The Australian Taxation Office (ATO) recently released draft practical compliance guidelines (Guidelines) in relation to centralised procurement, marketing, sales and distribution functions, colloquially known as “hubs”. The purpose of these guidelines is for taxpayers to understand (and self-assess) the transfer pricing risk associated with offshore hubs and how that risk assessment will drive the ATO’s compliance approach.
The ATO’s five “risk zones” for offshore hubs
The Guidelines categorises hubs into one of five colour coded “risk zones”. The risk zones are:
Falling within the green zone
In order for a hub to fall within the green zone, a hub will need to satisfy the “low risk benchmark” which will be published by the ATO for that type of hub. The Guidelines currently only address offshore marketing hubs, although the ATO envisions that the finalised guidelines will ultimately address a variety of different types of inbound and outbound hubs.
For offshore marketing hubs, a hub will only fall within the green zone if the hub’s profits from its marketing function (which would exclude freight revenues and costs) is less than or equal to a 100% mark-up on the hub’s marketing function costs. The cost of buying the product in the case of a buy/sell hub and pass through costs must be excluded.
The ATO is also proposing a “commercial realism indicator” test as a cross check. This secondary test has not yet been developed, but a hub must also satisfy this test in order to fall within the green zone.
Blue to red zones
If hub falls outside of the green zone, where that hub will sit in the ATO’s risk spectrum will depend on the combination of a number of different indicators. The ATO’s proposed approach is to apply a “net tax impact” test to determine the hub’s “base rating”. This base rating can then be adjusted by other indicators being:
- the existence, or otherwise, of contemporaneous transfer pricing documentation; and
- the taxpayer’s “behavioural indicators”, which in substance relates to the taxpayer’s level of voluntary co-operation with the ATO and can push a taxpayer up or down the rating scale.
For offshore marketing hubs, the ATO have set the “net tax impact” benchmarks for the blue, yellow and amber zones at AU$5m, AU$50m and greater than AU$50m respectively. The “net tax impact” for offshore marketing hubs is to be calculated as:
There is no minimum “net tax impact” threshold for falling into the red zone. The risk factors which could cause a hub to fall within the red zone are discussed further below.
Whilst there is no strict legal requirement for a taxpayer to prepare transfer pricing documentation,1 the inclusion of transfer pricing documentation as a relevant indicator further elevates the importance of possessing compliant documentation for hubs. Under the Guidelines, hubs which do not possess transfer pricing documentation will nearly always be rated in the red zone (i.e. very high risk).
Mandatory disclosures and self-assessment of risk rating
Whilst the Guidelines state that it is not compulsory for a taxpayer to self-assess their hub’s risk rating, as a practical matter it is also not truly voluntary. This is because taxpayers will usually be required to disclose (e.g. in the reportable tax positions income tax return schedule) whether they have undertaken an assessment of their hub’s risk rating. There will be some exceptions to the requirement to report a hub’s risk rating, but these involve circumstances where the ATO has already, in effect, reviewed the risk profile of the hub.2
The ATO have stated they are considering what other disclosures would be incorporated into the income tax return schedule, but presumably the disclosure would include the result of any risk assessment.
Further, the Guidelines suggest that if a taxpayer is unwilling or unable to calculate its hub’s “net tax impact” or apply the ATO risk benchmarks set out in Guidelines, that hub will automatically deemed to be in the red zone and very high risk, unless the taxpayer voluntarily engages with the ATO on its hub arrangements (including providing relevant documentation).
The ATO’s risk based approach to compliance
The ATO will also use the Guidelines to adopt a risk based approach to compliance activities, concentrating on hubs which are assessed as having the highest risk of non-compliance with Australia’s transfer pricing requirements. Further, the higher the risk rating, the greater the level the compliance activity a taxpayer can expect.
For example, under the guidelines, hubs which are classified as being low risk:
- can expect limited compliance activity from the ATO (e.g. to confirm the hub is eligible to fall within the green zone);
- will have access to simplified record keeping requirements; and
- will be permitted to access the ATO’s APA program (subject to normal eligibility criteria).
In contrast, the ATO has stated that taxpayers with hubs in the red zone:
- will be denied access to the ATO’s APA program;
- may find that matters proceed directly to audit (rather than commence through a risk review); and
- may find that information gathering will occur through formal processes (rather than informal requests).
Transitioning existing hubs to the green zone
The Commissioner has offered to remit penalties in full, and the shortfall interest charge to base rates, for taxpayers that make a voluntary disclosure in relation to their back years and adjust their pricing to fall into the green zone. Taxpayers that wish to make such a voluntary disclosure have 12 months to do so from the final publication of the relevant risk assessment schedule.
Compliance ‘hot spots’ flagged by the ATO
As part of the Guidelines, the ATO has taken the opportunity to flag what it sees are the current areas of focus for transfer pricing analysis of hubs. Areas which have been flagged include:
- the use of third party commission rates as comparable uncontrolled prices;
- transfer prices which, when assessed under cost-based profit level indicators, produce results which can’t be reconciled with market-based outcomes; and
- failing to revisit pricing mechanisms for significant changes in the external environment.
The ATO also singled out the need to understand how changes in the liquefied natural gas markets have or will impact on transfer pricing outcomes. In particular, the ATO has indicated they will focus on understanding the OECD ‘factors determining comparability’ and the impact on transfer prices as a result of such market changes.
In recent times, the ATO has moved away from providing formal rulings setting out definitive views of the law to a particular situation in favour of guidance that helps taxpayers to “swim between the flags”. While it is, of course, important for taxpayers to understand the ATO’s views on arrangements they enter into, taxpayers should not automatically adjust their arrangement to bring themselves within such guidance, particularly where there is a foreign tax authority that may take a different view as to the appropriate tax outcomes arising from the hub arrangements. However, if an assessment by a taxpayer suggests that its hub arrangements may fall in the yellow, amber or red zones, it will be important to seek independent legal/tax advice regarding the positions that is has adopted given the increased risk of a tax audit and subsequent dispute.