Australia: Moore Stephens comments on draft transfer pricing rulings and practice statements

Last Updated: 4 June 2014
  1. TR 2014/D3 Income Tax: transfer pricing – the application of section 815-130 of the Income Tax Assessment Act 1997 ("ITAA 1997")

Leaving aside the fact that one aspect1 of section 815-130 appears, at first blush, to potentially conflict with the current OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations ("OECD Guidelines") we turn to a consideration of the "basic rule" in section 815-130 (that arm's length conditions are based on actual conditions) and the three exceptions thereto.

Elements of those exceptions are, we submit, cause for concern. Our fundamental concern is around the fact that, to cite the OECD Guidelines: "Associated enterprises may and frequently do conclude arrangements of a specific nature that are not or are very rarely encountered between independent parties."2 Put simply, oftentimes there are no comparable arm's length dealings against which taxpayers may check the veracity of their arm's length actual commercial and financial conditions.

At paragraph 45 of TR 2014/D3 it is suggested that where the "third exception" is taken to have applied:

"...the actual conditions are disregarded and the arm's length condition that nothing would have occurred is substituted in their place" (our emphasis)

That is, the actual transaction, in language used elsewhere in the ruling, is "...annihilated"3


In the example used in the Ruling, it questions whether the sale of intellectual property ("IP") has been made, as a "question of fact" and, presumably then, sales proceeds have been received. At most, some form of adjustment may be appropriate to recognise those elements of the actual transaction that lacked commercial substance. We submit that one cannot merely "disregard" this transaction in its entirety as recognition must be given to the actual conditions, namely: the sale transaction and its attendant consequences (presumably recognition of assessable income and/or a capital gain in relation to the sale and, possibly, royalty payments for the right to use licenced IP etc.).

At paragraph 98 (foreword) a further example is provided in relation to the assignment of trademarks for "...consideration considered by AusCo to be arm's length..." [paragraph 100; our emphasis]. At paragraph 103 the statement is made that the purchaser of the IP "...would be rewarded only for its re-invoicing and reimbursement activities." This (like the foregoing example) is clearly incorrect. The purchaser of the IP should receive an arm's length return for its ownership (a question of fact) thereof.

We suggest that this example needs further development and explanation. For example, how will the ATO recognise that the IP, albeit perhaps in part, has been sold? Will the ATO disregard all the income tax consequences of sale of the property (be it the assessable income or capital gain on sale, the claw-back of the R&D tax concession etc.)? Some consolation in this regard can be taken from OECD Guidelines wherein it states:

"...where a restructuring arrangement involves a transfer of property between two parties, any non-recognition of the restructuring arrangement would need to reflect that a transfer of such property occurred between the two parties, although it may be appropriate to replace the character of the transfer with an alternative characterisation that comports as closely as possible with the facts of the case. (E.g. a purported transfer of all rights in the property might be re-characterised as a mere lease or licence of the property, or vice versa)."[Our emphasis].

As a general comment, we are seriously concerned that the ATO officials will be placed in situation whereby they "hypothesise"4 what independent parties would have done in comparable circumstances notwithstanding associated enterprises often engage in transactions where there are no comparables. In such circumstances, how will these ATO officials go about determining what independent entities would have done; more to the point perhaps: how will taxpayers satisfy their transfer pricing obligations in these circumstances? We submit that the inclusion in the Ruling of more substantiative guidelines in this regard would be much valued by taxpayers.

We note that there is also an example at Paragraph 31 of the Draft Rulings (which mirrors the example in the OECD Guidelines5 ) dealing with the re-characterisation of interest bearing debt to a subscription of equity. We support the inclusion of an example such as this in the Draft Ruling; however, we submit that the example does not go far enough. For example, in what circumstances will the ATO take a position that debt is in substance equity? Some guidance in this regard would be valuable. We are aware of situations where an independent bank has declined to provide loan funds to a subsidiary of a multinational, yet we do not accept that a subsidiary's inability to source third-party funding is necessarily determinative as to the debt/equity characterisation (albeit it should generally be one "relevant factor" that should be considered). We say that such a factor should not be determinative of the loan characterisation because the parent entity will generally be best placed to appreciate the profit earning potential of the subsidiary (given its detailed knowledge of the business) and, accordingly, an arm's length, third party, with that same depth of knowledge and a comparable risk-taking profile as the parent may, we suggest, well agree to provide the requisite loan funding6 .

