Bills Digest no. 91  2012–13

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WARNING: This Digest was prepared for debate. It reflects the legislation as introduced and does not canvass subsequent amendments. This Digest does not have any official legal status. Other sources should be consulted to determine the subsequent official status of the Bill.

Les Nielson
Economics Section
15 March 2013

Contents
The Bills Digest at a glance
Purpose of the Bill
Structure of the Bill
Background
Committee consideration
Policy position of non-government parties/independents
Position of major interest groups
Financial implications
Statement of Compatibility with Human Rights
Technical difficulties
Other provisions
Concluding comments
Appendix : UK House of Commons – Public Accounts Committee – HM Revenue and Customs: Annual Report – 1 Tax avoidance by multinational companies

The Bills Digest at a glance

Purpose of the Bill

• The Bill amends the anti-tax avoidance provisions of the Income Tax Assessment Act 1936 to remedy problems identified by judicial interpretation.
• The Bill also inserts new provisions for the assessment of transfer pricing arrangements into the Income Tax Assessment Act 1997.

Structure of the Bill

• The Bill is split into two Schedules, the first dealing with the anti-avoidance measures, the second with the assessment of transfer pricing arrangements.

Background

• Deficiencies in the text of the relevant anti-avoidance provisions of the Income Tax Assessment Act 1936 revealed by judicial interpretation have allowed some taxpayers to sidestep their impact.
• Changes in the ways in which transfer pricing arrangements are structured, together with changes in international best practice for assessing these transactions, require Australian law to be updated. Further, such transactions have recently been the subject of both government and public attention.

Stakeholder concerns

• Many of the specific industry concerns about the Exposure Draft legislation have been covered. However, whether retrospective examination of past, very abusive, transactions should be allowed remains an issue.

Key elements

• Proposed amendments to the anti-avoidance provisions clarify the basis on which the Australian Tax Office may assess such schemes, and restrict the grounds on which affected taxpayers may effectively argue against adverse assessments under these provisions
• The proposed transfer pricing assessment provisions ensure that:

–      these assessments depend on the application of the arms-length principle

–      the ATO may take into account the widest possible range of circumstances in which these transactions occur and

–      these transactions are assessed in accordance in the OECD conventions and models on taxing such transactions.

Tax Laws Amendment (Countering Tax Avoidance and Multinational Profit Shifting) Bill 2013

Date introduced: 13 February 2013
House: Representatives
Portfolio: Treasury
Commencement: Royal Assent, save for Part 4 of Schedule 2 which commences immediately after the commencement of the Tax Laws Amendment (Cross-Border Transfer Pricing Act (No. 1) 2012, that is 8 September 2012. However, see provisions for the application dates for the proposed amendments.

Links: The links to the Bill, its Explanatory Memorandum and second reading speech can be found on the Bill's home page, or through http://www.aph.gov.au/Parliamentary_Business/Bills_Legislation. When Bills have been passed and have received Royal Assent, they become Acts, which can be found at the ComLaw website at http://www.comlaw.gov.au/.

Purpose of the Bill

The purpose of the Tax Laws Amendment (Countering Tax Avoidance and Multinational Profit Shifting) Bill 2013 (the Bill) is to amend the following Acts:

• Income Tax Assessment Act 1936 (ITAA 36)
• Income Tax Assessment Act 1997 (ITAA 97)
• Income Tax Administration Act 1953 (TAA 53) and
• Income Tax (Transitional Provisions) Act 1997 (ITTP 97).

to update the general tax anti-avoidance rules in ITAA 36 and bring the transfer pricing tax regime in the ITAA 97 into line with international standard tax administration practice.

Structure of the Bill

This Bill is divided into two schedules:

• Schedule 1 amends the current anti-avoidance rules in the ITAA 36 and
• Schedule 2 updates the transfer pricing rules in the ITAA 97.

Schedule 1 seeks to achieve this outcome by ensuring that the two limbs of section 177C ITAA 36 for assessing whether an arrangement would have conferred a tax benefit upon a tax payer are separate alternative basis on which to decide this question.

Schedule 2 seeks to achieve this outcome by inserting new Subdivisions 815-B, 815-C and 815-D into the ITAA 97 and new Subdivision 284-E into the TAA 53. Current Division 13 of the ITAA 97 would be repealed.

The aim of these amendments is to ensure that Australia’s transfer pricing rules are consistent with the Organisation for Economic Cooperation and Development’s (OECD) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administration (OECD Guidelines).[1] These guidelines are based on the ‘arm’s-length’ principal in taxing transfers between related parties (see below).

Background

Current law

Anti-Avoidance

The anti-avoidance rules are designed to prevent the avoidance of tax in respect of the structuring of arrangements or transactions, which are aimed at exploiting the law to obtain a tax advantage not intended by the legislation. The arrangement in question complies with current tax law, but the effect is to eliminate, or dramatically reduce, a taxpayer’s liability.

The anti-avoidance rules may be applied where:

• a "scheme” is identified
• a "tax benefit" has been obtained in connection with the scheme and
• it is objectively concluded that the scheme was entered into for the "sole or dominant purpose" of enabling the taxpayer to obtain a tax benefit.

A "scheme" is widely defined to include agreements, arrangements and understandings. Examples of a "tax benefit" include an amount not being included in assessable income, a deduction being allowed or a capital loss being incurred or a foreign tax credit obtained.

