On 22 November 2012, the Government released for public comment the Exposure Draft of the Tax Laws Amendment (Cross Border Transfer Pricing) Bill 2013: Modernisation of Transfer Pricing Rules.
The Exposure Draft proposes to implement the second stage of the Government's transfer pricing reforms announced in November 2011.
- Division 13 will be repealed, and the recently-enacted Subdivision 815-A will no longer apply from the application date of the proposed changes;
- the proposed changes implement a self-assessment approach, in place of the current rules, which require the Commissioner to make a determination to effect a transfer pricing adjustment;
- unlike Division 13 (which focuses on the pricing of individual transactions), the proposed changes adopt a broader, profit-based approach;
- in line with subdivision 815-A, the proposed changes expressly allow the use of OECD guidance materials;
- the proposed changes contain an express reconstruction power, allowing the Commissioner to have regard to the economic substance of a transaction, and potentially reconstruct a hypothetical alternative;
- the proposed changes set out the types of transfer pricing documentation an entity may prepare and keep in self-assessing transfer pricing tax results; and
- the unlimited amendment period for transfer pricing adjustments will be reduced to eight years.
Key to the proposed changes is the introduction of a profit-based approach in subdivisions 815-B and 815-C. This is a departure from the current approach in Division 13, which focuses on the arm's-length pricing of individual transactions.
The proposed changes therefore introduce a more holistic approach to the question of transfer pricing, compared to the current provisions, which focus more on discrete transactions and their effect.
Subdivision 815-B calls for consideration of what an Australian taxpayer's position would be under "arm's-length conditions", taking into account all aspects of the commercial and financial relations that exist between it and another entity.
According to the Explanatory Memorandum, subdivision 815-B is designed to better align the Australian approach with international standards related to the arm's-length approach. Consistent with that aim, the provisions are to be interpreted and applied consistently with the OECD Transfer Pricing Guidelines. Accordingly, the taxpayer must use the OECD pricing method or methods that produce the most reliable assessment of the arm's-length conditions.
Under the proposed subdivision 815-B, the "commercial and financial relations" used to determine the arm's-length conditions are expressed broadly, and incorporate any connections or dealings between the entities that relate to or could otherwise affect their commercial or financial activities. These factors could include:
- a single, or a series of, transactions;
- unilateral actions or mutual dealings;
- a strategy; or
- the overall profit outcomes achieved by two or more entities.
Where the analysis demonstrates that a change in profits, revenues or expenses would not have affected its tax position, the Australian taxpayer will not have a transfer pricing benefit.
Notably, the proposed changes provide that where a taxpayer has no actual taxable income, no losses of a particular sort or no tax offsets, the taxpayer will be deemed to have taxable income of nil, against which the "arm's-length conditions" amount can be compared.
In the case of a permanent establishment (PE), the proposed subdivision 815-C reflects the profit-based approach introduced in subdivision 815-B.
Importantly, with the Government yet to decide whether to change its tax treaty practice by adopting the "functionally separate entity approach", proposed subdivision 815-C confirms the "single entity" approach currently applied in Australia.
According to the Explanatory Memorandum, the aim of subdivision 815-C is to ensure that the amount brought to tax in Australia by a resident taxpayer operating at or through a PE is not less than it would have been if the permanent establishment were a wholly distinct entity.
Under subdivision 815-C, the arm's-length principle is used to determine the actual income and expenses attributable to an entity's PE. That is, the profits that the PE might be expected to make if the PE was a distinct and separate entity that was engaged in the same or similar activities, operating under arm's-length conditions.
According to the Explanatory Memorandum, all the factors relevant to determining the arm's-length conditions under subdivision 815-B may be relevant to determining the arm's-length profits in subdivision 815-C.
Express reconstruction power
Another notable feature of the proposed changes is the express reconstruction power.
Under subdivision 815-B, regard must be had to the economic substance of the relevant transactions in determining the arm's-length conditions. According to the Explanatory Memorandum, the economic substance of what was done is to be determined by examining all of the relevant facts and circumstances, including the economic and commercial context, the object and effect of the transactions from a business point of view, the conduct of the parties, the assets used and the risks assumed.
The guiding question is said to be whether independent entities behaving in a "commercially rational manner", and acting in their own best commercial interest, would have dealt with each other in the same way, given the options realistically available to them.
The proposed reforms therefore introduce a broadly reconstructive power, under which the ATO is able to point to commercially viable alternatives in demonstrating that the relevant taxpayer has achieved a transfer pricing benefit.
The proposed subdivision 815-D introduce optional record-keeping requirements for taxpayers to which subdivisions 815-B or 815-C apply. This marks a departure from the current law, under which the general record-keeping provisions of the tax law apply to the transfer pricing rules.
Although the new record-keeping rules are optional, they are necessary (but not sufficient on a stand-alone basis) to establish a reasonably arguable position under the provisions of the Taxation Administration Act 1953.
In short, failing to keep the documentation as specified in subdivision 815-D could mean that taxpayers are not able to demonstrate a reasonably arguable position, and will not therefore be entitled to a lower scheme shortfall if applicable.
Information that should be included in documents for the purposes of subdivision 815-D include, among other things:
- details of the process undertaken by a taxpayer to satisfy itself that taxable income, tax offsets and related matters are worked out as if the arm's-length conditions had operated;
- particulars about the transfer pricing method selected and the comparable circumstances relevant in identifying the arm's-length conditions;
- details explaining the steps undertaken in identifying which method should be applied; and
- details of the amount by which taxable income, losses, or offsets would be different if the arm's-length conditions, instead of the actual conditions, had operated.