Tax Alert. Major changes to Australian Transfer Pricing rules. At a glance

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1 December 2012 Tax Alert At a glance Exposure draft (ED) law was released on 22 November 2012 Broad powers now given to the ATO to reconstruct or disregard related party arrangements Without documentation meeting minimum requirements, the taxpayer will receive penalties of at least 25% on any transfer pricing adjustments The responsibility of the Public Officer to ensure that actual conditions are consistent with arm s length conditions before signing the income tax return How Ernst & Young can help Major changes to Australian Transfer Pricing rules Exposure draft law (ED) was released on 22 November 2012, to replace Australia s transfer pricing domestic tax rules and introduce significant self assessment and documentation requirements. It is structured as Subdivisions 815 B, C, D & E. The draft legislation maintains the theme established by 815-A and provides the Australian Taxation Office (ATO) with broad powers to replace actual conditions with arm s length conditions. This is to ensure that the attribution of profits is consistent with what would be expected between independent parties. This exposure draft is the second tranche of the reforms to Australia s transfer pricing rules, which were foreshadowed in the Assistant Treasurer s Press Release on 1 November 2011 and outlined in a related Discussion Paper. The first tranche of the reform package (Subdivision 815-A) received Royal Assent on 8 September 2012 and applies retrospectively to 1 July The draft legislation comes shortly after the Government s mid-year economic outlook that flagged additional funding of $390m for ATO compliance enforcement over the next 3 years. The Government wants to raise an extra $1billion in taxes from the additional enforcement. The draft law includes significant new measures that will mean changes for most taxpayers with international dealings. Importantly, the onus will be on the Public Officer who signs the income tax return to confirm that the actual conditions are in line with the arm s length conditions as described in the draft law. If the actual and arm s length conditions do not align and this results in a better tax outcome for the Australian entity, there is a transfer pricing benefit.

2 If a transfer pricing benefit has been received, the taxpayer must make an upwards adjustment to taxable income or other tax attributes (e.g., tax losses or other tax offsets). Unlike the current transfer pricing disclosures in Schedule 25A and the International Dealings Schedule (IDS) (which are only information disclosures), if a Public Officer makes a false or misleading statement as part of an income tax return (and therefore in relation to a tax liability), the ATO may impose a range of specific penalties under the Tax Administration Act. Further, unless taxpayers keep transfer pricing documentation that meets the requirements of Subdivision 815-D and is prepared before the income tax return is lodged, they will be treated as not having a reasonably arguable position. As a result any transfer pricing adjustment by the Commissioner would attract at least a 25% penalty. Surprisingly, the start date for the new rules has not been stated. However, given that the principles outlined in the draft legislation are generally consistent with 815-A, taxpayers should not count on having a long lead time to prepare documentation. Therefore, it could potentially apply to income years commencing on or after 1 July It has been stated that the former transfer pricing provisions (Division 13) will be repealed and Subdivision 815-A will no longer have operation from the date of application of these changes. Taxpayers will need to now address gaps in their transfer pricing policies and documentation so as to be ready for these changes. Application of Subdivision 815-B Arm s length conditions The concept of arm s length conditions is the key to the new legislation and is relevant to many of the operative provisions. Arm s length conditions are the conditions that might be expected to operate between independent entities dealing wholly independently with one another in comparable circumstances (ss (1)). The concept of conditions should be read broadly and includes anything relevant to the economic substance of the entities and their dealings. Under the draft legislation these include such things as price, gross margin, net profit and the division of profits. In addition, the explanatory memorandum to the draft legislation clarifies that conditions can include other aspects of the arrangement such as terms of an agreement or the circumstances of the arrangement which may need to be modified (i.e. effectively reconstruct the transaction). Finally, the draft law also includes the power to effectively unwind or disregard the transaction where entities dealing wholly independently with one another in comparable circumstances would not be expected to have done anything. In determining whether actual conditions are consistent with arm s length conditions, taxpayers should select and apply the most appropriate method, or combination of methods, having regard to all relevant factors (ss (2)) including: The respective strengths and weaknesses of the possible methods The functions performed, assets used, and the risks borne by the entities The availability of reliable information to apply a particular method The degree of comparability, including the reliability of any comparability adjustments In determining whether actual conditions are consistent with arm s length conditions, taxpayers should have regard to the economic substance of what was actually done and not necessarily the legal form. Transfer pricing benefit Subdivision 815-B operates where an Australian entity gets a transfer pricing benefit (i.e. reduced taxable income, including increased losses) from actual conditions which differ from the arm s length conditions in connection with their financial or commercial relations. Where an entity gets a transfer pricing benefit, the arm s length conditions are taken to operate for income tax purposes and the taxpayer would be required to make an upwards adjustment to their taxable income. Importantly, 815-B only applies to increase taxable income, and cannot be used to self assess a reduction in taxable income. As with 815-A there is no specific guidance as to how the adjustments to taxable income will be linked to the various related party transactions which may have given rise to such adjustment. Establishing the appropriate link to the underlying transactions can have significant implications for customs duty and the effective use of Mutual Agreement Procedures under the treaty. Although there are a number of issues associated with the legal construction of this new draft legislation, these provisions have clearly been designed to provide the ATO sufficient flexibility to December 2012 Page 2