As to whether or not a loan is so "exceptional" as to warrant reconstruction (that is, it has in substance the characteristics of equity rather than debt), in addition to the ability borrow from independent financial institutions, a number of other factors are also relevant and should ideally be included as guidance to taxpayers in the Ruling; these factors are addressed in large part in TR 92/117 and may also include8:

  • The existence and content of loan documentation;
  • The intention of the parties;
  • Whether or not there is a stated repayment date (the absence of which may indicate that repayment was dependent upon success of the business);
  • The nature of the 'loan' viz a viz other creditors of the borrower;
  • The financial wellbeing of the borrower and whether or not it can readily meet its repayment obligations to the lender or whether repayment will depend upon future potential profits of the borrower;
  • Whether the "loan" has a status equal to or inferior to that of day-to-day creditors;
  • The gearing ratio of the borrower;
  • The interest cover ratio of the borrower;
  • The use to which the funds have been applied (capital assets viz a viz working capital);
  • The right to enforce repayment and whether the intention of the parties is to provide permanent financing of a type normally having the character of equity;
  • Whether or not interest payments are insisted upon in accordance with the agreement.

We further submit that in treating an amount of debt as notional equity, the ruling should state: "...accordingly, that element of the debt (treated as notional equity) would be treated as interest-free for the purpose of identifying the arm's length conditions."

Perhaps one way to deal with this example is to include details sufficient to secure the readers understanding of the factors that the ATO expects taxpayers to consider in evaluating whether debt should in fact be treated as notional equity. A high risk, greenfield business with no track record or apparent source of cash flow and inadequate assets for loan security purposes may be an appropriate basis for an example to include in the Ruling.

  1. TR 2014/D4 Income Tax: transfer pricing documentation requirements

Paragraph 38 of TR 2014/D4 states that "...records will need to evidence whether the basic rule and the three exceptions apply or do not apply..." to the taxpayer. Paragraph 24 and 39 state that transfer pricing documentation "...needs to exist and to be kept by the relevant entity." so as to "...allow the arm's length conditions relevant to the matter to be readily ascertained." We refer to our comments in relation to TR 2014/D3 and reiterate our concerns that the ATO record keeping evidentiary documentation expectations are seriously wanting particularly in circumstances where there are no "comparable" third party dealings that one may have reference to. Is the ATO really implying that taxpayers "evidence" this analysis by reference to the profitability of the taxpayer? If so, we suggest that paragraph 38 should clarify that expectation.

As to whether documentation is "kept" by the taxpayers, somewhat greater guidance is required in circumstances where that documentation is "available" to the taxpayer but held by the parent company overseas. We submit that for the Public Officer to sign the required "true and correct" declaration of an income tax return, unless "immaterial", (refer later comments) he or she must personally have perused that documentation and satisfied him/herself that it accords with Australia's legislative requirements. We believe that the Ruling lacks clarity on this point notwithstanding the comments at paragraphs 71 et al (and further comments at paragraph 39 et al of PSLA 3673 where the comment is made "...the records kept by the entity need to be in the possession of the entity or available to the entity..."). Such records may be "...available..." but has the taxpayer's Public Officer reviewed this documentation to be satisfied it is compliant with Australian law?

There is quite an apparent focus stated or implied in relation to the "materiality" of the commercial or financial conditions. At paragraph 51 TR 2014/D4 states that an entity's records should contain all the necessary information relevant to the operation of the arm's length conditions..."and "...include all questions that would ordinarily be considered in calculating any elements of the entity's tax position". Prima facie this documentation expectation is exceptionally onerous and goes way beyond the expectations of OECD Guidelines9 . What exacerbates this "expectation" is paragraph 61 of the Ruling wherein it states:

"A condition is material if it affects the entity's Australian tax position."

We submit that paragraph 61 requires serious attention and should ideally refer one back to accounting concepts or a specific dollar value (as to what is or is not "material"). We further suggest that paragraph 61 conflicts with PSLA 3673 (refer paragraphs 6, 11, et al) where the term "materiality" appears to have been somewhat better considered (albeit in want of further clarification). Paragraph 61 also appears to conflict with paragraph 66 and 67 insofar as OECD Guidelines, dealing with documentation expectations, are restated and the suggestion put that taxpayers should exercise "...good commercial judgement in determining the level of documentation..." How does one exercise good commercial judgement in circumstances where the Ruling provides no substantiative guidance on the concept of materially, (when read in concert with paragraph 61)10?

We suggest that greater, elaboration of the ATO five step documentation process and expectations in this regard, particularly for smaller to medium sized enterprises is wanting as contrary to the Exploratory Memorandum11 many of these enterprises do not presently retain documentation that would satisfy the "reasonably arguable position" documentation threshold12 .

  1. Draft Practice Statement Law Administration PSLA 3673

PSLA 3673 raises the "materiality" consideration (refer, for example, paragraphs: 6, 11, 13, 43, et al) and whilst it is suggested that taxpayers " efforts..."13 at complying with the five step documentation process will satisfy ATO documentation requirements, there is no comprehensive outline of what this process is (unlike the four step process outlined in detail in "chapter 5 of TR 98/11"14). We recommend greater clarity within this practice statement of the ATO documentation expectations.

