Over the past 18–24 months, there have been significant developments in the transfer pricing arena, both globally and in Australia.
The implementation of various Organisation for Economic Co–operation and Development (OECD) base erosion and profit shifting (BEPS) initiatives, including country-by-country reporting (CbCR), the enactment of the Multinational Anti–Avoidance Law (MAAL), the introduction of a diverted profits tax (DPT), and the landmark Federal Court decisions in the Chevron1 case are just some of the important changes that have already had an impact on how multinational enterprises (MNEs) operating in Australia manage their transfer pricing arrangements.
In addition, Australia has adopted the OECD's revisions to the Transfer Pricing Guidelines (TPG) from 1 July 2016 and has legislated a one hundred–fold increase in penalties for the late lodgement of certain documents by MNEs.2
Against this backdrop, the Australian Taxation Office (ATO) has skilled up in transfer pricing and continues to grow its anti–avoidance taskforce and economist practice, to assess transfer pricing risks and tackle disputes with taxpayers. A large part of the ATO's strategy is to foster a change in taxpayer behavior – in its words, "prevention before correction." Many of the ATO's publications, including Practical Compliance Guidelines (PCGs) issued in January 2017 in relation to offshore hubs3 and more recently related-party financing transactions,4 suggest taxpayers self– assess their transfer pricing risk profiles and take appropriate measures when needed to ensure they avoid future scrutiny.
2017 has already proven to be a busy tax year for MNEs in light of the aforementioned developments, particularly in relation to the preparation of transfer pricing documentation. Given the scale of the task, and the consequences of poor execution, many companies are devoting more resources to transfer pricing. Given the resources involved in defending historic arrangements and preparing documentation, this begs an important question – Is your organisation ready?
The minimum standard
Historically, the transfer pricing provisions were enforced by the Commissioner of Taxation (i.e., upon review of a taxpayer's affairs, the Commissioner could seek to make a transfer pricing adjustment and issue an amended assessment to reflect the revised tax position).
However, an important feature of Australia's "new" transfer pricing legislative provisions is that the onus is placed on taxpayers themselves to self–assess their compliance with the arm's length principle, and to ensure they have maintained contemporaneous transfer pricing documentation evidencing their application of the tax law. Any transfer pricing documentation report must therefore address the concepts of "transfer pricing benefit" and "reconstruction" to support the taxpayer's self–assessment of its transfer pricing position, as explained below.
A transfer pricing benefit arises when there is an understatement of taxable income, overstatement of a tax loss, over-claiming of tax offsets, or underpayment of interest or royalty withholding tax as a result of the conditions in related-party transactions not aligning with arm's length conditions. Arm's length conditions5 refer to conditions that might be expected to operate between independent entities in the same (or similar) circumstances. However, should one of three exceptions apply,6 the Commissioner has broad powers to reconstruct the actual transactions undertaken and the basis for identifying the arm's length conditions.7
To self–assess whether a reconstruction of the actual conditions is required, taxpayers must compare and equate the substance and form of the transaction, and must also consider what independent parties would have done in comparable circumstances.
The importance of demonstrating commercial and economic substance in this context cannot be overstated.
Subdivision 284–E of Schedule 1 of the Taxation Administration Act 1953 sets out what documentation taxpayers require to demonstrate the arm's length nature of their related-party dealings, and the consequences of not having this contemporaneous documentation are significant. In the event of an ATO adjustment, a taxpayer cannot have a Reasonably Arguable Position (RAP) without having the relevant documentation in place at the time of lodging the relevant tax return, and could therefore be liable for additional penalties and/or interest on any additional tax payable.
Similarly, the recent revision to Australia's penalty regime makes "getting it wrong" potentially a costly mistake. Increased administrative penalties for significant global entities8 (SGEs) will apply from
1 July 2017 and extend to the failure to lodge any tax document required to be lodged with the ATO on time or in an approved form.
Penalties range from AUD 105,000 for lodging a tax return or other required tax document just one day late, to a maximum penalty of AUD 525,000 when just one document is lodged more than 112 days late. MNEs also need to be meticulous in their approach, given that penalties relating to incorrect statements made in documents submitted to the ATO by SGEs are set to double. Penalties for entering into any tax avoidance or profit shifting scheme will also be doubled for SGEs without a RAP.