In determining whether the scheme was entered into for the sole or dominant purpose of obtaining a tax benefit, the Australian Tax Office (ATO) must consider several factors, including the manner in which the scheme was entered into and what the scheme achieved as a matter of substance.

If the ATO determines that the anti-avoidance rules apply, the Commissioner has the power to cancel the whole or part of the tax benefit.[2]

Transfer Pricing

Transfer pricing refers to the prices charged when one part of a multinational group buys or sells products or services from another part of the same group in a different country. The prices charged will impact their level of profits, and therefore the amount of tax they have to pay, in the respective countries. Another approach is for a parent company to charge its subsidiary an extremely high price for intellectual property used or goods supplied, so that subsidiaries’ profit is very low to non‑existent. Again, the subsidiaries’ tax payable will be very low.

It can be the case that one party charges a related party a very low price for the goods or services supplied by that related party. Thus the first party’s profits are low (or non-existent) and little, if any, tax is paid by the first party. The volume of transactions to which the transfer pricing arrangements apply has steadily grown, as shown in Figure 1.

Figure 1: Volume of Transfer Pricing Arrangements, % GDP, 2002-03 to 2008-09

Source: Australian Government, ‘Income tax: cross border profit allocation: review of transfer pricing rules’, Consultation paper, Treasury, Canberra, 1 November 2011, p. 2, viewed 19 February 2013, http://archive.treasury.gov.au/contentitem.asp?ContentID=2219&NavID=066

Any set of transactions representing over 20 per cent of Australia’s gross domestic product is a sizeable piece of its economic activity. It would concern any government that the expected revenue arising from such activity was not being collected.

Under current law transfer pricing arrangements are addressed under both:

• Division 13 of the ITAA 36 and Subdivision 815-A ITAA 97 and
• the Associated Enterprises Article of a relevant tax treaty (usually Article 9).

Australia’s current approach is based on the ‘arms-length’ principle. This is not specified in legislation, but is contained in the Associated Enterprises Articles in each of Australia's Double Taxation Agreements (DTAs). A typical example is Article 9 of the Australia Vietnam DTA, which states:

… conditions operate between the two enterprises in their commercial or financial relations which differ from those which might be expected to operate between independent enterprises dealing wholly independently with one another, then any profits which, but for those conditions, might have been expected to accrue to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.[3]

Assessing the taxable income requires the comparison of the 'conditions that exist in [the] commercial [and] financial relations' between associated enterprises, with the conditions that might be expected to operate between independent parties dealing wholly independently with each other.[4]

To determine whether an arm’s-length relationship exists the ATO focuses on the details of the actual transaction itself and uses a variety of methods, as appropriate to the circumstances, to determine the transfer price used for taxation purposes.[5] Only some of these methods are permitted by current tax law (see below).

Transfer pricing and multinational’s tax obligations – recent debate

In its recent review of the HM Revenue and Customs Department’s annual report and account the British Parliament’s House of Commons Public Accounts Committee noted substantial problems with the amount of corporate tax collected from multinational companies operating in that tax jurisdiction. The following quote illustrates the overall problem:

8. Starbucks told us that it has made a loss for 14 of the 15 years it has been operating in the UK, but in 2006 it made a small profit. We found it difficult to believe that a commercial company with a 31% market share by turnover, with a responsibility to its shareholders and investors to make a decent return, was trading with apparent losses for nearly every year of its operation in the UK. This was inconsistent with claims the company was making in briefings to its shareholders that the UK business was successful and it was making 15% profits in the UK. Starbucks was not prepared to breakdown the 4.7% payment for intellectual property (which was 6% until recently) that the UK company pays to the Netherlands based company. The Committee was sceptical that the 20% mark-up that the Netherlands based company pays to the Swiss based company on its coffee buying operations, with a further mark up before it sells to the UK, is reasonable . Starbucks agreed that it had a special tax arrangement with the Netherlands that made it attractive to locate business there, which the Dutch authorities asked Starbucks to hold in confidence, and that Switzerland offers a very competitive tax rate. In addition, there is an inter-company loan between the US Starbucks business and the UK Starbucks business over a period of time with the interest rate set at higher rate than any similar loan we have seen. We suspect that all these arrangements are devices to remove profits from the UK to these areas with lower tax.[6]

This is just one of three examples in this section of its report (the full extract is at Appendix 1).

There are also circumstances where local subsidiaries of multinational firms have no firm basis for determining a reasonable price on which to base their profit calculations for tax purposes. This can arise where there is a lack of competition in the markets in which they operate. It should not be assumed that simply because a business entity is a subsidiary of a multinational organisation that it engages in profit shifting.

The lack of tax collected from local subsidiaries of large multinationals operating in Australia has recently been the focus of government attention in Australia. In an address to the Institute of Chartered Accountants of Australia the Assistant Treasurer noted the very tax effective practices of a significant multinational company operating in Australia.[7] Treasury has set up a specialist reference group to examine multinational tax minimisation strategies and its risks to the sustainability of Australia's corporate tax base.[8] The proposed amendments in the Bill did not arise from the work of this specialist reference group, which has yet to report.

What specific problems are these amendments seeking to correct?

Anti-avoidance

In several recent cases, taxpayers have successfully argued that they did not get a tax benefit because if the scheme had not been entered into, they would not have entered into another arrangement that attracted tax. Rather, they would have done nothing or would have deferred their arrangements indefinitely. On this basis they were able to establish that the Commissioner's "alternative postulate" (being that a transaction with the same commercial effect would have occurred but with a higher tax liability) was unreasonable.

