Chapter 1

Introduction and overview of the Bill

1.1        On 14 March 2013, the Senate referred the provisions of the Tax Laws Amendment (Countering Tax Avoidance and Multinational Profit Shifting) Bill 2013 (the bill) to the Economics Legislation Committee (the committee) for inquiry and report by 14 May 2013.

1.2        Schedule 1 of the bill (general anti-avoidance rule) would amend the anti-tax avoidance provisions in the Income Tax Assessment Act 1936 (ITAA 1936), as contained in Part IVA, to ensure that it effectively counters arrangements which, while being consistent with the technical requirements of the tax law, have been carried out in a particular way for the sole or predominant purpose of avoiding tax.

1.3        Recent court decisions have, according to the government, exposed potential weaknesses in the capacity of Part IVA to properly protect the integrity of the income tax law from contrived or artificial arrangements that are designed primarily to obtain a tax advantage.

1.4        The amendments in schedule 1 of the bill are intended to address those apparent weaknesses, and ensure the general anti-avoidance rule operates as Parliament intended. The amendments do not represent a change in legislative policy.

1.5        Schedule 2 of the bill (Modernisation of transfer pricing rules) inserts new subdivisions into the Income Tax Assessment Act 1997 (ITAA 1997) and the Taxation Administration Act 1953 (TAA 1953) to, according to the Explanatory Memorandum, modernise Australia's domestic transfer pricing rules so that they are properly aligned with internationally accepted principles as established by the OECD.[1]

1.6        This chapter discusses the two schedules separately, and includes the following subsections for both schedules:

• background and policy context;
• overview of the schedule; and
• consultation.

Conduct of the inquiry

1.7        The committee advertised the inquiry on its website and in The Australian, and wrote directly to a range of individuals and organisations inviting written submissions. The committee received 17 submissions, which are listed at Appendix 1.

1.8        The committee also held a public hearing in Canberra on 30 April 2013. The names of the witnesses who appeared at the hearing are at Appendix 2. 

1.9        The committee thanks all who contributed to the inquiry.

Schedule 1: The general anti-avoidance rule

Background and policy context

1.10      According to the Explanatory Memorandum, Part IVA was enacted in 1981 to 'overcome deficiencies that judicial decisions had exposed in the operation of the previous anti-avoidance provision – section 260 of the ITAA 1936.'[2]

1.11      Part IVA is intended to counter schemes that comply with the technical requirements of the tax law but, when objectively viewed, were conducted or carried out in a particular way primarily to avoid tax.

1.12      In broad terms, Part IVA counters such schemes, as the Explanatory Memorandum puts it, 'by exposing the substance or reality of the arrangements to the ordinary operation of the income tax law.'[3]

1.13      Section 177F of Part IVA provides that the Commissioner of Taxation (the Commissioner) may cancel a tax benefit obtained by a taxpayer in connection with a scheme 'to which Part IVA applies.'

1.14      In determining whether Part IVA applies to a particular scheme, and specifically whether a person or persons gained a tax benefit from participation in the scheme and whether they participated in the scheme for the sole or dominant purpose of obtaining a tax benefit, it is implicitly necessary to make a comparison between the scheme in question and an 'alternative postulate' – that is, an arrangement with the same commercial effect but without the tax benefit. The alternative postulate, as defined in the Explanatory Memorandum, could 'merely be that the scheme did not happen or it could be that the scheme did not happen but that something else did happen.'[4]

1.15      As the then Assistant Treasurer, Senator the Hon Mark Arbib, explained in a 1 March 2012 media release, for Part IVA to operate:

...there must be a 'scheme' and a 'tax benefit' obtained in connection with the scheme, and it must be reasonable to conclude a person entered into the scheme for the 'sole or dominant purpose' of enabling a taxpayer to obtain the 'tax benefit'. 

If these conditions are satisfied, the Commissioner of Taxation may make a determination to cancel any 'tax benefit' obtained through the scheme.[5]

1.16      'Tax benefit' is defined in Section 177C of Part IVA and 'scheme' is defined in section 177A(1). Section 177D, meanwhile, is concerned with establishing the dominant purpose for which a taxpayer entered into a scheme.

