- The good news...
Historically, the Australian Taxation Office (ATO) has used a sledgehammer to crack the proverbial "nut" insofar as transfer pricing (TP) documentation expectations are concerned for small and medium sized enterprises (SMEs) with overseas related party dealings. Fortunately, a sense of proportion shimmers on the horizon as a possibility...for some taxpayers.
Last week the ATO published a range of possible safe harbours 1 for identified low-risk taxpayers either limiting or simplifying their TP documentation requirements for a three year test period. Formalisation of administrative concessions, in this regard, is expected later this year.
For completeness, we stress that whilst we refer to safe harbours throughout this document, arguably, we are taking some literary license in use of the term. This is as taxpayers will continue to be required to retain a base level of documentation sufficient to evidence compliance with the proposed simplified requirements. Where taxpayers self-assess as eligible for the concessions, the ATO will not allocate compliance resources or undertake other compliance initiatives to examine the TP records of the taxpayer. In short, the ATO recognises that for the most part, taxpayers want to comply with the law and their choice to apply the simplified approach will be seen as evidencing a willingness to do so. For all practical intents and purposes, if implemented as proposed, the simplification measures will be regarded as safe harbours and that is how we refer to them throughout this article.
The ATO proposals appear (albeit in part), to be a response to the Inspector General of Taxation's recommendations to the Government made in December 2013 for simplified TP documentation for SME taxpayers. The ATO proposals are to be commended, however, in their present form they do not go quite far enough.
For many years we have laboured the point that the ATO TP documentation expectations for SME taxpayers is not only a time consuming administrative burden, but the cost of compliance in many cases, exceeds the cost of the preparation of all other aspects of an SME taxpayer's income tax return.
Earlier this year, the ATO commenced a TP documentation simplification project for what it regards as low-risk dealings. The outcome of this project, for an initial test period of three years, will be that safe harbours will apply to those entities that satisfy the ATO low-risk criteria.
This news will be welcomed by eligible taxpayers as their compliance cost should reduce significantly. Whilst the ATO has long focussed its TP resources on risk, it has not ignored the so-called "low-risk" taxpayers in its audit related compliance activity. Indeed, there are many war stories of taxpayers that fall into this category. The historic issue and risk for taxpayers is that when a TP adjustment is successfully prosecuted against them, the primary tax adjustment is serious. However, the applicable penalties and interest when added to the primary tax can equal or exceed the revenue in question. In short, TP risk is very serious.
Taxpayers that qualify to take advantage of the simplification measures will continue to be required to complete the International Dealings Schedule (IDS) in all respects, except that they will make an election within the IDS that they adopt the documentation simplification measures. The fundamental change is that the record keeping requirements for eligible taxpayers will be significantly curtailed.
- Proposed safe harbours
Whilst many of the ATO draft proposals remain a work in progress, they are fairly well considered at this stage, indeed so much so that the ATO is now comfortable that we mention them and actively engage with taxpayers to gauge their response. We stress that a great deal of water remains to flow under the bridge before the TP simplification project concludes.
Proposed low-risk taxpayers - the potential beneficiaries of the ATO approach include:
- Small taxpayers with turnover up to $25 million; and
- Small distributors with turnover up to $50 million.
In addition, safe harbour type arrangements are proposed for these taxpayers where they have:
- Specified service fee arrangements (refer section 5 below); and
- Loans of up to $50 million in Australian dollars (refer section 6 below).
- Conditions, conditions, conditions...
The ATO is struggling to let go of the reins and it appears likely that significant pre-conditions will apply to taxpayers that wish to take advantage of the ATO simplification concessions.
To be eligible for the safe harbours, both small taxpayers and distributors cannot have any related party dealings involving:
- Licence fees
- R&D arrangements
- Loans (subject to comments at section 6 below); or
- Dealings of a capital nature
We are at a loss to understand these exclusions and have strongly recommended that de minimis threshold values should apply to items that may be of a concern to the ATO. For example, many subsidiaries of multinationals involved in distribution, have low value licence and/or royalty fee arrangements wherein the risk to revenue is immaterial. In addition, many taxpayers have relatively immaterial dealings of a capital nature. In our opinion, such entities should also benefit from the proposed concessions. The ATO is further considering some aspects of its planned approach and we shall expect to see further developments in these areas.