3 challenge business restructures, consistent low profitability or losses and higher risk intergroup funding arrangements where the Commissioner is of the belief that an arm length party would not have entered into the arrangement or would have entered into a different arrangement having regard to the options realistically available. The idea of notionally reconstructing transactions for the purpose of determining the tax liability is fraught with practical difficulty. Firstly it undermines the tenet that a tax liability should be capable of determination with reasonable certainty. Further, abandoning the actual transactions makes it far more difficult to determine the outcome as circumstances evolve over time, and is far more problematic to resolve through mutual agreement procedures. The application of this approach will no doubt significantly increase the level of uncertainty and controversy in relation to Australian transfer pricing. OECD guidance The draft law provides the ATO with greater powers to more routinely reconstruct transactions. This is through the potential replacement of actual conditions with what the ATO believes are the appropriate arm s length conditions. Unfortunately, this reconstructive power is not limited to exceptional circumstances as is the case under the OECD guidelines. In this regard, the OECD guidelines are based on the proposition that there is generally a range of equally valid arm s length outcomes. How these potentially divergent principles should be applied to self assess a tax liability will require further clarification. In coming to a view on whether there has been a transfer pricing benefit, taxpayers will need to interpret the rules to best achieve consistency with the OECD s guidelines. This provides some additional support for multi-national groups that have sought to ensure their transfer pricing policies are consistent with OECD principles. However at a practical level, it also increases the amount of material (in excess of 450 pages) a taxpayer has to consider in order to satisfy its Australian compliance obligations. It also calls into question the relevance of many of the existing transfer pricing rulings. The use of the OECD guidelines as the foundation for interpreting the new draft legislation is the same approach used in Subdivision 815-A, although importantly the words except where the contrary intention appears have been added. The legislation and explanatory memorandum (EM) discuss one contrary intention, being the application of Subdivision 815-B to unrelated parties that are not dealing wholly independently with one another. This exception would appear to provide the ATO with further flexibility to not follow OECD guidelines where an alternative approach is considered to be more appropriate. Thin capitalisation Section deals with the interaction between transfer pricing and thin capitalisation. It seeks to confirm the operation of TR 2010/7, which is that transfer pricing is concerned with determining an appropriate interest rate. The thin capitalisation rules then operate to reduce the otherwise allowable interest if an entity exceeds the thin capitalisation limit on the amount of debt. It also brings in a broader test for financing transactions by requiring a rate to be worked out as if the arm s length conditions applied. The intention of this, according to the EM, is to bring in two concepts appended by the ATO to TR 2010/7, being parental affiliation and an arm s length capital structure. The practical application of these concepts is controversial. We anticipate that they will be vigorously challenged by taxpayers and may ultimately be litigated. Subdivision 815-C - Arm s length principle for permanent establishments Subdivision 815-C introduces provisions intended to ensure that the profit taxed in Australia from entities operating through a permanent establishment (PE) is not less than it would be if the PE were a separate entity. 815-C applies to entities with inbound or outbound PEs. Given that the Board of Taxation is currently reviewing whether Australia should adopt the OECD s authorised separate legal entity approach, the inclusion of Subdivision 815-C is a little surprising at this time. The legislation and the EM make it clear that the draft provisions are intended to maintain the single entity approach but should be applied using the separate entity analytical framework to determine the appropriate allocation of the actual revenue and expenses of the entity in determining the appropriate profit of the PE. The provisions substitute the arm s length profits for the actual profits of the PE where otherwise the entity would obtain a transfer pricing benefit in an income year. As for 815-B, a transfer pricing benefit arises December 2012 Page 3