1.17      According to the Explanatory Memorandum, recent decisions by the Full Court of the Federal Court concerning the way in which Part IVA determines whether or not a tax advantage has been obtained, have revealed a weakness in the capacity of Part IVA to counter arrangements that have been carried out for the sole or dominant purpose of securing a tax advantage for a taxpayer.[6]

1.18      Specifically, as Mr Arbib explained when announcing the government's intention to amend Part IVA, in some cases taxpayers have successfully argued in court 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 instead. Rather, they would have entered into another scheme that also avoided tax, done nothing or deferred their arrangements indefinitely. On this basis, these taxpayers were able to establish that the Commissioner's alternative postulate was unreasonable.[7]

1.19      One relevant example of a Court decision made on this basis, and one which was mentioned by both the government and numerous witnesses throughout this inquiry, was RCI Pty Limited v Commissioner of Taxation [2011], which concerned whether the Commissioner was correct in determining that Part IVA applied to the circumstances of a particular transaction entered into by the James Hardie Group.

1.20      In that case, the Full Federal Court rejected the Commissioner's conclusion that the transaction in question was a tax avoidance measure, and that the additional tax cost for the company would be $172 million. The Court found that a tax benefit had not been gained because, had the scheme not been entered into or carried out, the reasonable expectation is that the relevant parties would have done nothing or deferred their arrangements.[8]

1.21      The amendments in schedule 1 of the bill are intended to address this weakness by ensuring that such arguments can no longer be successfully made. According to Mr Arbib's media release, this will in turn ensure that Part IVA remains effective in countering tax avoidance.[9]

1.22      Treasury explained the amendments to the committee as broadly intended to:

...ensure that part IVA continues to be effective in counting arrangements that exhibit artificial or contrived features which are explicable solely or principally by the desire of a person or entity to produce a tax advantage. That is, it is aimed at arrangements that are dressed up to appear to be something that they are not or that are convoluted or unnatural in the way that they have been carried out. The intention is that part IVA counter arrangements of that kind by exposing the substance and reality of the arrangements to the ordinary operation of the taxation laws. Put differently, part IVA should ensure that it is the change in a taxpayer's economic or commercial position that governs the operation of the taxation laws rather than the form in which the transaction has been conducted.[10]

1.23      As Treasury noted in its submission to the House of Representatives Standing Committee on Economics' inquiry into the bill, the amendments to Part IVA are 'wholly directed at addressing problems with the tax benefit test (section 177C) and do not amend the substance of the purpose test (section 177D), which is the main means by which Part IVA distinguishes between legitimate tax planning and impermissible tax avoidance.'[11]

1.24      Treasury further told the committee that, as the Explanatory Memorandum points out, the amendments to Part IVA are expected to prevent the loss of over $1 billion a year. Under questioning, Treasury confirmed that the $1 billion is not new revenue, but revenue that would otherwise be at risk if the amendments were not made to address the exposed weaknesses in the current law.[12]

Overview of schedule 1

1.25      According to the Explanatory Memorandum, the amendments in this bill to Part IVA of the ITAA 1936 'target deficiencies in section 177C, and the way it interacts with other elements of Part IVA, particularly section 177D, as revealed by recent decisions of the Full Federal Court.'[13]

The bases for identifying tax benefits

1.26      Subsection 177C(1) contains two bases upon which to demonstrate the existence of a tax benefit: first, that absent the scheme, a relevant tax outcome 'would have been' the case; and second, that absent the scheme, a relevant tax outcome 'might reasonably be expected to have been' the case. One approach to the first limb has been to view it as satisfied when a tax benefit is exposed after an alternative postulate has done its work deleting the scheme. This is known as an 'annihilation approach.' The second limb has been applied in cases where the mere deletion of a scheme would not have left a coherent state of affairs for the tax law to apply to; in such cases, it is therefore necessary to make a prediction about facts not in existence and/or facts which are in existence not being in existence. 'In other words,' as the Explanatory Memorandum puts it, the approach based on the second limb:

...contemplates a postulate based on a reasonable reconstruction of either the scheme, or of the scheme and things that happened in connection with the scheme. This is sometimes referred to as a 'reconstruction approach.'[14]