Following the ATO's loss on this issue in RCI Pty Ltd v Federal Commissioner of Taxation[9] the Federal Government announced in March 2012 that it would amend the anti-avoidance provisions.[10]

Transfer pricing

Australia has always based its transferring pricing regime on international standard best practice.[11] These standards have been based on the OECD’s long established work in this area. The OECD Report and Guidelines on transfer pricing which were first issued in 1979 and were subsequently revised and updated in 1995 and again in 2010.[12] This last revision is the basis for proposed changes contained in this Bill.

The OECD’s standards are based on the ‘arms-length’ principal, which in the latest guidelines is defined as:

Where “conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly”.[13]

At first glance this may not seem too different from the definition currently used by the ATO in the various double tax agreements (DTAs). However, this definition is not in current tax law and there is doubt whether it can be used in applying that law. The ATO maintains that the various DTAs, in particular the Associated Enterprise Articles of those treaties, may be used as an alternative taxation power for assessing transfer pricing arrangements. To date, the courts have not agreed with this view.[14] Including a reference to this definition, as well as to the OECD Guidance material, in tax legislation will put this matter beyond doubt, with the advantage that it will allow the Commissioner for Taxation to take into account the totality of arrangements where transfer pricing takes place instead of the particular circumstances of a specific set of transactions.[15]

There are other advantages to aligning actual tax law with current DTAs. Taxation outcomes achievable under the various DTAs are better aligned with the outcomes achievable under actual taxation law. Such an alignment may reduce the number of appeals against and assessment made under the provisions of a DTA. Further, the tax treatment of transfers between Australia and countries with which it does not have a DTA will be more consistent with the treatment of transfers to countries with whom Australia has such an agreement, as these transfers will be assessed under provisions similar to those existing in the DTAs.

A recent decision of the Federal Court in 2012 restricted the particular methods that the ATO could use in assessing the taxable income of a multinational operating in Australia.[16] Briefly, on appeal the full Federal Court decided that the ATO could not use the ‘profitability’ method in calculating the taxable profit of the local subsidiary of a multinational company.[17] The point here is the ATO was prevented from using what it considered to be the most appropriate method for assessing the taxable income of a multinational subsidiary operating in Australia. Including references to OECD guidance material (or other suitable guidance documents) in tax legislation may make it possible for the ATO to use a wider range of methods in assessing whether transfer pricing had taken place.

Further the Court found that it was not acceptable to use the OECD Transfer Pricing Guidelines as an aid to the construction of either Division 13 ITAA 36 or the Associated Enterprises Articles of Australia's DTAs.[18] Referring to these guidelines in legislation may alleviate this problem in respect of the proposed provisions.

The need for continual updating of provisions relating to transfer pricing has been recently set out by the OECD, as follows:

….international common principles drawn from common experience to share tax jurisdiction may not have kept pace with the changing business environment. Domestic rules for international taxation and internationally agreed standards are still grounded in an economic environment characterised by a lower degree of economic integration across borders, than today’s environment of global taxpayers, characterised by the increasing importance of intellectual property as a value driver and by constant developments in information and communication technology…[19]

In part the proposed changes are seeking to update the tax provisions to keep abreast of these developments.

Committee consideration

House of Representatives Standing Committee on Economics

The Bill has been referred to the House of Representatives Standing Committee on Economics for inquiry and report. Details of the inquiry are at: http://www.aph.gov.au/Parliamentary_Business/Committees/House_of_Representatives_Committees?url=economics/profitshiftingbill/index.htm.[20]

The Committee will examine the adequacy of the Bill in achieving its policy objectives and where possible identify any unintended consequences. The Committee reported on 13 March 2013 after receiving 16 submissions.[21] The majority report recommended passage of the Bill.[22]

Senate Economics Legislation Committee

The Bill has also been referred to the Senate Economics Legislation Committee for inquiry, and report by 14 May 2013. This Committee will consider:

• whether the amendments to Part IVA ITAA 36 are appropriately targeted and
• in relation to the Transfer Pricing amendments to consider the:

–      de minimis threshold (see commentary on item 41 of Schedule 2 below)

–      documentation requirements for affected companies self-assessing their obligations

–      the Commissioner’s powers to reconstruct a transfer pricing transaction and

–      the financial impact of these changes.[23]

Policy position of non-government parties/independents

The Coalition members of the House of Representatives Standing Committee on Economics do not support the passage of this Bill for a number of reasons, amongst which are:

• uncertainty about its financial impact, especially the financial impact of changes in Schedule 2 (Transfer Pricing)
• the Bill is possibly an over-reaction to recent losses in the Federal Court in relation to the anti-avoidance measures
• the provisions possibly give the Commissioner for Taxation unintended tax assessment powers in relation to both the anti-avoidance and transfer pricing measures
• the commencement date of 16 November 2012 is inappropriate because the provisions of the Exposure Draft of that date are significantly different to the provisions of the Bill, and
• the current transfer pricing provisions have stood the test of time and the drafting of the proposed provisions have been rushed. They require further consultation, scrutiny and testing.