CbCR, master file, and local file obligations
For the first time, certain Australian taxpayers will need to lodge transfer pricing documentation with the ATO as an ongoing compliance requirement. While many other countries have deferred the implementation of CbCR and master/ local file reporting to 2017, Australian taxpayers are already subject to CbCR. Applicable from 1 January 2016, Australian taxpayers who are part of SGEs (that is, an entity that is part of a multinational group with an annual global income of AUD 1 billion or more) must file a country-by-country report, a master file, and a local file. Companies with a 31 December 2016 year end must therefore submit their documentation to the ATO by 31 December 2017.
Whether or not the Australian taxpayer is the head company of the global group or a member, it is the Australian taxpayer that is obliged to file the necessary documentation locally with the ATO, not the ultimate parent of the MNE. In a tax consolidated context, that would be the Australian head company of the tax consolidated group. Australian subsidiaries of MNEs may be eligible for exemptions
for some of the filing requirements in certain circumstances; however, based on discussions with the ATO and recently released CbCR exemption guidance,9 there are no blanket exemptions for submission of the documents. Each request will be assessed on a case-by-case basis.
Whilst the ATO has adopted the OECD's BEPS Action 13 master file template, the ATO's approved form for the local file has diverged from the OECD guidance. The Australian local file is akin to the International Dealings Schedule (IDS), which already forms part of the company income tax return; however, it requires more granularity at a transactional level. It also requires the digital provision of information that is generally largely included in an entity's transfer pricing documentation, including agreements (not required by Subdivision 284–E but typically annexed to documentation reports), names and jurisdictions of counterparties, and transfer pricing methods applied. Similar to the IDS, the local file information will be used by the ATO to risk assess taxpayers.
The provision of agreements to the ATO means that it is timely to review those agreements and ensure that the legal form matches the substance of the arrangement, as well as the consistency of agreements (and pricing approaches) for similar transactions occurring within the MNE around the world.
Unfortunately, the preparation and lodgement of CbCR and master and local file documentation is separate and distinct from the preparation of Subdivision 815–B documentation for Subdivision 284–E purposes. That is, the new rules simply add an extra layer of reporting, and an additional reporting date (12 months following year end).
If your company is a member of a global group, now is the time to reach out to your parent company to confirm what you need to be collating at the local level for CbCR purposes. Action 13 is a clear reminder that the local reporting requirements are merely one piece of the puzzle. Changes are happening at the global level as well, so solutions need to be consistent and coordinated.
In this evolving tax environment, one which demands increased transparency by the taxpayer and is characterised by greater sharing of information between tax authorities, technological solutions are more important than ever. Planning, centralisation, consistency, efficiency, and risk assessment will be the foundation of effective transfer pricing management by MNEs.
Enacted late in 2015, the MAAL is broadly intended to ensure that MNEs do not use complex, contrived, and artificial schemes to avoid a taxable presence in Australia. From a transfer pricing perspective, the philosophy underlying the MAAL is to prevent the risk and rewards of selling from being artificially alienated from the selling functions/activities (consistent with the OECD's desire to ensure transfer pricing outcomes align with where value is created).
For example, the MAAL targets scenarios whereby a foreign entity supplies goods or services to Australian customers but an Australian related party performs activities (such as sales and marketing support) that go some way to securing the sales.
Central to the ATO's application of the MAAL is a review of the nature of activities performed in Australia, their principal purpose, and the global structure and value chain as it is relevant to the Australian entity's operations.
Before 31 March 2016, taxpayers were given transitional concessions, including relief from penalties, and the ATO took a less adversarial approach, including guidance on provisions, and the potential to seek binding rulings and advance pricing arrangements (APAs). Any application of the MAAL provisions now goes through the standard ATO compliance processes and thus faces a greater risk of increased penalties. The ATO also has identified potential anti–MAAL planning structures, and has released Taxpayer Alert TA 2016/11–Restructures in response to the MAAL involving foreign partnerships. In the 2017-18 Federal Budget, the government announced retrospective changes to the MAAL to address the concerns raised in this taxpayer alert.
