Australia's income tax legislation has long contained specific anti-avoidance legislation dealing with international tax avoidance schemes; one example of this is Division 13 of the Income Tax Assessment Act 1936 (ITAA 1936). Division 13 operated for all taxpayers until 1 July 2004 and for some until 1 July 2013-refer table below). Division 13, along with the recently introduced legislative changes to our transfer pricing legislation, operates in relation to transactions between related parties (or between branches of one entity) that are perceived to "shift" profits outside Australia and thereby minimise Australian tax payments.
The pricing of transactions between Australian and overseas associated parties is critical for taxpayers and governments alike. This is so as the pricing of such transactions largely determines what income falls to tax and in which jurisdictions, if any, it is taxed. Governments around the world have responded to perceived transfer pricing practices of multinationals, branded "profit shifting", by introducing new measures in an endeavour to counter the erosion of their tax base.
Australia is at the forefront of this response introducing new legislation to "reform" or "modernise" our transfer pricing rules. The new legislation, introduced in two phases, firstly Division 815-A; and thereafter Division 815-B,C and D, is contained in the Income Tax Assessment Act 1997 (ITAA 1997). As taxpayers would be aware, the first tranche of this 'reform' (Division 815-A) came into effect from September 2012, with retrospective effect to 1 July 2004. Final refinements to our legislation (namely Division 815-B et al) were introduced nearly 18 months after their announcement with effect from 1 July 2013. The following table illustrates both the timing and operative dates of this legislation:
As noted in the above table, Division 13 of the ITAA 1936 applies to all taxpayers until 30 June 2004 (and until 30 June 2013 for taxpayers dealing with residents of non-treaty countries). Division 815-A of the ITAA 1997 applies from 1 July 2004 to taxpayers dealing with residents of treaty countries and Division 815-B, 815-C and 815-D of the ITAA 1997 (Division 815-B) (coupled with significant related amendments to our Taxation Administration Act 1953 [ITAA]) applies to all taxpayers for income years commencing on or after 1 July 2013.
The fundamental principle or "basic rule" in Division 815-B is that taxpayers should identify "arm's length conditions" and where the commercial or financial relations of the actual conditions differ to the arm's length conditions, having regard to both the form and substance of those dealings, arm's length conditions are substituted in circumstances where the taxpayer's derive a "transfer pricing benefit" (including, for example, a reduction in taxable income). In short, the new rules continue to apply the arm's length principle.
Division 815-B, as for Division 815-A, operates so as to direct taxpayers to consider guidance provided by OECD material in identifying what are arm's length conditions; in particular, taxpayers are directed to the OECD publication: "Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations" (OECD Guidelines) published on 22 July 2010.[Section 815-135].
The reference to 'commercial or financial relations' in Division 815-B is seen to potentially enable the Commissioner to consider, inter alia, what were the 'options' available to the taxpayer including a consideration of the overall commercial outcome or 'profitability' of the dealings in question.
We note that Moore Stephens has been highly critical of the complexity of the legislative change, some of the content thereof and the failure of our Government to have any regard whatsoever to the burden cast upon affected taxpayers by the layers of legislative amendments. The new transfer pricing rules, rules that operate on a self assessment basis, do however contain some 'positives'.
As foreshadowed in our earlier 'Transfer Pricing Insights' articles, a significant and positive aspect of the new regime is that a seven year time limit has been introduced within which the Commissioner of Taxation must make any transfer pricing adjustment; historically, there has been no time limitation within which the ATO may process a transfer pricing adjustment.
The most recent amendments enshrine in our legislation details of the type of documentation that taxpayers are encouraged to prepare. Whilst preparation and maintaining transfer pricing documentation is not mandatory, failing to prepare such documentation at or before the time of lodging a taxpayer's income tax return can be expected to result in significantly harsher penalties than would otherwise apply. Maintaining appropriate documentation should establish for taxpayers a 'Reasonably Arguable Position' (RAP) pursuant to Subdivision 284-E of the TAA; absent documentation, a taxpayer would be prevented from arguing that it has a RAP.
The ATO is in the process of updating several of its key rulings and guidance dealing with transfer pricing and we understand that one of the first rulings will address documentation requirements.
As previously advised, we have serious concerns as to the potential of the new provisions to enable the Australian Taxation Office (ATO) to hypothesise and 'substitute' or reconstruct actual transactions particularly where some 'head-strong' ATO official may perceive a taxpayer's operating performance as being less than 'commercially realistic'. The OECD Guidelines should act as something of a 'brake' on an overly enthusiastic ATO official, however, there is likely to be an unnecessary 'cost' to taxpayers in defending their positions.
The new provisions dealing with the interaction as between the transfer pricing provisions and thin capitalisation provisions have greater clarity in Division 815-B (compared with Division 815-A) and pretty much adopts into law the income tax ruling on the matter (TR 2010/7).