It is notable that this Committee did not hold public hearings on this particular Bill. Many of the above objections stem from this lack of consultation.[24]

Position of major interest groups

Reactions to the consultation paper

On 1 November 2011 Treasury released a consultation paper on transfer pricing rules and invited submissions from interested parties.[25] Some for the major themes of significant interest groups in response to this consultation paper were:

• there was general support for incorporating the OECD guidelines on transfer pricing into Australian Tax law
• there was also strong support for adopting the Permanent Establishment of Multinational Enterprises rules included in the OECD guidelines
• there was also strong support for the rewriting of the transfer pricing rules so that they are ‘self‑executing’, that is, the taxpayer self-assess the tax payable in the first instance
• there was strong opposition to the retrospective application of these amendments back to cross border transactions occurring on or after 1 July 2004
• there was also strong opposition to using the DTAs an alternative taxing power and a number of submissions noted that successive court decisions had denied the Commissioner for Taxation the ability to use the DTAs in this way
• there was also strong opposition to the ATO’s use of profit based methods for determining a taxpayers’ assessable income arising from these transactions and
• there was strong opposition for the retention of the Commissioner for Taxation’s power to reassess a transaction using a different assessment method to that used by the taxpayer (that is, reconstructing the transaction).[26]

Many of these concerns have been addressed in the current Bill. For example, the current Bill is not retrospective. It does not allow the Commissioner to re-examine past transactions under the proposed new rules.

Reactions to the Exposure Draft

On 22 November 2012 Treasury released an Exposure Draft of the Bill. Key industry concerns, as expressed in a range of industry submissions, include:

• the scope and extent of the reconstructive powers contained in new Subdivision 815-B; the key industry concern focussed on the uncertainty taxpayers will face, given the ATO's extensive power to substitute arm’s-length conditions for the commercial realities of the transaction
• the onerous nature of the record-keeping requirements contained in new Subdivision 815‑D, with no concession granted for small to medium businesses, and
• the absence of a mechanism enabling penalties [in cases of inadequate records for an assessment] to be remitted to a rate of less than ten per cent; industry submissions on this point highlight that this approach does not provide any incentive to voluntarily comply.[27]

Reactions to the Bill

The Institute of Charted Accountants has observed in relation to the current Bill that:

…the new legislation creates a stable framework for both international investors and Australian businesses operating abroad.

“Australia is a relatively small, open market economy that is heavily reliant on foreign direct investment to help drive growth in our productive capacity. Aligning our transfer pricing rules with the OECD standards is an important step in enabling Australian businesses to compete efficiently on the global stage…”[28]

The multinational law firm DLA Piper has noted some concerns and challenges of the proposed legislation:

Questions arise as to whether the statutory language or text used in parts of the legislation is consistent with and/or achieves the intent reflected in the accompanying Second Reading Speech and particularly the Explanatory Memorandum (Accompanying Aids). Recently in Commissioner of Taxation v Consolidated Media Holdings Limited (2012) HCA 55 at para 39 (5 December 2012), the High Court has re-emphasised the paramount significance of the words of the statute (the text) and that the legislative history and extrinsic materials cannot displace the meaning of the statutory text.

Though helpful, heavy reliance on the OECD guidance contained in the OECD Model Tax Convention, its commentaries and the OECD Transfer Pricing Guidelines can create an element of uncertainty. These guidelines are as they suggest, just guidelines and are limited in their certainty of practical application, particularly with specific issues including proposed re-characterisation of transactions, debt/equity treatment and increasing debate as to the appropriate approach to permanent establishments.

The interaction of Division 820 [ITAA 97] as the regime dealing with Thin Capitalisation and the transfer pricing (TP) Rules provides challenges in analysing the impact on certain financing arrangements. Similar to Subdivision 815-A, it is intended that the TP Rules be applied first, followed by Division 820 (where applicable) to potentially reduce debt deductions creating a circular approach and potentially duplication of process, particularly with the arm’s-length thin capitalisation method.[29]

Many of the above concerns were repeated in interested parties’ submissions to the House of Representatives Economics Committee inquiry into this Bill. In respect of the proposed transfer pricing rules many of these submissions made the additional following points:

• the proposed transfer pricing provisions are broader in scope than the OECD Transfer Pricing assessment guidelines and related material
• the proposed transfer pricing provisions operate in only one direction, that of increasing tax assessable income. They should also operate to reduce tax assessable income where that is justified by the facts of the case and
• the ability of the Commissioner to reopen a transfer pricing assessment within seven years is too long a period. It should be a four year period, as applies to other taxpayers under section 170 ITAA 36[30]

–      in relation to the proposed adoption of the 4 year limit several submissions note that the current subsection 170(7) ITAA 36 allows the Commissioner for Taxation additional time to examine a taxpayer’s affairs, if required. But I note that this extension has to be accomplished through a Federal Court order, which may be both expensive and time consuming to achieve, and take time away from actually assessing the taxpayer’s affairs

• the compliance and record keeping requirements are too onerous and do not strike the appropriate balance between the risk to revenue and administrative costs and
• there is a conflict between the assessment of transactions under the proposed transfer pricing rules and the valuation of goods for Customs purposes.

In respect of the proposed anti-avoidance provisions many of these submissions raised the following points:

• changes to Part IVA ITAA 36 (Anti-Avoidance provisions) are an over-reaction to the recent ATO losses in cases concerning the application of this part. Better case selection and management on the part of the ATO would render these changes unnecessary[31] and
• the proposed new test to commence a Part IVA ITAA 36 assessment is whether obtaining a tax benefit was the sole or dominate purpose of the scheme in question. Rather, interested parties consider that the current starting point, that of whether there was a tax benefit in the first place, should be retained.