What is abundantly clear from this is that the ATO will not tolerate any anti–MAAL-type structuring. Taxpayers should ensure they review their arrangements and consider an ATO engagement strategy if necessary.
Over and above the MAAL, the DPT was proposed in the 2016 Budget as a secondary anti–avoidance measure targeting the unsupported shifting of Australian profits to offshore entities in lower-tax jurisdictions (those where the effective tax rate is less than 24 percent). Australia's version of the DPT is modelled on the UK equivalent, and the UK's HMRC are currently in the process of risk–assessing taxpayers to which the DPT could potentially apply. However, the Australian DPT is significantly broader in scope than the UK version and, unlike the UK rules, is designed to capture financing arrangements within its ambit.
The application of the DPT will be based on the satisfaction of several gateway tests that capture Australian taxpayers that are part of an SGE, who engage in dealings with a foreign related party. The DPT has been included as part of Australia's general anti–avoidance provisions (Part IVA Income Tax Assessment Act 1936), and consistent with those provisions, requires the ATO to form a view as to whether there was a principal purpose of obtaining a tax benefit. Central to a taxpayer's ability to show that the DPT should not apply to it will be its ability to demonstrate sufficient "economic substance" associated with its transactions.
Having received Royal Assent in early April, the DPT will apply from 1 July 2017 regardless of when the relevant transaction was entered into. The DPT allows an assessment to be issued based on a "tax benefit" identified by the ATO. The tax benefit (based on existing Part IVA principles) is effectively the ATO's view of the diverted profits under the arrangement entered into, as compared to the Australian tax position under a reasonable alternative counterfactual asserted by the ATO. The diverted profit is taxed at 40 percent, to be paid upfront. This reflects the ATO's general strategy to change taxpayers' behaviour regarding aggressive structuring and transfer pricing, as well as their approach toward disputes with the ATO.
Taxpayers should consider the potential application of the DPT to their existing and new transactions, and should be able to support/evidence the "substance" of entities in lower-tax jurisdictions with which they are transacting. Every ATO risk review of MNEs is expected to include a DPT focus. The messaging from the ATO is that although DPT is not a provision of last resort, the DPT is expected to be applied only in very limited circumstances, after giving consideration to the operation of the ordinary provisions in the income tax law. However, because the DPT is enacted as part of Part IVA, in the event the ATO applies the DPT to a taxpayer, double tax is likely to arise, because Part IVA is expressly excluded from Australia's double tax agreements. Thus, taxpayers cannot invoke the mutual agreement procedures in tax treaties to relieve the double tax.
ATO encouraging taxpayers to self–assess their risk
The ATO issued PCG 2017/1 in January 2017 setting out the ATO's compliance approach to transfer pricing issues related to the location and relocation of certain business activities (for example, procurement, marketing, sales and distribution functions), and associated operating risks into centralised operating models (referred to by the ATO as "hubs"). This is a significant development on an issue that has been a "hot topic" for the ATO for many years and will need to be considered by many taxpayers in the mining and oil & gas sectors. The guidance primarily focuses on existing and newly created offshore marketing arrangements; however, it is expected to be expanded to include procurement and shipping arrangements.
The guidance outlines a white zone and five risk zones from green (low risk) to red (very high risk) and explains how the ATO will approach taxpayers in each zone differently in terms of resourcing, and the type/extent of any compliance review.
The white zone provides a concession from self–assessment of risk by the taxpayer on the basis that there has already been ATO engagement in the form of an APA, settlement agreement, or review resulting in the allocation of a low risk rating.
Broadly, the risk rating turns on the hub's profit compared to its "costs" (effectively, operating expenses). If its profit is less than a 100 percent mark–up on its total costs, and it also passes a secondary test (the "commercial realism" indicator, which is still being developed by the ATO), then the arrangement will be classified as low risk (green zone) and ATO resources will generally not be applied.10
When the hub's profit is greater than a 100 percent mark–up of hub costs, the arrangement will fall into one of four higher risk zones (blue, yellow, amber, or red).