We submit that paragraph 44 does not go far enough in providing a degree of certainty to taxpayers (in relation to penalty remission) where they have used their best efforts (in good faith) to retain comprehensive transfer pricing documentation. That is, five step documentation prepared by a taxpayer should not merely be "...a relevant factor..." in a consideration of penalty remission but rather "the" critical consideration. Accordingly, we recommend an inclusion in PSLA 3673 akin to paragraph to 2.11 of TR 98/11, namely:

"Taxpayers who have in good faith followed the four steps outlined in Chapter 5 of this ruling in preparation of their returns and kept sufficient and relevant contemporaneous documentation to show compliance with the arm's length principle will not be subject to penalties..." (Our emphasis. Refer also paragraph 5.4 of TR 98/11 for further guidance in this regard).

The "background" comments to PSLA 3673 (and later paragraphs 41 and 42 of PSLA 3673) raise questions for taxpayers as to those circumstances where dealings with non-associated entities are captured by Subdivision 815-B et al and in what circumstances transfer pricing documentation may be required in relation to such transactions. The implication is that such documentation is only required for non-arm's length dealings; however, some guidance as to what evidentiary documentation the ATO expects of taxpayers if they are to substantiate that there are no non-arm's length dealings with third parties is required.

Paragraphs 32, 34 and 35 are quite specific as to some elements of documentation that the ATO expects of taxpayers. For example, a taxpayer's "worldwide organisation structure" is a stated requirement. We submit that generally such information may not be readily available to an Australian taxpayer, indeed it may not be relevant to the Australian related party dealings and it should not be a specified annual documentation requirement. It is noteworthy too that large corporate groups regularly undergo change to their organisational structures and hence any requirement in this regard should only fall for consideration in the event of an ATO transfer pricing review of a taxpayers dealings.

Paragraph 68 discusses Step 5, namely the monitoring/reviewing of transfer prices. We submit that in the "simple transaction" example provided at Paragraph 68 the words "may not" should be amended to read "...would not". The statement to which we refer is as follows:

"...a detailed comparability (including functional) analysis may not be needed every year."
  1. Draft Practice Statement Law Administration PSLA 3672

We refer to our forgoing comments on penalties and the suggestion that those taxpayers that maintain their best efforts to satisfy ATO documentation requirements should not suffer penalty imposition. In particular, we refer to the comfort taxpayers have historically been able to take from (paragraph 2.11 and 5.4 of) TR 98/11; accordingly, we recommend that like statements to those made in TR 98/11 should be included in PSLA 3672 so as to provide greater certainty to taxpayers.

We suggest that greater clarity around penalty imposition is all the more important given that the resolution of transfer pricing disputes frequently turns to "negotiation" between the ATO and taxpayer, and more often than not, ultimately the dispute is resolved by compromise agreement rather than on the basis that one party is correct and the other incorrect. In short, the subjective nature of the determination of what amount or amounts are arm's length in nature should exclude a consideration of penalties where the taxpayer has exercised "best efforts" in "good faith" to satisfy the five step documentation process.


1We refer to Section 815-130(4) of the ITAA 1997 insofar as the legislation prima facie anticipates disregarding actual transactions arguably more readily than do OECD Guidelines. Section 815-130 (4) provides that one is to determine arm's length conditions based on the "...absence of commercial or financial relations..." where independent parties would not have entered into the actual arrangements. Given that related parties frequently enter into arrangements where there are no arm's length comparables and given that "comparability" is the foundation stone of the arm's length principle, this provision requires significant clarification as to the ATO documentation expectations as OECD Guidelines, at paragraph 1.64 et al, makes patently clear that other than in "exceptional circumstances" actual transactions of a taxpayer should not be disregarded.

2OECD Guidelines Paragraph 1.67 see paragraph 1.11

3TR 2014/D3 Paragraph 135

4Refer TR 2014/D3 Paragraph 33

5Refer OECD Guidelines Paragraph 1.65

6See also TR 92/11 Paragraph 60 (g)

7Income tax: application of Division 13 transfer pricing provisions to loan arrangements and credit balances.

8See for example, Estate of Mixon v United States July 5, 1972

9Refer OECD Guidelines paragraphs 5.7, 5.15, 5.28, et al.

10 Refer also paragraph 105(e) reference to "materiality"

11Refer Explanatory Memorandum to the bill wherein it states: "compliance costs impact: Not expected to be significant. Much of the required information is already kept by taxpayers in complying with their tax obligations and the existing transfer pricing rules."

12 Refer also TR 98/11, Chapter 6, reduced documentation expectations for "small taxpayers and taxpayers with relatively low levels of international dealings with associated enterprises..."

13Refer PSLA 3673, Paragraph 6

14Refer: Income Tax: documentation and practical issues associated with setting and reviewing transfer pricing in international dealings (TR 98/11)

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 © 2014 Moore Stephens Australia Pty Limited. All rights reserved.

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