Taxing authority and tax law

Tax authority: Australian Taxation Office (ATO)

Tax law: Division 13 of Part III of Income Tax Assessment Act and relevant provisions of double tax treaties

Relevant regulations and rulings

Taxation Ruling (TR) TR92/11: Loans, TR94/14: Application of Division 13, TR95/23: APAs, TR97/20: Methodologies, TR98/11: Documentation, TR98/16: Penalties, TR 1999/1: Services, TR2000/16: Relief from Double Taxation, TR2001/11: Permanent Establishments, TR2001/13: Interpretation of Australia’s Double Tax Agreements, TR2002/2: Meaning of Arm’s Length for the purposes of § 47A(7) Dividend Deeming Provisions, TR2002/5: Definition of Permanent Establishment, TR2003/1: Arm’s Length Debt Test, TR 2004/1: Cost Contribution Arrangements, TR2005/11: Branch Funding for Multinational Banks, TR2007/1: Consequential Adjustments and TR2010/7: Interaction of Transfer Pricing and Thin Capitalization Provisions. TR2010/D2: Transfer Pricing Implications of Business Restructures (issued in draft).

Tax Determinations (TD) TD2002/20: Film Production Companies and the Impact of the Tax Offset Scheme, TD2202/28: Foreign Bank Election to not Apply Part IIIB of the Income Tax Assessment Act (1936), TD2007/1: Market Value of Goodwill of an Entity that becomes a Member of a Consolidated Group. Draft Tax Determinations, TD2007/D20: Interaction of Division 13 and the Thin Capitalization Rules, TD2008/20: Interaction of Division 13 and the Debt/Equity Rules.

ATO Booklets: Concepts and Risk Assessment, Applying the Arm’s Length Principle, Advance pricing arrangements, Documentation and Risk Assessment for Small to Medium Businesses, Dependent Agent Permanent Establishments, Marketing Intangibles, Business Restructuring — Discussion Paper on application of Australia’s transfer pricing rules, and ATO Discussion Paper on Intra-group finance guarantees and loans — Application of Australia’s transfer pricing and thin capitalization rules.

OECD guidelines treatment

The ATO accepts the principles of the OECD guidelines and indicates in the relevant ATO transfer pricing tax rulings where there are “differences in emphasis or extensions of OECD principles.” The ATO will consider the use of all of the OECD-recognized transfer pricing methods and will also consider broader (or other) methods for particular facts and circumstances.

Priorities/pricing methods

The ATO seeks to adopt the “most appropriate” method. Methods outlined in ATO rulings include traditional transaction methods (CUP, resale price and cost plus) and profit methods (profit split and TNMM). Although traditional transaction methods (e.g., CUP) may be preferred by the ATO, the TNMM is accepted as an appropriate method in circumstances where traditional transaction data is not available, comparable or reliable. Two recent transfer pricing decisions have placed more emphasis on transaction methods and have been critical of the particular applications of the TNMM.

Transfer pricing penalties

If the Commissioner applies Division 13 and the relevant section of the International Tax Agreement Act, and it is determined that there is a transfer pricing adjustment resulting in a tax shortfall, a penalty of 25% applies, but is reduced to 10% where the taxpayer can demonstrate that it has a reasonably arguable position (RAP).

Where the tax Commissioner can demonstrate that the sole or dominant purpose is tax avoidance, a penalty rate of 50% applies, but is reduced to 25% where the taxpayer can demonstrate that it has a RAP. The taxpayer may have a RAP “if it would be concluded in the circumstances, having regard to relevant authorities, that what is argued for is about as likely to be correct as incorrect or is more likely to be correct than incorrect.”

Penalties could increase by a further 20% if the taxpayer “took steps to prevent or obstruct” the ATO from discovering the tax shortfall or if a penalty was imposed for a previous accounting period.

For 2004-05 and later income years, a Shortfall Interest Charge (SIC) will apply to any amount of tax shortfall from the day on which income tax under the first assessment for that income year was due and payable to the day on which the Commissioner gave notice of an assessment. SIC applies regardless of whether the taxpayer is liable for any shortfall penalty.

Penalty relief

Penalties will be reduced by 20% for voluntary disclosure after notification of an audit or by 80% for voluntary disclosure before notification of an audit. Where the taxpayer has contemporaneous documentation (i.e., prepared prior to or at the time of filing the company’s annual tax return and Schedule 25A) to support a RAP, the penalty may be reduced.