There are some important messages that flow from this legislative reform, they include:
- Preparation of documentation at or prior to lodging a taxpayers income tax return will become more important than ever if taxpayers are to benefit from the lower level of penalties that apply to a RAP situation. That is, the quantum of penalties, by law, is now linked directly to a taxpayer's documentation.
- As taxpayers now operate under a self assessment regime, they need to give serious consideration to these new provisions at the time of preparing their income tax returns. In this regard, if taxpayers are to 'evidence' a consideration of the actual and arm's length 'conditions' and maintain that there is no transfer pricing 'benefit', it appears to us that at a minimum, some documentation must be maintained to support the representations in the relevant income tax return. Public Officers should note that their signature is on a return and states that the return is "...true and correct..." More so than heretobefore, we recommend consideration be given to amending this declaration to "...true and fair..." which better aligns to reality (and the nature of a statutory auditors sign-off on the financial affairs of a taxpayer). Having said that, we believe that Public Officers that take reasonable precautions in acquitting their responsibilities should be free from potential prosecution. We note that some authors on this subject appear, in our view, to be crying "wolf" which, we believe, is self-serving.
- Notwithstanding OECD Guidelines that suggest that other than in exceptional cases, the tax administration "...should not disregard actual transactions or substitute other transactions for them..." (Paragraph 1.64) taxpayers are encouraged to appraise intercompany borrowing arrangements both as to the appropriateness of the level of debt, from an arm's length perspective, and the interest rate that would apply on an arm's length quantum of debt. We point out that OECD Guidelines do suggest that in certain circumstances transactions should be re-characterised to accord with the "substance" thereof. The OECD Guidelines proceed to state that interest bearing debt may in certain circumstances be characterised in accordance with its "economic substance" such that a loan may be treated as a subscription of capital. Taxpayers, we believe, should expect to see significant ATO activity in this area.
- We regularly see taxpayers referring to transfer pricing documentation prepared by their overseas parent company and they conclude, therefore, that they have maintained appropriate documentation. We strongly recommend a review of this documentation to ensure that it addresses the specific requirements of Australia's transfer pricing requirements; in particular, the adoption of the ATO 'four-step' process and ensuring that the documentation addresses all the legislative requirements enshrined within Subdivision 284-E of the TAA.
- From time to time we see dealings between related parties where simple journal entries are raised in lieu of invoices and attendant written agreements; we recommend that documentation that could be expected to be prepared as between independent arm's length parties, should generally be maintained as between related parties. This extends to the suggestion that intercompany service agreements, loan agreements, guarantee arrangements and so on are all committed to writing and executed by the parties concerned.
We mention that the annual ATO publication titled: "Compliance in focus 2013-2014", (Compliance Plan) states that a major focus of the ATO in the coming year will include a review of companies that "...engage in practices designed to shift profits offshore or avoid tax obligations." During the 2014 year the Compliance Plan states that the ATO plans to conduct 125 transfer pricing risk reviews and 26 audits. To be frank, given the extent of the ATO resources and the new 7 year time limit within which the ATO may make transfer pricing adjustments, we were rather surprised that a greater number of audits are not planned. Having said that, we are aware that the ATO has a large number of senior personnel tied up in some major transfer pricing disputes, disputes dealing with business restructures, the implementation of central marketing hubs and loan and guarantee fee arrangements.
Finally, for those taxpayers that require greater certainty and/or that have a "no surprises" approach to their taxation affairs, we comment as follows. As international related party dealings arguably present as the most significant potential tax adjustment, taxpayers may wish to consider entry into an Advance Pricing Arrangement (APA). APAs have presented as a viable, albeit somewhat expensive, option to consider over the past decade or so and interestingly a number of our overseas trading partners are seeing an increase in APA activity in recent years. Whilst generally an APA will operate for three to five years many, for example, in the United States, operate for much longer terms. One may have expected to see a greater number of APA applications in Australia; having said that there is evidence that the ATO is far less accepting of APAs that has been the case in the past. This begs the question: how are taxpayers able to obtain greater certainty in relation to their transfer pricing 'risk'? For our part, we recommend that consideration be given to entry into an APA or, alternatively, consideration could be given to requesting a written ruling from the ATO in relation to the arm's length nature of a taxpayer's international related party dealings.
This publication is issued by Moore Stephens Australia Pty Limited ACN 062 181 846 (Moore Stephens Australia) exclusively for the general information of clients and staff of Moore Stephens Australia and the clients and staff of all affiliated independent accounting firms (and their related service entities) licensed to operate under the name Moore Stephens within Australia (Australian Member). The material contained in this publication is in the nature of general comment and information only and is not advice. The material should not be relied upon. Moore Stephens Australia, any Australian Member, any related entity of those persons, or any of their officers employees or representatives, will not be liable for any loss or damage arising out of or in connection with the material contained in this publication. Copyright © 2011 Moore Stephens Australia Pty Limited. All rights reserved.