1.27      According to the Explanatory Memorandum, while the two limbs have been viewed as distinct alternatives, recent court cases have brought this into question and instead suggested that the two limbs are in fact two ends of a spectrum of certainty within which acceptable alternative postulates must lie. The amendments in the bill are therefore intended, in part, to ensure that the two limbs are recognised beyond doubt as separate and distinct bases upon which the existence of a tax benefit can be demonstrated.[15]

1.28      The Explanatory Memorandum suggests that it is 'desirable that reconstruction be permitted in addition to, and not to the exclusion of, voiding an arrangement.'[16]

Limiting the 'annihilation' approach to the deletion of a scheme

1.29      With regard to the annihilation approach described above, proposed subsection 177CB(2) makes clear that a decision that a tax effect 'would have' occurred if the scheme had not been entered into 'must be made solely on the basis of a postulate comprising all of the events or circumstances that actually happened or existed, other than those that form part of the scheme.'[17] The Explanatory Memorandum further explains:

In other words, the speculation that is permitted about any other state of affairs that might have come about if the scheme had not been entered into or carried out is limited to the removal of the scheme.  A postulate cannot assume the existence of events or circumstances not in existence, nor can it assume the non-existence of events or circumstances that are in existence (other than those that form part of the scheme).[18]

1.30      According to the Explanatory Memorandum, recent Court decisions appear to suggest that the operation of the 'would have' limb involves a prediction about events or circumstances, as opposed to a mere deletion of the scheme. The amendments therefore make clear (as above) that the 'would have' limb operates on the basis of a postulate that comprises existing facts and circumstances minus the scheme.[19]

The reconstruction approach

1.31      The reconstruction approach (that is, the second limb of 177C(1)) to demonstrating the existence of a tax benefit has, according to the Explanatory Memorandum, been interpreted as allowing a broad-ranging inquiry into what reasonably would have been expected to have happened absent the scheme, unconstrained by the matters that must be considered under section 177D(b) in testing the purpose for which the taxpayer entered into the scheme.

1.32      As the Explanatory Memorandum puts it, under the second limb approach the 'matters that can be taken into account in the inquiry are unlimited and can include evidence from the taxpayer as to what it would have done in the absence of the scheme (provided foundation facts are given to support what would otherwise be a bald speculative statement)'.[20]

1.33      The amendments require that in determining whether an alternative postulate under the reconstruction approach is a 'reasonable alternative' to the scheme in question, it is necessary to have particular regard to the 'substance of the scheme' (that is, its commercial form and economic substance, as distinct from its legal form or shape), and to 'any result or consequence for the taxpayer that would be achieved by the scheme' (tax results aside).[21] 

1.34      The amendments further require that taxation consequences should not be taken into account in assessing the likelihood or reasonableness of an alternative postulate.[22] One consequence of the interpretation of Part IVA as it currently stands is that it is currently permissible for an alternative postulate based on the second limb to be rejected on the basis that the tax costs involved in undertaking the alternative action would have caused the taxpayer to do nothing or deferred their arrangements indefinitely.[23]

1.35      The Explanatory Memorandum states that it is 'not conducive to the effective operation of Part IVA for the inquiry to take into account the potential tax consequences of an alternative postulate in determining whether it is a reasonable alternative to the scheme.' To allow the tax consequences of an alternative to be taken into account would, it is argued, 'allow the normal tax consequences of what it is that the taxpayer has achieved to function as a shield against the operation of Part IVA.'[24]

1.36      According to the Explanatory Memorandum, the amendments make it clear that, in determining whether a postulate is a reasonable alternative to the entering into or carrying out of the scheme, regard should not be had to any tax costs that are generated for the taxpayer by the scheme itself or that would be generated for the taxpayer or any other person by the postulate.[25]

1.37      The amendments will thereby remove the possibility of an alternative postulate being rejected on the grounds that the tax costs involved in the postulate would have caused the parties to either abandon or indefinitely defer the scheme or schemes of which they were a part. [26]

Deciding when Part IVA applies

1.38      Under the current law, the first test to be satisfied in deciding if Part IVA applies is whether a taxpayer gained a tax benefit as a result of a scheme. Only if the answer to this question is 'yes' does the consideration turn to whether the taxpayer participated in the scheme for the sole or dominant purpose of obtaining that tax benefit.

