Adsidui emptor or taxpayers beware: The implications of new guidance on transfer pricing documentation, reconstruction and penalties

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17 April 2014

Yesterday the Australian Taxation Office (ATO) released its long awaited guidance on the new transfer pricing rules operative from 29 June 2013. While it is useful to understand how the ATO intends to apply the new regime, there is reason for multinational (MNE) taxpayers to be concerned about the implications going forward in terms of how they assess their transactions, what documentation they need to prepare and when, and what penalties may apply if the ATO disagrees with their approach.

The new transfer pricing regime is contained in Subdivisions 815-B to 815-E of the Income Tax Assessment Act 1997 and applies to tax years commencing on or after 29 June 2013.  As we’ve said previously, the new regime can be seen to be positive to the extent it enhances the alignment of Australia’s transfer pricing regime with international practice through the requirement for the rules to be interpreted consistently with OECD guidance.  However, we’ve had long held concerns about the requirement for extensive documentation and the potential for the actual arrangements between a taxpayer and a foreign associate to be restructured and priced based on some completely different “arm’s length” arrangement. 

Yesterday the ATO released a suite of draft guidance on the new rules, being:

Type

Number

Scope

Public ruling

TR 2014/D4

Documentation requirements

Practice statement

PS LA 3673

Process for transfer pricing documentation when conducting an ATO review

Practice statement

PS LA 3672

Administration of penalties

Public ruling

TR 2014/D3

Application of section 815-130 (reconstruction rules)

While these will help taxpayers to understand the ATO’s proposed approach to these aspects of the new regime, they confirm a number of the concerns we have held.

Documentation

Under the new transfer pricing regime, taxpayers cannot have a “reasonably arguable position” – which is relevant to the application of penalties (see further below)  unless they have appropriate transfer pricing documentation in place.  The ATO has now confirmed its expectations on what the transfer pricing documentation should address.  Set out below is a comparison between the four step process envisaged under the previous transfer pricing rules and the five step process contemplated by the ATO under the new rules:-

 

TR 98/11

PS LA 3673

Step 1

Accurately characterise the international dealings between the associated enterprises in the context of the taxpayer's business and document that characterisation.

Identify the actual conditions in connection with the commercial or financial relations.

 

Step 2

Select the most appropriate transfer pricing methodology or methodologies and document the choice.

Select the most appropriate and reliable method to be used to identify the arm's length conditions.

Step 3

Apply the most appropriate method, determine the arm's length outcome and document the process.

Identify the comparable circumstances relevant to identifying the arm's length conditions.

Step 4

Ensure documentation is complete and implement support processes. Install review process to ensure adjustment for material changes.

Application of the transfer pricing rules so as best to achieve consistency with the relevant guidance material.

Step 5

Not applicable.

Monitor, review and update transfer prices, as necessary.

 Some important points to note are that for documentation to be relevant to the determination of penalties, it must:

  • be prepared before the time by which the taxpayer lodges its tax return.  So, if a taxpayer’s year end is 30 June 2014, it would ordinarily need to have its documentation completed by 15 January 2015.  Any subsequent documentation will not assist to reduce the applicable penalties if the ATO makes a transfer pricing adjustment;
  • be held by or be readily accessible to the taxpayer.  It is not sufficient that the documentation is prepared and held by a related foreign associate; and
  • exist even where entities participate in joint ventures, partnerships and other business structures or otherwise deal with third parties.  Accordingly, where information is required from third parties to complete transfer pricing documentation, the contractual arrangements needs to ensure appropriate access to that information.

There is no discussion in the ruling or practice statement about simplified documentation for SME taxpayers, although the ATO does indicate that “prudent business management principles” apply and that “entities with relatively low levels of relevant dealings are not expected to prepare and maintain documentation beyond the minimum necessary to arrive at the arm’s length conditions in the context of their business”.  Further, the ATO says that “the requirements should not be applied so as to create an impractical onus disproportionate to the materiality of the matter … to the entity’s Australian tax position”.  It is hoped that the ATO will provide some greater clarity around this aspect.

Penalties

As noted above, the existence or otherwise of transfer pricing documentation can impact on the penalties imposed if the ATO makes a transfer pricing adjustment.  The base penalties imposed are:

 

With documentation and reasonably arguable position

Without documentation (or if documentation does not provide reasonably arguable position)

Dominant purpose of getting a transfer pricing benefit

25%

50%

Other cases

10%

25%

In assessing any remission of the penalties, the ATO will have regard to whether a taxpayer has made its best efforts to comply with the documentation requirements, taking account of the taxpayer’s resources and the materiality of the issue, and whether the calculation or mechanical process in the law results in an unintended or unjust outcome in the particular circumstances.  Unlike the position under the old transfer pricing regime, there is no suggestion that penalties will automatically be remitted to nil if the taxpayer has genuinely made a reasonable attempt in good faith to comply with the arm's length principle in preparing the tax return, having regard to what a reasonable business person in the taxpayer's circumstances would do, and has otherwise co-operated with the ATO and used its best endeavours in preparing transfer pricing documentation (see Taxation Ruling TR 98/16).  Further, the quantum of the penalty and the taxpayer’s capacity to pay are generally not relevant.

Reconstruction

The ability of the ATO to reconstruct a transaction – that is, to replace all or part of the actual arrangements with an allegedly arm’s length arrangement – has been the most controversial aspect of the new regime.  In particular, the concern has been that the ATO may seek to do so in situations outside the “exceptional circumstances” contemplated in the OECD transfer pricing guidelines and that, if the ATO does so, taxpayers may be subject to double taxation because the revenue authority in the jurisdiction of the counterparty does not accept that reconstruction. 

While the ATO says, that “in most cases, it is expected that the identification of the arm’s length conditions will be able to be accomplished by applying the ‘basic rule’” – that is, by reference to the form and substance of the actual commercial and financial relations between the taxpayer and the relevant counterparty – the examples provided as to when the exceptions will be applied do not provide as much comfort.  The examples include:-

Transaction

Test

Recharacterised as…

Transfer of trademarks and sale of products from Australian company to foreign subsidiary

Substance differs from its form (s.815-130(2))

Re-invoicing and reimbursement services

 

(because Australian company continues to undertake all economically significant tasks and foreign subsidiary does not have the resources to manage or control the activities or risks)

Sale of goods by Australian manufacturer to controlled foreign distributor and payment of fee of 1% for distributor taking manufacturing warranty risk

Entities dealing at arm’s length would have entered into different commercial or financial relations (s.815-130(3))

Manufacturer retains warranty risk

 

(because no evidence of other distributors taking on the risk and distributor does not have financial capacity to do so)

Australian company enters into debt factoring arrangement with foreign subsidiary for fee equal to 2% of gross sales

Entities dealing at arm’s length would not have entered in any commercial or financial relations (s.815-130(4))

No transaction

 

(because there is no possibility of late payment risk as binding third party guarantees are received)

This is likely to only scratch the surface of the circumstances where the ATO will seek to argue that some other transaction or arrangement should be considered. Moreover, as the new transfer pricing regime operates on a self-assessment basis, taxpayers will need to second guess whether their actual arrangements are arm's length.

Want to know more or have your say?

Having been involved in the consultations as the new transfer pricing regime was developed by Treasury, and with the ATO in discussing how they will administer those rules, Corrs is well placed to assist you to consider the impact on your business.

Taxpayers and their advisers are able to make comments on the draft rulings and practice statements by 30 May 2014.  


The content of this publication is for reference purposes only. It is current at the date of publication. This content does not constitute legal advice and should not be relied upon as such. Legal advice about your specific circumstances should always be obtained before taking any action based on this publication.


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