Retrospective transfer pricing regime to commence soon
Law implementing the first tranche of Australia’s transfer pricing reforms have now passed through all stages of Parliament and will commence operation following Royal Assent*.
The reforms ensure that Australia can make transfer pricing adjustments to the taxable income of residents, and non-residents with permanent establishments in Australia, in accordance with its tax treaties with other countries.
While the new law will clarify a long-standing area of uncertainty, the implementation of the amendments is not without some controversy due to their retrospective application and the expansion of the powers of the Australian Taxation Office (ATO).
Transfer pricing laws address arrangements under which profits are shifted out of Australia, most often through international transactions between resident and non-resident companies that are not on an arm’s length basis. Shifting profits out of Australia has the general effect of reducing amounts of income that would otherwise be brought to tax in Australia.
Australia's existing domestic transfer pricing laws are contained in Division 13 of the Income Tax Assessment Act 1936. The long-standing view of the Commissioner of Taxation was that Division 13 was supplemented by an independent taxing power to make transfer pricing adjustments under Australia’s tax treaties. The alternate view, held by many commentators, was that tax treaties operated only to allocate taxing power, and not to confer it. The issue has never been directly resolved by a Court.
Overview of new regime
The amendments introduce a new Subdivision 815-A into the Income Tax Assessment Act 1997 to ensure that the transfer pricing articles in Australia’s tax treaties can be applied independently of Division 13, and require that the “arm’s length” principle is interpreted consistently with OECD guidelines.
Subdivision 815-A empowers the Commissioner to make a determination to increase the taxable income or reduce the tax or capital losses of an Australian resident or a non-resident with a permanent establishment in Australia in circumstances where the taxpayer derives a “transfer pricing benefit”.
Whether a transfer pricing benefit arises is to be determined by reference to relevant OECD commentaries and guidelines on transfer pricing and the model tax convention. This will overcome doubts raised about the relevance of those materials in relation to Division 13 and is expected to allow the Commissioner to make greater use of indirect profit based methodologies in reviewing the pricing of transactions.
Importantly, the new subdivision will only apply to taxpayers and arrangements that would be subject to either the “associated enterprises” or “business profits” articles under a tax treaty at the time a transfer pricing benefit arose. Until the second tranche of the reforms is implemented, only Division 13 will apply to dealings involving entities not resident in a country with which Australia has a tax treaty.
Subdivision 815-A also seeks to clarify the interaction between the transfer pricing and thin capitalisation regimes. The rate of interest on debt deductions is to be determined under the transfer pricing rules, consistent with OECD guidance, but applied to the amount of the actual debt in place. The thin capitalisation rules may then further reduce the amount of debt deductions where the level of debt exceeds the maximum allowable debt ordinarily based on a 3:1 debt to equity ratio. This rule reflects the Commissioner’s administrative approach in Taxation Ruling TR 2010/7.
The principal, and most controversial, concern raised during the consultation stage was the retrospective application of Subdivision 815-A, which will apply to arrangements between related parties in treaty countries for all income years from 1 July 2004 onwards.
The explanatory memorandum argues retrospective application is justified on the basis that Subdivision 815-A merely clarifies the Parliament’s intentions under existing law. However, despite this, administrative penalties will only apply prior to 1 July 2012 to the extent that they would have been imposed under the existing rules.
Issues and challenges for taxpayers
The retrospective application of Subdivision 815-A has been strongly debated and is a significant issue for many taxpayers. To date, the ATO has not clearly indicated the extent to which it will examine those arrangements that have previously been subject to review or audit. However, with or without such confirmation, taxpayers are faced with a detailed re-examination of their international dealings to ensure compliance with OECD transfer pricing guidelines as far back as 2004.
The reforms also raise concerns as to the extent to which the Commissioner will seek to simply apply profit based transfer pricing methods at the expense of the transactional methods (favoured by the Courts), and do so based on its view of the appropriate commercial arrangements rather than those actually entered into by the parties.
The second tranche of the (prospective) transfer pricing reforms, which will also cover international dealings between Australia and non-treaty countries, is expected in September 2012.
 Commissioner of Taxation v SNF (Australia) Pty Ltd  FCAFC 74.
*Royal Assent to the new regime was given on 8 September 2012.