Many of these objections have been answered by Treasury in its submission of the House of Representatives Economics Committee inquiry.[32]

Financial implications

The general anti-avoidance provisions are expected to prevent the loss of about $1 billion per year. The Explanatory Memorandum notes that the changes to the transfer pricing provisions are not expected to have any financial impact.[33]

To say the least this lack of expected financial impact from proposed changes to the transfer pricing provisions seems odd, given that the Government considers that some multinational companies operating in Australia have possibly not paid their fair share of tax.[34] On the other hand, the proposed approach is a new one, and it may be quite difficult to put any kind of figure on any additional revenue that may be raised.

Statement of Compatibility with Human Rights

The Statement of Compatibility with Human Rights can be found at page 29 for the anti-avoidance amendments and page 98 for the transfer pricing amendments, of the Explanatory Memorandum to the Bill. As required under Part 3 of the Human Rights (Parliamentary Scrutiny) Act 2011 (Cth), the Government has assessed the Bill’s compatibility with the human rights and freedoms recognised or declared in the international instruments listed in section 3 of that Act. The Government considers that the Bill is compatible.

However, the Joint Parliamentary Joint Committee on Human Rights has raised the possibility the penalties that may be imposed under items 3 to 5 of Schedule 2 (particularly new section 248-60, Schedule 1 TAA 53) could be classed as criminal penalties under Articles 14 and 15 of the International Covenant on Civil and Political Rights (ICCPR).[35] The current Bill describes them as ‘administrative penalties’. If they are criminal penalties under the ICCPR, and they are imposed, this could result in those being fined effectively being declared to be criminals without having gone through any due criminal trial process. This Committee is seeking clarification from the Government on this matter.

Technical difficulties

Items 3 and 4 of Schedule 1 amend subsection 177C(1) ITAA 36. Item 3 inserts new subparagraph 177C(1)(bc) which seeks to define the amount of a tax benefit arising from not having to pay withholding tax, in the following words:

(bc) the taxpayer not being liable to pay withholding tax on an amount where the taxpayer either would have, or might reasonably be expected to have, be liable to pay withholding tax on the amount if the scheme had not been entered into or carried out;

Item 4 adds new sub paragraph 177C(1)(g), which defines a tax benefit as including, reads:

;and (g) in a case to which paragraph (bc) applies-the amount referred to in that paragraph.

Note that item 3 can arguably be read as not referring to an amount at all. Rather, it can be read as referring to a situation where the taxpayer was not liable to pay withholding tax, and not to the amount of withholding tax that they were not required to pay as a result of entering into the scheme in question.

The Corporate Tax Association observes that new subparagraph 177C(1)(bc):

appears to define the tax benefit in a withholding tax scenario as being the gross amount on which tax would be withheld, rather than the quantum of the withholding tax benefit itself.[36]

Current subsection 177C(1) ITAA 36 defines a tax benefit as the amount of:

• income that would have been included, or might reasonably have been included, in the taxpayers assessable income had the scheme in question not been entered into or been carried out
• a deduction that would not have been allowed or might reasonably have not been allowed if the scheme in question not been entered into or carried out
• a capital loss that would not have been allowed, or might not have reasonably been allowed, had the scheme in question not been entered into or carried out or
• a foreign tax offset that would not have been allowed, or might not have reasonably been allowed, had the scheme not been entered into or carried out.

It is arguable that this particular amendment does not refer to an amount of withholding tax that the taxpayer would have to have been paid, or might reasonably have to have been paid, had the scheme in question not been entered into or not have been carried out.

Key provisions - Anti-Avoidance

Item 5 of Schedule 1 deletes current sections 177CA and 177D from the ITAA 36 and substitutes new sections 177CB and 177D in their place.

New section 177CB tests whether a tax effect (also known as a tax benefit) would have occurred, or might reasonably be expected to have occurred if the scheme had not been entered into or carried out in either of two circumstances (see below). Briefly a tax effect is:

• an amount being included in a taxpayer’s assessable income
• some or all of a tax deduction not being allowed
• some or all of a capital loss not being incurred
• some or all of a foreign tax credit not being allowed and/or
• the taxpayer being liable to pay withholding tax.

The two circumstances are either:

• would one or more of the above tax effects occurred if the taxpayer had not entered into the scheme in question or
• would one or more of the above tax effects occurred if the taxpayer had undertaken a course of action that was a reasonable alternative to the scheme entered into.

Further, new section 177CB makes it clear that the ATO can only take account of events that actually happened or existed (other than those that form part of the scheme in question); or where considering an alternative course of action only reasonable arrangements that achieved the same non-tax outcome as the scheme actually undertaken by the taxpayer. Events that did not exist (such as not proceeding with the scheme in question), or courses of action that were not reasonable in the circumstances (such as different arrangements that did not achieve the same non-tax outcome as the scheme in question) or the particular tax costs of any reasonable alternative, could no longer be used to argue that the tax effects would not accrue in alternative circumstances.

The Explanatory Memorandum notes that new section 177D, in conjunction with the amendments to section 177F, ensure that the operation of this part of the ITAA 36 commences with the consideration of whether a scheme participant entered into these arrangements for the sole or dominate purpose of securing a tax benefit. These changes ensure that the participant’s purposes in entering the scheme are examined, and not just whether the tax benefit occurred or not as apparently is the case in the existing section 177D.[37]

As noted above, this new approach is controversial. Industry practitioners contend that these new sections will not work because to determine whether a scheme was entered into for the sole or dominant purposes of obtaining a tax benefit requires that the existence of a tax benefit be first determined.

