Transfer pricing - A changing landscape

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26 March 2012

The government has recently released tranche one of its proposed transfer pricing reforms, which are designed to “confirm” that Australia can make transfer pricing adjustments in accordance with its tax treaties with other countries. While the recognition of indirect or profit based transfer pricing methodologies is welcome, the proposed reforms raise significant concerns regarding the retrospectivity of the changes and the extent to which the new powers may be employed by the Commissioner of Taxation to ignore or re-characterise transactions.

Background

Australia's domestic transfer pricing provision, Division 13 of the Income Tax Assessment Act 1936, was introduced in 1982.  However, until 2008, there had been no substantive decision concerning its operation.

The decisions of the Administrative Appeals Tribunal in  Roche Products Pty Limited and Commissioner of Taxation[1]  and Full Federal Court in Commissioner of Taxation v SNF (Australia) Pty Ltd[2] raised concerns, at least for the Australian Taxation Office (ATO), that Division 13 does not permit resort to indirect or profit based methodologies.  Further, while the decisions in those cases did not directly address whether the ATO has an independent power to make transfer pricing adjustments under Australia's tax treaties, there were some obiter comments suggesting that the tax treaties operate more as a "shield" (for taxpayers) rather than a "sword" (for the ATO).

In November last year, the then Assistant Treasurer (Bill Shorten MP) announced that Australia's transfer pricing rules would be amended to reflect developments in the OECD transfer pricing guidelines and to "confirm" that Australia can make transfer pricing adjustments in accordance with its tax treaties with other countries. 

On 16 March, the current Assistant Treasurer (David Bradbury MP) released an exposure draft of the legislation for "tranche one", being retrospective measures applying from 2004 principally to address the latter issue through the introduction of a new subdivision 815-A into the Income Tax Assessment Act 1997.

Outline of proposed changes

In broad terms, the proposed changes allow the ATO to make a determination to increase the taxable income or reduce the tax or capital losses of an Australian resident where the associated enterprises article in one of Australia's tax treaties applies and the amount of profits which might be expected to accrue in accordance with that article exceeds the amount which has accrued. A similar rule applies to a permanent establishment in Australia of a foreign resident where the business profits article applies.  The provisions are required to be interpreted to best achieve consistency with the OECD model tax convention and transfer pricing guidelines.

A special rule has been included to clarify the interaction of the transfer pricing and thin capitalisation rules in relation to the interest deductions of an entity.  Essentially, the transfer pricing rules apply to determine the appropriate interest rate first and then the thin capitalisation rules may operate to deny an amount of interest if the level of debt exceeds the safe harbor debt amount (ordinarily 75% of the entity's assets).  The rules include a provision indicating that, for the avoidance of doubt, a reduced amount of debt is to be used to determine the pricing "if that best achieves the consistency" with OECD guidelines.  In other words, it provides legislative confirmation of the somewhat controversial approach adopted by the ATO in Taxation Ruling TR 2010/7.

Issues and challenges

While previous decisions of the High Court of Australia have confirmed the power of the parliament to introduce retrospective changes in the law under the Australian constitution[3], the proposed changes raise legitimate questions about the respect of the government for the rule of law. As Senator Don Chipp observed in relation to the retrospective measures to address the so-called "Bottom of the Harbour" tax schemes in the early 1980's, "to make illegal today something that was legal last year" is "the track that every tyrant in history has gone down"[4]. It also raises questions about the level of sovereign risk for foreign investment in Australia, particularly having regard to other recent retrospective tax measures.[5]

While alignment of Australia's transfer pricing regime with the arm's length standard under OECD guidelines may be desirable for international consistency, the concern is that the ATO will seek to use the changes to re-characterise transactions according to some vague notion of commercial reality.  For instance, the draft explanatory memorandum notes that, in applying the transfer pricing rules to interest deductions, "the application of [proposed subdivision 815-A] will require the cost of debt capital to be determined ... having regard to an arm's length amount of debt ... rather than its actual amount of debt", at least in (unspecified) "exceptional cases".  It is likely that the ATO will also use this line to support its position, as set out in Taxation Ruling TR 2011/1, that it can effectively ignore or re-characterise business restructuring transactions that would not be entered between parties dealing at arm's length.

At a minimum, the proposed rules will lead to an increase in compliance costs as it will be necessary for taxpayers to review their transfer pricing documentation going back to 2004 to ensure that it is consistent with OECD guidance.

While Corrs will be actively involved in further consultation on these measures, and advocating change, it seems the government policy position is somewhat set in stone. 


[1] [2008] AATA 639
[2] [2011] FCAFC 74
[3] Polyukhovich v Commonwealth ("War Crimes Act case") [1991] HCA 32
[4] Senate Hansard, 19 November 1982 at 2592
[5] For example, the recent changes to the petroleum resources rent tax and the tax consolidation treatment of rights to future income.


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