1.39      The Explanatory Memorandum suggests this approach is undesirable, and that the objects of Part IVA would be better served if the analysis instead starts with an inquiry into whether a person participated in a scheme for the sole or dominant purpose of enabling the taxpayer to obtain a tax benefit.[27] The amendments are intended, in part, to achieve this. 

Summary of amendments

1.40      The Explanatory Memorandum summarises the intended effects of the amendments as follows:

...to put it beyond doubt that the 'would have' and 'might reasonably be expected to have' limbs of each of the subsection 177C(1) paragraphs represent alternative bases upon which the existence of a tax benefit can be demonstrated;

to ensure that, when obtaining a tax benefit depends on the 'would have' limb of one of the paragraphs in subsection 177C(1), that conclusion must be based solely on a postulate that comprises all of the events or circumstances that actually happened or existed other than those forming part of the scheme;

to ensure that, when obtaining a tax benefit depends on the 'might reasonably be expected to have' limb of one of the paragraphs in subsection 177C(1), that conclusion must be based on a postulate that is a reasonable alternative to the scheme, having particular regard to the substance of the scheme and its effect for the taxpayer, but disregarding any potential tax costs; and

to require the application of Part IVA to start with a consideration of whether a person participated in the scheme for the sole or dominant purpose of securing for the taxpayer a particular tax benefit in connection with the scheme; and so emphasising the dominant purpose test in section 177D as the 'fulcrum' or 'pivot' around which Part IVA operates.[28]

1.41      The Explanatory Memorandum includes a direct comparison of the key features of the new law and the current law, which is reproduced below in Table 1.1.

 Table 1.1: Comparison of key features of new law and current law[29]

New law	Current law
It is clear that the 'would have' and 'might reasonably be expected to have' limbs of each of the subsection 177C(1) paragraphs represent alternative bases upon which the existence of a tax benefit can be demonstrated.	It is unclear whether the 'would have' and 'might reasonably be expected to have' limbs of each of the subsection 177C(1) paragraphs represent separate and distinct bases upon which the existence of a tax benefit can be demonstrated.
It is clear that the 'would have' limbs of each of the subsection 177C(1) paragraphs operate on the basis of a postulate that comprises existing facts and circumstances minus the scheme.	The operation of the 'would have' limbs of each paragraph of subsection 177C(1) is uncertain.  Recent Federal Court cases appear to have proceeded on the basis that the 'would have' limb involves a prediction about events or circumstances, as opposed to a mere deletion of the scheme.
It is clear that the 'might reasonably be expected to have' limbs of each of the subsection 177C(1) paragraphs operate on the basis of postulates that are reasonable alternatives to the scheme, having particular regard to the substance of the scheme and the non-tax results and consequences achieved by the taxpayer from the scheme, but disregarding potential tax costs.	The operation of the 'might reasonably be expected to have' limbs of each of the subsection 177C(1) paragraphs depends on an inquiry about what other courses of action were reasonably open to the participants in the scheme.
The question whether Part IVA applies to a scheme starts with a consideration of whether any person participated in the scheme for the sole or dominant purpose of securing for the taxpayer a tax benefit in connection with the scheme.  This ensures that the examination of the tax benefit happens in the context of examining a participant's purpose.	The question whether Part IVA applies to a scheme starts with a consideration of whether a taxpayer has secured a particular tax benefit in connection with the scheme.

Consultation

1.42      Following the government's announcement on 1 March 2012 that it would introduce amendments to Part IVA, it appointed a roundtable of academic and practitioner experts 'to advise how best to implement the proposed clarifications to the law without inappropriately affecting genuine commercial and business activity.' Meetings of the roundtable, either in Canberra or by teleconference, were held in May, September, October and December 2012.[30]

1.43      Public consultation on the draft legislation was conducted between 16 November 2012 and 19 December 2012. 23 submissions were received.[31]

Schedule 2: Modernisation of the transfer pricing rules

Background and policy context

What is transfer pricing?

1.44      Transfer prices are, in the OECD's words, 'the prices at which an enterprise transfers physical goods and intangible property or provides services to associated enterprises.' For taxation purposes, it is necessary to establish what an appropriate transfer price should be, as these prices 'determine in large part the income and expenses, and therefore the taxable profits, of associated enterprises in different tax jurisdictions.'[32]

1.45      An entity is considered to have gained a 'transfer pricing benefit' when it has reduced the amount of tax it is liable for as a result of special conditions in its dealings with other entities which would not have existed had those dealings been conducted at arm's length – that is, if the dealings had been conducted in comparable circumstances between independent entities dealing wholly independently with one another.[33]

What is the object of Australian transfer pricing rules?