The final allocated rating will depend on other factors, including the amount of tax at risk, the transfer pricing analysis and documentation, and behavioural indicators (e.g., voluntary engagement with the ATO, whether there is full disclosure and provision of primary supporting evidence). Should the risk rating fall within the higher risk zones (amber and red zones), the ATO will commence reviews. Taxpayers that fall in the red zone will also attract unwanted attention from the ATO, because such cases are much more likely to proceed directly to audit, and any resolution of the matter through non–adversarial channels (settlement or alternative dispute resolution) may be limited.11
Ultimately, the ATO can risk assess as it likes, so while the PCG provides valuable insight into its overall approach to risk assessment, taxpayers could use the guide as a self–assessment tool. This is particularly relevant in light of the ATO's proposal to amend the IDS to include a "hub" risk rating disclosure.
Taxpayers should see the PCG as an indication of what to expect from the ATO – a clear emphasis on internal risk processes, how taxpayers should be working with the ATO going forward, and the disclosures expected of them. However, despite public consultation on PCG 2017/1, there appears to remain some ambiguity regarding its application, and it provides limited technical guidance regarding the ATO's transfer pricing analysis of hubs. But it is clearly imperative that the hub have commercial and economic substance, and that the taxpayer can evidence risks borne in practice by the hub (and the ability to bear these risks).12
The case on everyone's lips at the moment is Chevron Australia Holdings Pty Ltd (CAHPL) v Commissioner of Taxation (2017) FCAFC 62, a landmark decision in the transfer pricing arena given the fundamental concepts drawn out in the judgement, not just in respect of intra–group financing transactions.
Broadly, the case concerned the pricing of interest on an intercompany loan between Chevron Australia (the borrower) and a US subsidiary (the lender) over the period 2004–2008. No explicit parental guarantee was provided and the lender did not have security over the borrower's assets.
The Commissioner made a determination that the interest rate of 1 month Australian LIBOR plus 4.14 percent (which represented a mark–up on the external funding costs of the US subsidiary) charged by the lender on the loan was excessive. The Federal Court in the first instance agreed with the Commissioner, and this position was affirmed by the Full Federal Court on 21 April 2017. The court found that in considering the application of the arm's length principle, the borrower was not an "orphan" (a stand–alone entity) but a subsidiary of a major MNE. In other words, if a lender providing finance to a subsidiary takes into account the fact that the entity is part of the wider global group, then that is the appropriate reflection of the arm's length principle.
The case also highlighted that the application of the arm's length principle requires commerciality of the arrangements. In the context of this case, the courts were of the view that an unsecured loan arrangement, as described in the legal agreement between the parties, would not have taken place in the market. Instead, security, operational/financial covenants, and/or a parental guarantee would have been provided.
MNEs, regardless of the industry in which they operate and the type of international related-party dealings they have, must take note of the decision, because many of the issues are not confined to financing or the oil and gas industry. Themes throughout the case such as "contractual form versus substance," whether conduct was truly "arm's length," the "commerciality" of arrangements and agreements, and true "comparability" are some key concepts the ATO expects to see addressed in any transfer pricing analysis.
Financing issues have long been considered a material risk, so increased ATO activity in this area is expected following the Chevron decision. Most recently, the ATO has made it clear that inbound financing transactions are a top priority.13
Buoyed by the Chevron appeal outcome, on 16 May 2017 the ATO released the long–anticipated draft PCG 2017/D4 outlining its risk assessment framework for related-party financing arrangements. Similar to PCG 2017/1, PCG 2017/D4 sets out a risk assessment methodology for taxpayers to apply to determine which "risk zone" their inbound and outbound financing arrangements fall within, based on a cumulative scoring system. The qualitative and quantitative indicators, and their relative weights have been developed based on the ATO's expectation that, in most cases, the cost of related-party financing should align with the financing costs that could be achieved by the ultimate parent company (on an arm's length basis). Importantly, the framework is to be applied against each related-party financing arrangement.
While PCG 2017/D4 is still subject to consultation and feedback, it signals a significant uplift of the ATO's focus and activity in the area of cross–border financing.
