cannot make a profit in dealing with oneself. The Exposure Draft presently deals with this conflict by adopting the former OECD Model Tax Convention as the relevant "OECD guidance" in the Exposure Draft. It is noteworthy that the OECD Transfer Pricing Guidelines themselves do not specifically deal with attribution of profits to a PE.
Finally, with regard to arm's length debt provisions, Treasury has left Taxpayers in no doubt that the ATO does indeed have 'powers to reconstruct' the level of a Taxpayer's debt, so as to calculate the arm's length interest rate, notwithstanding they may comply with the thin capitalisation provisions. The Exposure Draft achieves this by stating that in working out the "rate" that is to apply to the actual quantum of debt interest one must do so "...as if the arm's length conditions had operated".
Submissions on the Exposure Draft are to be sent to Treasury by 20 December, 2012. Moore Stephens plans to present a submission to Treasury outlining the concerns held for Taxpayers borne out of the legislative amendments. We invite you to discuss your thoughts and potential impact on your business with us in the coming weeks.
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