1.46      As the Explanatory Memorandum explains, the object of Australia's transfer pricing rules, which is not changed by the bill, is to 'ensure that an appropriate return for the contribution made by an entity's Australian operations is taxable in Australia for the benefit of the community.'[34] In other words, Australian transfer pricing rules (both current and new) are intended, at least in part, to prevent taxpayers from using a transfer pricing benefit to reduce their Australian tax liability.

OECD Guidelines on transfer pricing 

1.47      Australia's approach to determining whether a taxpayer has gained a transfer pricing benefit has always been based on the standard established by the OECD.[35]

1.48      The OECD issued its first iteration of its guidelines on transfer pricing in the 1979 report, Transfer Pricing and Multinational Enterprises. These guidelines were updated and released in 1995 as the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the OECD Guidelines), which were again updated in 2010. (All references below are to the 2010 iteration of the guidelines.)

1.49      The OECD Guidelines are based on the separate entity approach to intra-group transactions, wherein individual group members of multinational enterprises (MNEs) are 'taxed on the basis that they act at arm's length in their transactions with each other.'[36]

1.50      As the OECD Guidelines explain, while the integrity of the tax law requires that individual group members of a multinational group are taxed on the basis that they are separate entities, the:

...relationship among members of an MNE group may permit the group members to establish special conditions in the intra-group relations that differ from those that would have been established had the group members been acting as independent enterprises operating in open markets.[37]

1.51      The arm's length principle is thus intended to ensure the correct application of the separate entity approach, as when applied it eliminates, for taxation purposes, the effect of special conditions on an entity's levels of profit.[38]

1.52      The arm's length principle is set out in Article 9 of the OECD Model Tax Convention as follows:

[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.[39]

1.53      The application of the arm's length principle to allow a meaningful separate entity approach in taxing intra-group transactions of MNEs is intended, as the OECD Guidelines explain, to serve the:

...dual objectives of securing the appropriate tax base in each jurisdiction and avoiding double taxation, thereby minimising conflict between tax administrations and promoting international trade and investment.[40] 

1.54      As the Treasury noted in a 2011 consultation paper on transfer pricing in Australia, the 2010 revisions to the OECD Guidelines reflected emerging transfer pricing issues in global trade and investment:

The 2010 Guidelines included new guidance on selecting the most appropriate transfer pricing method, conducting a comparability analysis and applying the transaction profit methods (that is, the transactional net margin method and profit split method). The 2010 Guidelines replace the earlier hierarchy that gave preference to transactional methods over profit methods with a new 'most appropriate method' standard.[41]

Why do Australian transfer pricing rules need to be updated?

1.55      The 2010 revisions to the guidelines are the basis for the proposed changes in schedule 2.[42] 

1.56      Specifically, schedule 2 makes amendments to current Australian transfer pricing rules that, in contrast to treaty rules and the transfer pricing approach of many of Australia's trading partners, focuses on pricing individual transactions.  As Treasury noted in its 2011 consultation paper on the issue, the transaction focus of Australian rules (outside of Australia's tax treaties) may result in a judicial reluctance to accept profit-based, as opposed to transaction-based, transfer pricing methods. This is despite the fact that:

...from a policy perspective the objective of the rules is to ensure the overall profits of the parties reflect an arm's length outcome given their respective economic contributions. While transaction methods are very important and in many cases may prove to be the most appropriate method for determining the arm's length outcome, in practice, profit methods are frequently relied upon by taxpayers and administrators alike.[43]

1.57      The arm's length principle already guides Australia's approach to transfer pricing; the bill does not change this. What the new rules in the bill do change, in effect, is how the arm's length principle is applied, by requiring taxpayers that have gained a transfer pricing benefit to identify 'the conditions that might be expected to operate in comparable circumstances between independent entities dealing wholly independently with one another.'[44] That is, this approach requires a determination of the arm's length conditions that would have existed if entities were independent, as distinct from the narrower focus under existing rules on determining simply the arm's length consideration for the supply or acquisition of property and/or services under an international agreement.[45]