Measures to ease the compliance burden
For taxpayers with low-level international related-party dealings, the ATO released simplified transfer pricing recordkeeping options14 to mitigate the documentation burden for eligible taxpayers. To qualify, certain general and specific eligibility criteria must be met. Though being able to apply the simplification measures does not waive the operation of Subdivision 815–B, taxpayers that can apply the simplification measures can make positive documentation disclosures in their IDS and/or local file, and the ATO has stated that it will not allocate resources or take compliance action to examine transfer pricing records for eligible entities. Importantly, the simplification measures are not a safe harbour or administrative concession – as noted above, taxpayers must evidence that each eligibility criterion for the relevant measure(s) has been correctly applied, and that Subdivision 815–B has been applied. Nonetheless, the measures have certainly eased the transfer pricing compliance burden for eligible taxpayers, particularly SMEs.
The ATO recently announced that it is also proposing to issue formal letters of comfort to taxpayers they consider to be "swimming between the flags." The letters will constitute an administrative indication of the ATO's position. While the letters cannot be relied upon as binding against the ATO, this is still a welcome proposed addition to the ATO's suite of compliance products, and should provide additional assurance to taxpayers with low-level/low-risk international related-party dealings.
The ATO: skilling up to fight the transfer pricing battle
The ATO has signaled its intention to focus on tax avoidance issues with the creation of a Tax Avoidance Taskforce from 1 July 2016, and an additional 390 people to be recruited to the task force. Further, the government's International Structuring and Profit Shifting (ISAPS) funding was also extended through 2017.
We have seen a focus on greater transparency and proactive enforcement by the ATO through its release of tax alerts and guidance on various topics. In these publications, the ATO emphasises the importance of open communication and early engagement. The requirement for groups to prepare general purpose financial statements for their Australian operations, and implementation of the tax transparency code for large Australian corporates, are further examples of the ATO's drive for open dialogue with taxpayers and the general public. Its significant audit activity (seven major MNE audits to be finalised by June 2017) is a reflection of the ATO's renewed strategy and expanded capacity. The ATO's Corporate Plan 2016–17 suggests we should expect more of the same in the coming year. In light of the ATO's evolving capabilities and drive for transparency, the demands being placed on tax departments at the domestic level have increased significantly.
Adoption of the OECD's revised TPG
The OECD revised the TPG in accordance with Actions 8–10 of the OECD's BEPS Project in May 2016; the revised TPG will apply to Australian taxpayers from 1 July 2016. The revisions to the TPG are designed to align transfer pricing outcomes with value creation, focusing on the following key areas:
- Contractual arrangements, including the contractual allocation of risks and corresponding profits, and the importance of substance in the allocation of risk
- Multinational group synergies, including passive association
- Transfer pricing issues relating to transactions involving intangibles
- Low value-adding intragroup services
- Cost contribution arrangements
In the context of intangibles, MNEs must perform a detailed analysis of the economic ownership and 'DEMPE functions' (development, enhancement, maintenance, protection, and exploitation) required in respect of any identified group IP. The revised TPG reflect the concept that reward is driven by risk/substance rather than legal form or ownership. MNEs must ensure that group companies performing important functions, controlling economically significant risks and contributing assets, receive returns commensurate with the value of their contributions.
The revised TPG also emphasise the importance of ensuring that any risks allocated to an entity are consistent with that entity's functions and financial ability to bear the risk. MNEs must ensure that only those risks that can be, and are in substance managed and controlled by an entity, are allocated to them.
Where to now? Assess, Reset, Communicate
Transfer pricing has been at the forefront of the ATO's recent compliance activity and this will continue to be the case in the face of public sentiment that MNEs are not paying their "fair share" of tax.15 Taxpayers should be prepared for earlier ATO intervention and engagement. The onus is now squarely on taxpayers to ensure they have a clear understanding of their reporting obligations, can support the economic and commercial substance of their dealings/international related parties, and have adequately self–assessed and managed their transfer pricing risk. This is especially relevant in light of the increased penalties that could apply.
The continued release of guidance from the ATO should be taken into account by taxpayers, as these publications are usually roadmaps as to what information the ATO would request in the event of review, and what consequences may arise should the cases be elevated to audit.
