Australia’s transfer pricing landscape has been transformed in the last 12 months. While some of the change is positive, much of it is problematic and aspects are positively alarming. As 2012 draws to a close, it is appropriate to reflect on the year that was.
During the year, the government introduced a new domestic transfer pricing provision, Subdivision 815-A of the Income Tax Assessment Act 1997 (the "retrospective TP legislation"), which gives the Commissioner of Taxation the power to make transfer pricing adjustments under Australia’s tax treaties.
An exposure draft of Subdivisions 815-B to 815-E (the "go forward TP legislation") was also released which will replace the old domestic transfer pricing rules in Division 13 of the Income Tax Assessment Act 1936 when enacted.
These are positive developments in so far as they enhance alignment of Australia's TP regime with international practice by requiring the rules to be interpreted consistently with OECD guidance. While not a complete panacea, it does mitigate the potential for different approaches to transfer pricing to be taken by Australia and its trading and investment partners which can result in double taxation.
This also resolves the uncertainty which has existed since the decisions of the Administrative Appeals Tribunal in Roche and the Federal Court in SNF Australia about the use of profit based methods, such as the transactional net margin method, for calculating arm's length pricing. This is important given that profit methods were used in approximately 75% of advance pricing arrangements finalised by taxpayers and the Australian Taxation Office for the 2010-2011 financial year.
Another welcome development in the proposed go forward TP legislation is the introduction of a statutory limitation period for the Commissioner to make transfer pricing adjustments. Once enacted, the Commissioner will have 8 years from the issue of an assessment for a given tax year (usually on filing of a tax return) to increase a taxpayer's taxable income or reduce its tax or capital losses to give effect to a transfer pricing adjustment. This may be even less under some tax treaties.
Unlike the current TP regime in Division 13, and even the retrospective TP legislation, it is proposed that the go forward TP legislation be self-assessed. That is, rather than requiring the Commissioner to make a determination, taxpayers must determine if the actual conditions of their cross border dealings reflect arm's length conditions or, if not, what adjustments ought to be made. That, of itself, is not a bad thing as it is consistent with the structure of the Australian tax system generally and taxpayers still have the ability to enter an advance pricing arrangement with the Commissioner to resolve any uncertainty.
However, coupled with that change is the inclusion of annual documentation requirements. While these are not mandatory, taxpayers that don’t have documentation to support their calculations of taxable income or losses under arm's length conditions will be denied the ability to argue they have a "reasonably arguable position". It follows that penalties will be imposed at a base rate of 25% rather than 10% in the event the Commissioner subsequently makes transfer pricing adjustments.
In practical terms, unless taxpayers are confident that any transfer pricing adjustments will be less than the de minimis limits (generally the higher of $10,000 or 1% of taxable income), they will effectively be forced to maintain documentation of their cross border dealings to mitigate their penalty exposures.
Much has already been written about the retrospective nature of Subdivision 815-A and its potential impact on assessments of sovereign risk in Australia. Further, there are real questions about whether the measures are constitutionally valid.
While the go forward TP legislation does not share this problem, it contains its own issues that will concern many multinationals operating in Australia. In particular, the proposed rules provide that in identifying the arm's length conditions, regard must be had to the "economic substance" of what was actually done; and the "legal form" of what was done does not limit the identification of the arm's length conditions.
On its face, that might seem reasonable, however the draft explanatory memorandum states it is possible to substitute actual dealings or arrangements if "independent entities would not have done what was actually done given the options that are realistically available to them". This is concerning, for as the OECD warns in its guidelines: "[r]estructuring of legitimate business transactions would be a wholly arbitrary exercise the inequity of which could be compounded by double taxation created where the other tax administration does not share the same views as to how the transaction should be structured". Unlike the OECD guidelines, the proposed rules do not require the existence of "exceptional circumstances" before undertaking an exercise of reconstruction.
There are also some ominous sounding warnings from government about the taxation in Australia of profits derived by internet based businesses such as Google, Amazon and Apple. In a speech delivered by the Assistant Treasurer on the day the exposure draft of the go forward TP legislation was released, he indicated concern about whether those companies (and others like them) were paying their fair share of taxes. He signalled that the government will work with other countries through global forums to address the issues.
While this is unlikely to be solved through transfer pricing alone (in the absence of an international move away from the arm’s length principle to the allocation of global profits based on some formula), it might result in some changes to source rules to address the particular issues that arise from e-commerce activity.
While there are some changes that are welcome, by and large, the new transfer pricing landscape will be a headache for many taxpayers. Making a segue from spaghetti westerns to sci-fi movies, it might be observed that “this is getting real ugly, real fast”.