The Commissioner of Taxation has discretionary power to remit penalties where he considers it fair and reasonable to do so. A taxpayer with an APA will not incur penalties except in relation to non-arm’s-length dealings that are not covered by the APA or non-compliance with the terms and conditions of the APA.

Documentation requirements

The ATO has outlined a four-step process in TR98/11 to assist companies in satisfying contemporaneous documentation requirements. This process is not mandatory but is highly recommended. The documentation should:

• Record the transfer price setting process and, in particular, verify the outcome of those transactions against the arm’s-length standard
• Include business, economic and industry analyses
• Be relevant to the Australian operations (i.e., country- and company-specific)

In addition, taxpayers are expected to implement a review process to ensure that transactions and outcomes are reviewed at appropriate intervals and to ensure that the impact of material changes in the business is considered and documented.

Documentation deadlines

Documentation should be contemporaneous with the relevant transactions. Documentation is generally only required to be submitted to the ATO following a specific notification, for example, during an ATO transfer pricing documentation review or audit.

Statute of limitations on transfer pricing assessments

There is generally no statute of limitations with respect to transfer pricing adjustments. The tax legislation specifically empowers the Commissioner of Taxation to make amendments to tax assessments with respect to any year for transfer pricing adjustments.

Australia and Japan have recently signed a new double tax agreement that provides for a statute of limitations on transfer pricing adjustments. A tax authority must initiate an inquiry into an enterprise’s profits within seven years from the end of the taxable year in which the profits at issue might have been expected to have accrued to the enterprise. However, the statute of limitations does not apply in the case of fraud, willful default, or if the inability to initiate the inquiry results from the actions or inaction of the enterprise.

Return disclosures/related-party disclosures

The ATO requires a Schedule 25A to be filed with each tax return where the aggregate amount of transactions or dealings with international related parties was greater than AU$1m. Information disclosed on the Schedule 25A includes:

• Industry classification code(s)
• Countries with which the taxpayer has international related-party transactions
• International related-party transaction types and quantum
• The percentage of transactions covered by contemporaneous documentation that has been prepared in accordance with the four-step process
• Transfer pricing methodologies selected and applied
• Interests in foreign companies or foreign trusts

The ATO is planning to introduce the International dealings schedule in 2010, which requires an increased level of disclosure in respect of international related party transactions and financing transactions. The International dealings schedule will replace the Schedule 25A and thin capitalization schedule.

Audit risk/transfer pricing scrutiny

In determining whether an Australian taxpayer’s transfer pricing should be reviewed or audited by the ATO, the ATO generally gives consideration to the size and nature of the related-party dealings, the quality of any transfer pricing documentation and whether or not the taxpayer’s results appear to be commercially realistic. The ATO has developed a sophisticated risk engine which takes these factors, along with a number of other financial and industry data, into consideration in determining which taxpayers to review. Related-party transactions undertaken in connection with the following may receive particular attention by the ATO:

• Royalties
• Intangibles (both Australian and foreign-owned)
• Management services
• Financing arrangements, including interest-free loans, interest-bearing loans and guarantee fees
• Companies undergoing supply chain restructurings
• Transactions with recognised tax haven jurisdictions

The ATO also focuses on taxpayers whose overall operations do not achieve a commercially realistic result (e.g., incur losses or low returns in any particular year or over a range of years). Additionally, the ATO has been focusing on the arm’s length nature of business restructures.

The ATO concentrates on a range of industries each year, including mining, energy and utilities, motor vehicles, pharmaceuticals, distributors, banking and insurance. The ATO continues to conduct transfer pricing reviews (documentation reviews) and transfer pricing audits. These reviews and audits target small and medium-sized enterprises as well as large enterprises.

The risk of transfer pricing audit in Australia would be assessed as medium/high as the ATO continues to perform transfer pricing audits and make transfer pricing adjustments.

APA opportunity

The ATO actively promotes the use of APAs and has a well-established program for both unilateral and bilateral APAs. Circumstances that the ATO has indicated may be unsuitable for an APA include those where:

• Timely agreement is unlikely to be reached with respect to the methodology, comparable data and overall arm’s length outcome
• There is a lack of materiality in the dealings in the context of the business
• There is insufficient complexity to warrant the level of certainty that is provided by an APA

or

• Obtaining a tax benefit in Australia or overseas was a principal element of the dealings

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