Key issues and provisions - Transfer Pricing

Introduction

Item 2 of Schedule 2 inserts new Divisions 815-B, 815-C and 815-D into the ITAA 97. Briefly, these new divisions cover:

• assessment of transfer pricing for separate legal entitles of multinational companies (new Division 815-B)
• assessment of transfer pricing for permanent establishments of multinational companies operating in Australia (new Division 815-C) and
• assessment of transfer pricing arrangements of trusts and partnerships (new Division 815-C).

Generally, these new Divisions achieve these assessments by substituting arm’s-length conditions for the actual conditions existing in their relations with another entity. The company, trust or partnership then self-assesses whether a transfer pricing benefit from these arrangements arises. Those entities’ tax payable is calculated on the basis of the self-assed tax benefits not existing where they are not otherwise allowed by tax law.

Specific provisions

Legally separate entities (new Subdivision 815-B)

New section 815-115 requires that a legally separate entity operating in Australia substitutes arm’s‑length conditions in the place of the financial relations it may have with another entity.

New section 815-120 defines a transfer pricing benefit to be:

• an increase in the entities’ taxable income
• a reduction in the entities’ losses
• a reduction in the entities’ tax offsets or
• an increase in the amount of the entities’ withholding tax.

The meaning of arm’s-length conditions for a legal entity operating in Australia is defined by new section 815-125 as:

…the conditions that might be expected to operate between independent entities dealing wholly independently with one another in comparable circumstances

New subsection 815-125(2) requires the use of the most appropriate method, or combination of methods to identify the arm’s-length conditions applying. These methods include profit based methods.[38]

New section 815-135 allows the use of specified documents to identify arm’s-length conditions. These documents include:

• Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, as approved by the Council of the Organisation for Economic Cooperation and Development and last amended on 22 July 2010 or
• a document, or part of a document, prescribed by regulations for the purposes of this paragraph.

However, regulations can be made to otherwise provide that these Transfer Pricing Guidelines do not apply (new subsections 815-135(3) and (4)).

New section 815-150 allows the amendment of transfer pricing assessments for legal entities within a seven year period from which the Commissioner gives notice of the assessment of that entity. As noted above, industry generally wants this period to be in line with the general time limit for other taxpayers (four years).

Permanent establishments (new Subdivision 815-C)[39]

New section 815-215 requires a permanent establishment (PE) of an overseas company to disregard the amount of profit actually attributed to it and calculate this amount under arm’s-length conditions.

New section 815-220 defines a tax benefit arising when the profit calculated under the arm’s-length conditions differs from this actual profit, in terms similar to new section 815-120 (see above).

New section 815-225 defines these arm’s-length conditions for a PE as the profits that it might be expected to make if:

• the PE were a distinct and separate entity and
• the activities and circumstances of the PE, including the functions performed, assets used and risks borne by that PE were those of a separate entity.

New section 815-235 the arm’s-length profits and arm’s-length conditions are to be worked out to achieve consistency with:

• the Model Tax Convention on Income and Capital and its Commentaries, as adopted by the Council of the Organisation for Economic Cooperation and Development, as amended on 22 July 2010 (save for Article 7 and its related commentary as they read before that date)

–      this is a different document to that used for legally separate entities in new section 815-135 (see above) or

• a document, or part of a document prescribed by regulations for the purposes of this section.

Regulations may be made to prescribe different documents than the above mentioned Model Tax Convention for the purposes of this new section.

Under new section 815-240 the Commissioner for Taxation may amend an assessment at any time up to seven years after the initial assessment has been made.

Trusts and Partnerships (new Subdivision 815-D)

New sections 815-305 and 310 allow the income of a trust or partnership to be assessed in the same way as a legally separate entity or PE are assessed under new Subdivisions 815-B and 815-C.

Domestically the tax assessment of trusts and partnerships in same manner as companies has been a specific policy of the Australian Greens.[40] These specific provisions achieve this aim in respect of transfer pricing arrangements undertaken by these entities.

On Retrospectivity

Item 54 of Schedule 2 Part 3 adds new section 815-15 to the Income Tax (Transitional Provisions) Act 1997. This new section specifies that the application of new Subdivisions 815-B, 815-C and
815-D ITAA 97 is the earlier of 1 July 2013 or the date of Royal Assent for this Bill. In other words, these provisions are not retrospective in their application, despite an earlier official pronouncement to that effect.[41]

Briefly, retrospectivity is objectionable because it potentially penalises those who have made, and settled, past legally valid transactions. Further, it introduces significant uncertainty into the tax affairs of those making past transfer pricing arrangements. As noted above, industry, and both a Coalition and an independent Senator strongly objected to the retrospective provisions in previous transfer pricing legislation.

No doubt these are valid points. However, there are a few other points that should be noted before coming to a final position on this matter:

• the provisions of this Bill actually limits the ability of the ATO to go back and look at previously concluded transactions.[42] Under current tax law the Commissioner has the capacity to look at any past transfer pricing transaction.[43] Apparently industry have been living with these provisions for some time and
• application of tax law retrospectively is not a new development. Rather it is a constant fact that a change to tax law is announced and applied to transactions that took place before the relevant legislation commences.[44]

There is a significant public interest reason for allowing the Commissioner to re-examine past transfer pricing transactions under the proposed arrangements. The above example of Starbuck’s conduct in the UK is an alleged example of the unacceptable abuse of that countries’ corporate tax arrangement, together with the provisions applying in other countries. It is safe to argue that these provisions were used in a manner far beyond the intention of the United Kingdom (UK) Parliament. Should such examples exist in Australia then it would be in the public interest for the Commissioner for Taxation to re-examine such cases using the proposed provisions. For where such cases exist Australia’s tax laws at the time were similarly abused, though their legal form may have been adhered to.