4 where the taxable income of the entity would be greater, a loss smaller, or the offsets would be less. Although a step in the right direction, the approach does not address many of the issues that arise in the practical application of these principles. It is hoped that the current Board of Taxation review will take the next steps in providing taxpayers with greater certainty in this area. Subdivision 815-D - Transfer pricing record keeping requirements While documentation is not mandatory in the strictest sense, a taxpayer that does not keep transfer pricing documentation that meets the specific requirements of Subdivision 815-D, will be treated as not having a reasonably arguable position. As a result any transfer pricing adjustment by the Commissioner would attract at least a 25% penalty. The documentation must contain specified content, including: An identification of the actual conditions and arm s length conditions The method used The comparable circumstances relevant to identifying the arm s length conditions The quantification of any transfer pricing benefit With the annual self executing nature of Subdivision 815-B, it is difficult to see how a taxpayer could fulfill the requirements to identify the actual and arm s length conditions without some form of transfer pricing analysis. Given this, it is advisable that any analysis that is prepared should meet the requirements of Subdivision 815- D so that a taxpayer also gets the penalty protection benefit of a reasonably arguable position. The prescriptive requirement for the transfer pricing documentation to deal with all conditions for the entity that are cross border, for an income year, would require most complex businesses to significantly widen the scope of their existing documentation. Rather than focus on categories of transaction that are material or risky, the draft rules in 815-D appear to require comprehensive documentation. We would also hope that the ATO would clarify that taxpayers who have made a genuine attempt to maintain the required documentation, will not be disadvantaged because the ATO reaches a different conclusion as to arm s length conditions and whether there is a transfer pricing benefit. Subdivision 815-E Special rules for trusts and partnerships The rules applying to trusts and partnerships use the same principles from Subdivisions 815-B, 815- C and 815-D. Penalties There are de minimis rules for administrative penalties. If the shortfall amount in the event of an adjustment is less than the greater of $10,000 or 1% of the income tax payable for the income year, no administrative penalty will be imposed. While the concept of a de minimis rule is sound, its practical use will be limited, given that it is doubtful that the Commissioner would ever make such a small transfer pricing adjustment. However, it does potentially provide some guidance to taxpayers as to the extent of analysis they may need to go to in preparing their income tax return disclosures. Action required In our view, taxpayers should identify any gaps in their current transfer pricing policy in light of the proposed legislation. In this respect there will be a number of issues to consider, including but not limited to: Transactions reflecting arms length conditions Chosen transfer pricing method is the most appropriate Documentation meets the minimum requirement to establish a Reasonably Arguable Position and thus reduce risk of penalties In addition taxpayers need to establish a robust framework of transfer pricing policies and systems that are able to produce the information to demonstrate the application of the policies. Where taxpayers have gaps in their policies or information systems, they will need to review their transactions and ensure that an appropriate position will be ready before the public officer signs their income tax returns. The above comments are especially relevant for taxpayers with any or all of the following circumstances: Business restructure Intra group financing arrangements Consistently low profits or losses December 2012 Page 4

5 Ernst & Young Assurance Tax Transactions Advisory Given the degree of uncertainty for historic and future arrangements, many taxpayers may wish to pursue an Advance Pricing Agreement (APA) with the ATO. This strategy could be an effective tool for managing transfer pricing risk and minimising ongoing documentation requirements. How Ernst & Young can help Please speak with your Ernst & Young transfer pricing contact if you have any questions or require any assistance with respect to any of the following aspects of the new legislation: Assessing the impact of the legislation with respect to your specific facts and circumstances Completing the steps necessary for lodging your income tax returns Preparing for potential ATO challenges Determining whether pursuing an APA may be appropriate under the new rules Ernst & Young are currently in the process of preparing a submission to address the key areas of concern for taxpayers. Please contact a member of your Ernst & Young transfer pricing team if you would like to provide input into the submission. About Ernst & Young Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 167,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential. Ernst & Young refers to the global organisation of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organisation, please visit About Ernst & Young Tax Services Your business will only achieve its true potential if you build it on strong foundations and grow it in a sustainable way. At Ernst & Young, we believe that managing your tax obligations responsibly and proactively can make a critical difference. So our 25,000 talented tax professionals in over 135 countries give you technical knowledge, business experience, consistent methodologies and an unwavering commitment to quality service wherever you are and whatever tax services you need. It s how Ernst & Young makes a difference. For more information, please visit Transfer Pricing Brisbane Kevin Griffiths Tel: kevin.griffiths@au.ey.com Melbourne Keir Cornish Tel: keir.kornish@au.ey.com Perth Joe Lawson Tel: joe.lawson@au.ey.com Sydney Paul Balkus Tel: paul.balkus@au.ey.com Jesper Solgaard Tel: jesper.solgaard@au.ey.com David Tracey Tel: david.tracey@au.ey.com 2012 Ernst & Young, Australia. All Rights Reserved. SCORE NO AU This communication provides general information which is current as at the time of production. The information contained in this communication does not constitute advice and should not be relied on as such. Professional advice should be sought prior to any action being taken in reliance on any of the information. Ernst & Young disclaims all responsibility and liability (including, without limitation, for any direct or indirect or consequential costs, loss or damage or loss of profits) arising from anything done or omitted to be done by any party in reliance, whether wholly or partially, on any of the information. Any party that relies on the information does so at its own risk. Liability limited by a scheme approved under Professional Standards Legislation. December 2012 Page 5