TR 2014/D3 on Reconstruction, TR 2014/D4 and PS LA 3673 on Documentation & PS LA 3672 on Penalties

The first draft guidance released today on Australia’s rewritten transfer pricing laws highlights the difficulties taxpayers will face in self-assessing transfer pricing adjustments to their cross-border dealings:

  • TR 2014/D3 covers the new reconstruction provision in s 815-130 of the Income Tax Assessment Act 1997;
  • TR 2014/D4 deals with the special rules about documenting transfer pricing positions in Subdivision 284-E of Schedule 1 to the Taxation Administration Act 1953;
  • Draft PS LA 3673 explains a process for transfer pricing documentation when conducting a transfer pricing review; and
  • Draft PS LA 3672 provides guidance on the application of transfer pricing penalties under subdivisions 815-B and 815-C.

Reconstruction ruling

Draft ruling TR 2014/D3 considers the relevance of actual dealings to the identification of arm’s length conditions. The “basic rule” in Division 815 is that the arm’s length conditions must be based on the actual commercial or financial relations between parties to a cross border dealing. The draft ruling sets out examples of exceptions to the basic rule.

Broadly, taxpayers are required to ignore their actual cross-border dealings in identifying arm’s length conditions where:

  • The form of the actual dealings is inconsistent with their substance;
  • Independent entities in comparable circumstances would have behaved in a way which differs in substance from the actual dealings; or
  • Independent entities in comparable circumstances would not have entered into any commercial or financial relations.

The three exceptions to the basic rule go beyond what is envisaged by the current OECD Transfer Pricing Guidelines and have strong parallels to the “reconstruction” and “annihilation” approaches in the Part IVA general anti-avoidance rules which were also re-written last year at the same time as Australia’s transfer pricing rules.

The current OECD Guidelines, which according to the explanatory memorandum to the new transfer pricing laws, “are widely recognised as representing international best practice” provide that the actual transactions undertaken should be recognised in all but “exceptional circumstances”.

Exceptional circumstances, as defined, squarely cover exception No 1 above. Exception No 2 is partially recognised, however, the OECD Guidelines only allow reconstruction to accord with commercial reality of independent parties where “the actual structure practically impedes the tax administration from determining an appropriate transfer price”. In respect of exception No 3, the OECD Guidelines specifically say that actual cross-border dealings should not be ignored:

For example, where one element of a restructuring arrangement involves the closing down of a factory, any recharacterisation of the restructuring cannot ignore the reality that the factory no longer operates.

This example from the OECD Guidelines appears to be inconsistent with an example in the draft ruling, which envisages that a sale of intellectual property rights can be entirely ignored under Australia’s new transfer pricing laws.

Division 815 provides that generally, arm’s length conditions should be identified to best achieve consistency with the OECD guidelines. It is difficult to predict how a Court might weigh this legislative purpose against clear but inconsistent words in the legislation, although the supremacy of the statutory text was most recently emphasised by the High Court in Thiess v Collector of Customs [2014] HCA 12.

Documentation and penalties

Draft ruling TR 2014/D4 and draft PS LA 3673 set out the minimum documentation requirements that must be met by taxpayers in order to be able to establish that their transfer pricing position is “reasonably arguable”. As explained in draft PS LA 3672, under the new transfer pricing documentation rules, a matter will not be considered to be “reasonably arguable” for penalty reduction purposes unless transfer pricing records are prepared before lodgment of the relevant tax return. Taxpayers who cannot demonstrate a “reasonably arguable” position will generally be subject to penalties of at least 25% of the primary tax shortfall, while demonstrating a position that is reasonably arguable can reduce those penalties to 10%.

Draft PS LA 3673 sets out a five step process that ATO officers will look for when undertaking a transfer pricing review:

  • identify the actual conditions in connection with the commercial or financial relations (or for permanent establishments - the actual and arm’s length profits and the particulars of the activities and circumstances of the permanent establishment);
  • select the most appropriate and reliable method for identifying the arm’s length conditions;
  • identify the comparable circumstances and any necessary adjustments;
  • explain the particular way in which you have applied Division 815 and why this best achieves consistency with the OECD Guidelines;
  • monitor, review and update transfer prices, as necessary.

ATO guidance says that taxpayers should make best efforts to comply, having regard to the materiality of the relevant conditions and the impact on the entity’s overall Australian tax position. The documentation must explain the tax result of applying Division 815 in the particular way chosen.

The extent of a taxpayer’s transfer pricing documentation will ultimately come down to a cost/benefit analysis and it will be interesting to see whether any of the simplification measures under consideration will be adopted in the practical guidance being developed by the ATO for Australian taxpayers. The OECD’s latest BEPS Discussion Draft on transfer pricing documentation and country-by-country reporting may also influence the ATO’s final guidance on transfer pricing documentation.

Comments and release in final

Consultation on the draft rulings and practice statements is underway. Taxpayers are invited to make submissions by 30 May 2014.

The final rulings and practice statements are currently expected to be issued together on 15 October 2014.

Reliance on ATO guidance

Transfer pricing is an area undergoing rapid development and the ATO’s views on these issues are unlikely to be finally settled for some time. Taxpayers should take extra care when relying on the ATO’s guidance in this area as reliance on rulings and practice statements may not be taken into account by Courts in the event of a subsequent dispute. A number of taxpayers have recently faced this problem in the Federal Court, including Macquarie Bank Ltd v CoT [2013] FCAFC 119 and CoT v Resource Capital Fund III LP [2014] FCAFC 37.

Need help with transfer pricing?

The KWM transfer pricing team is defending a client in the Federal Court against the ATO’s attempt to reconstruct a cross border financial supply.

We are also advising a number of clients who are concerned about the implications of the new reconstruction provision on their transfer pricing documentation in a self-assessment environment.

Our depth of experience with transfer pricing documentation and disputes allows us to negotiate the successful resolution of transfer pricing issues with the ATO for many of our clients with large and complex tax affairs.