Other provisions

Item 10 of Schedule 1 applies the amendments to the anti-avoidance rules in that Schedule to all schemes that were entered into or commenced to be carried out after 15 November 2012. This latter date is when the Exposure Draft of these provisions was first released by Treasury.

This provision is controversial, as one industry commentator argues that the current Bill differs significantly from the Exposure Draft, thus the proposed new laws should apply from the date on which the new provisions take effect.[45]

Item 1 of Schedule 2 repeals Division 13 of the ITAA 36. Item 53 adds new subsection 815-1(2) that ensures that current Subdivision 815-A does not apply to income years in which new Subdivisions 815-B, C and D apply. Thus the current transfer pricing tax laws do not operate at the same time as these new provisions.

Items 3 to 5 of Schedule 2 amends the TAA 53, imposing substantial administrative penalties (either 25 or 50 per cent of the tax shortfall) where transfer pricing or anti-avoidance assessments are later amended. These penalties are on top of the additional tax an entity may have to pay.

Item 6 of Schedule 2 inserts new section 289-165 into Schedule 1 of the TAA 53, under which the penalty relating to a transfer pricing reassessment is remitted if it the tax shortfall is equal to or less than that entities reasonably arguable threshold.

An entities’ reasonable arguable threshold is defined by item 41 of Schedule 2, which inserts a definition of this term into subsection 995(1) ITAA 97. In turn, this definition refers to new subsection 284-90(3) of Schedule 1 TAA 53. Item 48 inserts this new section, where this threshold is specified as the greater of:

• $10 000 or one per cent of the income tax payable or
• if the entity is a trust or partnership $20 000 or two per cent of the trust or partnerships’ net income.

Taxpayers will have to be quite accurate in their application of the proposed transfer pricing provisions to avoid these administrative penalties.

Item 7 of schedule 2 inserts new sections 284-250 and 284-255 into Schedule 1 TAA 53. These new section set out the documentation requirements for the operation of new Subdivisions 185-B, C and D ITAA 97.

These documentation requirements are also controversial. As noted above, the tax assessment of transfer pricing arrangements will move to the self-assessment model. The onus will be on the taxpayer to make the initial assessment and pay the relevant amount of tax. Such a system requires the keeping of accurate records in relation to each assessment. Such records enable the ATO to assess the accuracy of those assessments, and issue amended assessments if necessary. If movement towards a self-assessment model for transfer pricing assessment is desirable, the price is the keeping of such records.

Concluding comments

As noted above, the volume of international transfer pricing transactions is growing. Further, the types of transactions are moving away from those involving goods towards trade in intangibles, such as intellectual property and advertising services. These changes, together with improvements in electronic communications, will most likely lead to changes in the way these transactions are structured. Consequently, these amendments are unlikely to be the last word in this particular area.

 

