Will your transfer pricing documentation provide penalty protection?

The ATO has finalised its guidance package on the cross border transfer pricing rules introduced in 2013 as a rewrite of Australia’s rules on profit shifting. The guidance has been finalised just as taxpayers are preparing to self-assess their transfer pricing position for the first time. Subdivisions 815-B to 815-D of the Income Tax Assessment Act 1997 apply to income years commencing on or after 29 June 2013, meaning that June balancing taxpayers will need to apply these transfer pricing rules in their tax returns for the 2014 income year.

Guidance recently finalised by the ATO includes:

These rulings will replace the draft guidance published in April. In addition to this guidance, an online guide to “Simplifying Transfer Pricing Record Keeping” will be published shortly by the ATO.

Reconstruction

Appendix 1 to TR 2014/6 sets out examples of the three circumstances under which the “basic rule” that arm’s length conditions must be based on the taxpayer’s actual dealings will not apply. The reconstruction provision may be enlivened where:

  1. the form of the actual dealings differs from their substance;
  2. the behaviour of independent parties would differ in substance from the actual dealings; or
  3. independent parties would not have entered into commercial or financial relations at all.

The examples demonstrate that the Commissioner’s reconstruction power is broader than para 1.64 of the OECD Guidelines which requires tax administrations to price the actual transaction undertaken in all but exceptional circumstances. TR 2014/6 acknowledges that the ATO will not be constrained by limitations on reconstruction in the OECD material, saying:

The exceptions contained in subsections 815-130(2) to 815-130(4) of Subdivision 815-B operate automatically. There is no discretion with their application. In particular, section 815-130 neither requires nor contemplates the existence of any other 'exceptional circumstances', nor any subjective analysis in this regard, before subsections 815-130(2) to 815-130(4) inclusive apply.

The ruling specifically foreshadows that “it might not be possible to identify arm's length conditions so as to achieve total consistency with the relevant OECD guidance.” One potential inconsistency arises as the OECD Guidelines say that “[t]ax administrations do not have the right to dictate to an MNE how to design its structure”, while TR 2014/6 says that “it is important to consider the economic reality and effect of a transaction … rather than proceeding only on the basis of how it has been characterised or structured.” Another inconsistency with the OECD material is that there is no need for the tax administration to be impeded from determining an appropriate transfer price before the reconstruction provision can apply. This is explained in the compendium.

Rather than pricing their actual transactions, taxpayers are expected to work out what conditions would operate between independent entities dealing wholly independently with one another in comparable circumstances. According to TR 2014/6, “it is not of itself sufficient to propose that independent entities might have dealt with one another in an alternative manner.” The test resembles the “most reliable prediction” test under the general anti-avoidance rules, however, rather than making a prediction about the taxpayer, it is a prediction about what independent entities would do, making the test even harder for taxpayers to apply. Adding to the complexity is the directive to consider “both acts and omissions that are not at arm's length… since profit shifting between associated enterprises can take place either through acting or refraining from acting”.

Of concern to taxpayers is that “exceptions to the basic rule will not apply to enable an entity to get a taxation advantage”, which exposes taxpayers whose cross border dealings are reconstructed by a foreign tax administration to the risk of double taxation in Australia.

Documentation

Extensive transfer pricing documentation requirements outlined in TR 2014/8 will add to taxpayers’ ongoing tax and transfer pricing compliance costs, however, without such documentation taxpayers will not be able to argue that their transfer pricing position was reasonably arguable in the event that penalties are imposed following a transfer pricing adjustment. Documentation requirements for transfer pricing will be more rigorous than the general record keeping requirements in subsection 262A(1) of the Income Tax Assessment Act 1936.

Taxpayers seeking penalty protection will need to keep contemporaneous documentation in respect of conditions that are both material and relevant to their transfer pricing position for the relevant income year. This is not a high hurdle as a “condition is material if it affects the entity's Australian tax position and is ultimately relevant where it is subject to an adjustment by the Commissioner”. The timing of transfer pricing documentation is now critical with a statutory mandate to prepare documentation before lodgment of the income tax return for the relevant income year.

Taxpayers with existing transfer pricing documentation processes should consider having their documentation reviewed by their legal advisors to ensure that the documentation answers the five “key questions” set out in para 80 of TR 2014/8 and will be effective for penalty protection, not just for lowering technical risk.

Multinational taxpayers must also ensure that their Australian operations have continuous full and free access to any Australian transfer pricing documentation held offshore. Otherwise, they will be at risk of not having “kept” appropriate documentation for penalty protection purposes.

Penalties

PS LA 2014/2 explains that transfer pricing penalties will be imposed only where an entity’s shortfall amount exceeds its reasonably arguable threshold, being the greater of $20,000 or 2% of net income for trusts or partnerships and the greater of $10,000 or 1% of tax payable for other entities. Although a step in the right direction, the threshold is low in comparison with the additional compliance costs of preparing transfer pricing documentation in the new self-assessment environment.

Penalties still generally apply at 10%, 25% or 50% and turn on whether the taxpayer had:

  1. a dominant purpose of getting a transfer pricing benefit; and/or
  2. a reasonably arguable position.

The question of whether the dominant purpose test is objective or subjective remains open on the current state of authorities, but unsurprisingly, PS LA 2014/2 refers to this as an objective test.

Further, as already mentioned, under the new rules a taxpayer cannot argue that their position was reasonably arguable unless they have complied with the transfer pricing documentation requirements.

Simplified transfer pricing record keeping

In PS LA 2014/3 the ATO recognises that documentation meeting all of the requirements of Subdivision 284-E may impose administrative burdens on taxpayers that are disproportionate to the risk of non-compliance with transfer pricing rules. Under the online guidance on “Simplifying Transfer Pricing Record Keeping”, which is expected to be published shortly by the ATO, smaller taxpayers may be eligible to apply one or more of the transfer pricing record keeping simplification options. If an entity is eligible for one or more of the simplification options, the ATO will not allocate compliance resources to examining that entity’s relevant transfer pricing records.

The online guidance on “Simplifying Transfer Pricing Record Keeping” follows the March 2014 ATO discussion paper on options to simplify transfer pricing documentation.