In the meantime, large corporates should start planning (if they have not done so already) how they will tackle their transfer pricing obligations and risks for the year ahead. Transparency, risk assessment, and proactive engagement with the ATO by the taxpayer should be a priority for boards. Tax, and more specifically transfer pricing, has become a major strategic business issue requiring consultation across the business. "Substance" should set the agenda for every tax conversation – what are the functions, who bears the risk, where is the value created?
We have seen companies devoting significant resources and spending years battling transfer pricing audits with the ATO. Now is the right time to assess, reset, and communicate.
Assess – analyse your existing value chain with a view to ensuring profits are commensurate with functions, assets, and risks. If you apply the law and document your position, you should have a strong line of defence. Rather than seeing it as a burden, use the documentation process as a way of putting your best foot forward, not just dotting the 'i's' and crossing the 't's'. Fail to do so and be prepared for the consequences.
Reset – consider the implications of the OECD's Actions 8–10 guidance, which now form the reference to Australia's transfer pricing law. If necessary, revisit pricing arrangements to ensure the pricing aligns with value creation and substance, can be considered "commercial," and negotiate with your related parties to reset such pricing or profit allocations if required. Revisit your intercompany agreements to ensure they align with substance.
Communicate – with your international related parties and within your organisation. Discuss potential transfer pricing risks at the board level, and proactively communicate with the ATO (or other revenue authorities) if you are keen to obtain certainty. Consider APAs as a tool to manage global transfer pricing risk.
- Chevron Australia Holdings Pty Ltd (CAHPL) v Commissioner of Taxation No.4  FCA 1092; Chevron Australia Holdings Pty Ltd v Commissioner of Taxation  FCAFC 62.
- Treasury Laws Amendment (Combating Multinational Tax Avoidance) Act (No 27) 2017.
- ATO, 'Practical Compliance Guideline (PCG) 2017/1: ATO compliance approach to transfer pricing issues related to centralised operating models involving procurement, marketing, sales and distribution functions,' <https://www.ato.gov.au/law/view/document?DocID= COG/PCG20171/NAT/ATO/00001>.
A further discussion paper (potentially to be converted into a PCG) is also nearing finalisation on lease–in lease–out arrangements.
- ATO, 'Practical Compliance Guideline (PCG) 2017/D4: ATO compliance approach to taxation issues associated with cross–border related party financing arrangements and related transactions', <https:// www.ato.gov.au/law/view/view.htm?docid= %22COG%2FPCG20174%2FNAT%2FATO%2F00001%22>.
- Section 815–130, Subdivision 815–B of the Income Tax Assessment Act 1997.
- The three exceptions to the basic rule, i.e. where actual and arm's length conditions may not align hence the reconstruction provisions could apply, include: (i) when substance and form do not align, (ii) when independent parties would have entered into alternative transactions, or (iii) when independent parties would not have entered into the transaction at all.
- Section 815–130, Subdivision 815–B of the Income Tax Assessment Act 1997.
- Broadly, members of groups with global revenues exceeding AUD 1 billion.
- ATO, 'Country–by–Country reporting: Exemption Guidance', https://www.ato.gov.au/Business/ International–tax–for–business/In–detail/Transfer–pricing/Country–by–country–reporting––Exemption– guidance/?page=1
- ATO, 'PCG 2017/1: ATO compliance approach to transfer pricing issues related to centralised operating models involving procurement, marketing, sales and distribution functions,' para 6, 25 and 77–78, <https://www.ato.gov.au/law/view/document?DocID=COG/PCG20171/ NAT/ATO/00001>. It is noted that the OECD's Revised Transfer Pricing Guidelines also address commodity pricing and the attribution of value to marketing hubs.
- Ibid, para 85–108,
- Ibid, para 19.
- ABC news, 'ATO chief issues 'enough is enough' ultimatum to corporate tax dodgers', http://www.abc.net. au/news/2016–02–10/tax–commissioner–chris–jordan–attacks–multinational–companies/7156500
- https://www.ato.gov.au/Business/International–tax–for–business/In–detail/Transfer–pricing/Simplifying– transfer–pricing–record–keeping/
- ABC News, 'Corporate tax minimisation costs governments $US1 trillion says accounting insider',<http://www.abc.net.au/news/2016–07–11/corporate–tax–minimisation–costs–governments –1– trillion/7587092>.
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