Appendix: UK House of Commons – Public Accounts Committee – HM Revenue and Customs: Annual Report – 1 Tax avoidance by multinational companies
1. In 2011-12, £474.2 billion of total tax revenue accrued to HM Revenue and Customs (the Department) which was £4.5 billion higher than for 2010–11. Yet there was a decrease in corporation tax revenue of £6.3 billion. 2. HMRC stated that it had been a policy of successive governments to make the UK an attractive place for business and for multinationals to see the UK as competitive. But HMRC also expected everybody to pay their fair share of tax and saw its role as strictly enforcing the tax laws which it felt were strong enough to collect tax owing under both national and international tax systems and rebutted any suggestion that it had been lenient with big businesses. 3. We were not sufficiently convinced by the Department's assertion that it was pursuing all the tax due from big businesses given the reduction in corporation tax revenue from last year. There is genuine public anger and frustration because there is an impression that rigorous action is taken against ordinary people and small businesses and British companies based wholly in the UK but, apparently, lenient treatment is given to big corporations, of which almost half have a head office overseas. 4. HMRC considered that it had a well-resourced unit bringing in very significant amounts of money; for the 770 largest businesses it had 1200 staff and was able to draw on expertise across the Department, for instance 65 transfer pricing experts. HMRC told us that it had the right talent: many of its staff resist offers from firms and are motivated by the public service ethos. We were sceptical of these claims. 5. HMRC was not able to show conclusively that tax avoidance was not increasing. HMRC also could not tell us how many of the big corporations were handling their tax affairs through offshore tax havens but suggested that it could provide figures in future annual reports. HMRC told us that all it could do was to apply the law as it is and, in an international setting, multinational businesses could choose, to some extent, where to set up and where some of their profits are based. International co-operation will be required to improve global tax legislation. 6. HMRC acknowledged that it has to maintain broad confidence and credibility in its administration of the tax system to maintain the very high levels of compliance that there is in the UK. However, we felt that this was undermined by the Department's use of selective prosecutions; a practice which it could not clearly justify to the Committee. HMRC had not carried out any analysis into the effect high-profile cases of large companies avoiding tax could be having on the compliance rate of individuals and small and medium companies. Multinational companies appear to be using transfer pricing, payment of royalties for intellectual property or franchise payments to other group companies to artificially reduce their profits in the UK or to remove them to lower tax jurisdictions. We were not convinced that HMRC has the determination to robustly challenge the practices of these companies. 7. To explore these issues, the Committee held a hearing with representatives from three multinational companies (Amazon, Google and Starbucks) and we are grateful to those companies for providing evidence to us. While their circumstances and business models are different they all have a significant commercial presence in the UK and we wished to gain an understanding as to why it appears that they do not pay their fair share of corporation tax in the UK. Our intention in inviting these companies was to provide an illustration of what we perceive to be a wider problem of possible corporation tax avoidance; not to single out Amazon, Google and Starbucks as the only companies engaging in these practices. 8. Starbucks told us that it has made a loss for 14 of the 15 years it has been operating in the UK, but in 2006 it made a small profit. We found it difficult to believe that a commercial company with a 31 per cent market share by turnover, with a responsibility to its shareholders and investors to make a decent return, was trading with apparent losses for nearly every year of its operation in the UK. This was inconsistent with claims the company was making in briefings to its shareholders that the UK business was successful and it was making 15 per cent profits in the UK. Starbucks was not prepared to breakdown the 4.7 per cent payment for intellectual property (which was 6 per cent until recently) that the UK company pays to the Netherlands based company. The Committee was sceptical that the 20 per cent mark-up that the Netherlands based company pays to the Swiss based company on its coffee buying operations, with a further mark up before it sells to the UK, is reasonable . Starbucks agreed that it had a special tax arrangement with the Netherlands that made it attractive to locate business there, which the Dutch authorities asked Starbucks to hold in confidence, and that Switzerland offers a very competitive tax rate. In addition, there is an inter-company loan between the US Starbucks business and the UK Starbucks business over a period of time with the interest rate set at higher rate than any similar loan we have seen. We suspect that all these arrangements are devices to remove profits from the UK to these areas with lower tax. 9. At the hearing we were frustrated with the representative from Amazon, who we found evasive and unprepared to answer legitimate questions on the company's structure and the true location of its economic activity. Amazon has subsequently provided this information. Amazon has a reported turnover of £207 million for 2011 for its UK company (Amazon.co.uk), on which it has shown a tax expense of only £1.8 million, however it shows a European-wide turnover of €9.1 billion for its Luxembourg based company (Amazon EU Sarl) and a tax of €8.2 million. Amazon.co.uk is a service company in the UK providing services to Amazon EU Sarl for which it receives payment. That company is owned by a holding company, which is a subsidiary of Amazon's group companies. Amazon subsequently provided a copy of the unaudited accounts for Amazon Europe Holding Technologies S.C.S for 2011 showing a profit of €301.8 million and no tax payments. Amazon also provided information showing that for 2011, £3.35 billion of sales were from the UK, 25 per cent of all international sales outside the Unites States of America (USA). Yet Amazon has over 15 000 staff in the UK, invoices UK customers from the UK, hires UK staff in the UK, has inventory physically in the UK for UK customers and to all intents and purposes has the majority of its economic activity in the UK, rather than in Luxembourg, but pays virtually no corporation tax in the UK. Amazon has received an assessment from the French tax authorities which it disputes. 10. Google explained in its responses that it minimised tax within the letter of the law and that low tax areas or tax havens influenced where it located its group companies. The vast majority of Google's non-USA sales are billed in Ireland. Google makes money from business to business advertising, adverts which can be targeted to the UK website and to UK Google users. In the UK, Google Ltd recorded revenues of £396 million in 2011, from Google Ireland, but paid corporation tax of only £6 million. Google Ireland paid for the services provided by the 1300 staff in the UK. Google had approximately 700 staff who undertake marketing work in the UK as part of their activities, but only 200 of Google's Irish staff of 3000 were involved in marketing Google in the UK. 11. Google accepted that profits should be taxed in the jurisdictions where the economic activity generating those profits occurred but it asserted that its underlying economic activity arose from the innovative software technology underlying its Google search engine generated by the US company. Google also confirmed that it had an entity based in Bermuda to protect its intellectual property. We consider that the company undermined its own argument since it remits its non-USA profits (including from the UK) not to the USA but to Bermuda and therefore may be depriving the USA of legitimate tax revenue as well as the UK. Subsequently, Google told us that there were no outstanding issues with HMRC about Google UK's accounts. HMRC is currently carrying out a review of the tax returns filed by Google UK for 2005-11 inclusive and Google told us this is standard practice and that it is co-operating fully with that review. 12. All three companies accepted that profits should be taxed in the countries where the economic activity, that drives those profits, takes place and that, alongside their duty to their shareholders, they had obligations to the society, from which they derive their profits, which included paying tax. However, we were not convinced that their actions, in using the letter of tax laws both nationally and internationally to immorally minimise their tax obligations, are defensible. They all accepted that the perceived ethical behaviour of corporations could affect consumer behaviour. Being more transparent about their business practices, including paying their fair share of taxes, was becoming an increasingly important issue to their customers. The Tax Gap 13. The tax gap is the Department's measure of the difference between tax collected and the tax that would be collected if all individuals and companies complied with both the letter and the spirit of the law. The Department estimated that some 25 per cent of the tax gap is down to large businesses, although this includes other taxes as well as corporation tax discussed above. 14. HMRC's latest published estimate of the gap for 2010–11 is £32.2 billion which has reduced from £33.3 billion for 2004–05. HMRC did not agree with the Committee's view that there has been disappointing progress in closing the tax gap as the gap, while trending down only very slowly, is competitive when compared with most countries and is lower than Sweden and the United States.

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