In addition, a precondition applying to distributors, if they wish to rely upon the concessions, is that they must derive a Profit Before Tax ("PBT") of 3% of sales revenue or more. We have strongly emphasised the case that separate provisions deal with the question of interest deductibility; accordingly, Earnings Before Interest and taxes (EBIT) is the appropriate reference point rather than PBT. In addition, we see the 3% PBT (or EBIT) falling on the high side and have recommended a 2% threshold.
- Intra group services
The ATO is proposing a pragmatic approach to TP documentation for intra group services for low-risk taxpayers. The present proposal is where the related party service arrangements result in a total charge, income and/or expenses of:
- $1 million or less; or
- More than $1 million but 15% or less of total dealings (revenue
...provided that cost plus a mark-up is:
- 7.5% (or more) for outbound services; or
- No more than 7.5% for inbound services
...the arrangement will be acceptable to the ATO.
We have strongly urged the ATO to consider a range of margins, with a low of 5%. In our opinion, the 7.5% margin exceeds a commercial markup particularly for routine, administrative type services. The ATO is considering the possibility of lowering the margin expectation to a range of 5% to 7.5%.
- Related party loans
For many, the provision and receipt of intercompany loans is the very reason completion of the IDS is an annual income tax return requirement. The ATO has proposed simplifying the TP documentation expectations for entities where their combined cross border loan balance is $50 million or less throughout the year. The loans must be denominated in Australian dollars "...or total borrowing costs of an other than AUD loan are not greater than those that would exist if the loan was denominated in AUD."
The interest rate will likely be determined by reference to a benchmark rate (such as BBSW) plus a margin. The ATO will publish the margin, to be added to the relevant base rate, annually. We anticipate that the margin will likely be 1% to 2%. Options to use other ATO reference rates such as the Division 7A interest rate are also being considered by the ATO.
In addition to the eligibility criteria referred to at point 4 above, entities will be excluded from the simplification concessions where they have:
- Sustained losses (presently defined as three years or more of losses)
- Dealings with specified countries (as defined in the IDS but subject to review)
- Undergone a restructure within the year
Whilst we endorse the logic of excluding entities with sustained losses (although we remain surprised that there is no counterbalance restriction in terms of taxable income within a defined period), we question the ATO approach to the other two exclusions. For example, a company that goes through a restructure during the year, remains a matter to be disclosed within that taxpayer's IDS, accordingly, if the ATO so chooses, it could soften its approach and simply make specific written enquires about all restructures rather require full TP documentation to be completed where the simplification concessions would otherwise apply.
As for distributors, the PBT 3% requirement to enable a taxpayer to take advantage of the concessions, appears to conflict with the sustained losses exclusion. The logic of this view appears to follow as a distributor that is prima facie required to derive an annual PBT of 3% (or more) can hardly have one year, least of all three years, of losses!
- Concluding comments
We commend the ATO for "grasping the nettle" and actively developing the TP documentation simplification measures for some SME taxpayers. We have great faith that the final outcome of the ATO simplification measures will appease concerns and reduce the compliance costs of many taxpayers. We also remain hopeful that, in the final analysis, the taxpayer beneficiaries of the simplification measures will be expanded beyond those presently contemplated based upon the initial draft proposals.
We note that the ATO is actively seeking feedback on its proposed approach to the simplification measures and, in the interim, it will be fine-tuning some of the loose ends in the draft proposals outlined above. We anticipate that the ATO will finalise its position within the coming months. In the meantime, we would welcome feedback, comments and suggestions from clients and taxpayers with an interest in the proposals as we continue to proactively engage with the ATO to ensure that it appreciates the compliance burden cast upon taxpayers and the pragmatic way it may respond to taxpayer concerns in this regard.
1 It is noteworthy that the OECD has long contemplated the possible use of safe harbour' provisions that "...applies to a given category of taxpayer and that relieves eligible taxpayers from certain obligations otherwise imposed by the tax code by substituting exceptional, usually simpler obligations." [Refer OECD TP Guidelines for Multinational Enterprises and Tax Administrations paragraph 4.94]. The OECD recognises that there are both benefits to taxpayers (from compliance relief, administrative simplicity and certainty) and potential risks, for example, taxpayers may value a safe harbour to such an extent that a non-arm's length price is charged for the purpose of qualifying for the safe harbour relief. This, and other concerns, and the attendant risk of double taxation is particularly relevant to the profit expectations (PBT of 3%) of distributors proposed by the ATO [refer Section 4 hereof]. Australia for its part has long been seen to have a safe harbour in relation to intercompany services in TR 1999/1.
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