1.58      The Explanatory Memorandum explains how increasingly complex cross-border intra-party trade has created a growing need for an approach to transfer pricing that compares arm's length conditions against actual conditions, rather than simply comparing the arm's length and actual consideration provided:

Cross-border intra-firm trade in services and intangible assets has increased dramatically for Australian entities over recent years. Determining the arm's length conditions in these situations is likely to go beyond looking at the consideration provided in relation to a single condition (such as the price of trading stock) or a discrete element of the overall arrangement.[46]

1.59      In addition to aligning the application of the arm's length principle in Australian transfer pricing rules with the international standard, the changes in schedule 2 are intended to remove uncertainty regarding the role of the OECD Guidelines in applying Australia's transfer pricing rules. As Treasury's 2011 consultation paper on transfer pricing explained, while the OECD Guidelines have long formed the basis of administrative guidance on transfer pricing, at a formal level:

...direct resort to the Guidelines has not been endorsed by the courts in Australia, but evidence based on the approach taken in the Guidelines has been accepted. It appears that the OECD Guidelines could be available if it was demonstrated that parties to a relevant treaty would apply the Guidelines in similar circumstances. In practice the OECD Guidelines are extensively used by treaty partner administrations, the ATO and practitioners. Importantly the Guidelines changed in 2010 to give profit based methods equal priority to traditional methods. There is a strong case for reducing uncertainty by mandating the use of the OECD Guidelines in tax legislation. A clearer legal pathway for use of the Guidelines might also reduce the need for legal argument on this point in litigation.[47]

Overview of schedule 2

1.60      Australia's current transfer pricing rules are set out in Division 13 of the ITAA 1936 (Division 13) and in subdivision 815-A of the ITAA 1997, as well as in Australia's bilateral tax treaties. Division 13 focuses on determining the arm's length consideration for the supply or acquisition of property and/or services under an international agreement. Section 815-A, enacted by the Tax Laws Amendment (Cross-Border Transfer Pricing) Act (No. 1) 2012, applies to ensure that Australia's tax treaty transfer pricing rules operate as intended.[48]

1.61      Schedule 2 of the bill repeals Division 13 of the ITAA 1936 and inserts subdivisions 815-B, 815-C and 815-D into the ITAA 1997 and subdivision 284-E into the TAA 1953. Subdivision 815-A of the ITAA 1997 will cease to have effect when subdivisions 815-B and 815-C are enacted. The introduction of subdivisions 815-B, 815-C and 815-D into the ITAA 1997, and the repeal of Division 13 of the ITAA 1936, effectively relocates Australia's transfer pricing rules into the ITAA 1997.

1.62      Subdivisions 815-B, 815-C and 815-D, according to the Explanatory Memorandum, modernise Australia's transfer pricing rules, and better align those rules with the internationally consistent transfer pricing approaches set out in the OECD Guidelines.[49]

1.63      The amendments apply to both tax treaty and non-tax treaty cases. According to the Explanatory Memorandum, this will ensure 'greater alignment between outcomes for international arrangements involving Australia and another jurisdiction irrespective of whether the other jurisdiction forms part of Australia's treaty network.'[50]

1.64      Unlike the current transfer pricing rules in Division 13 and subdivision 815-A, which both rely on the Commissioner making a determination, subdivisions 815-B and 815-C are self-executing in their operation. According to the Explanatory Memorandum, this better aligns Australia's domestic transfer pricing rules with the design of Australia's overall tax system, which generally operates on a self-assessment basis.[51]

1.65      Subdivision 284-E of schedule 1 to the TAA 1953 contains rules related to transfer pricing documentation.

1.66      Schedule 2 also makes additional consequential amendments to the ITAA 1997, ITAA 1936, the Income Tax (Transitional Provisions) Act 1997, and the TAA 1953.

Subdivision 815-B: Arm's length rule for entities

1.67      Subdivision 815-B applies transfer pricing rules to dealings between separate legal entities. It does so by requiring that entities that would otherwise get a tax advantage in Australia from non-arm's length conditions, calculate their Australian tax position as though arm's length conditions had instead operated.[52]

1.68      In order for there to be a transfer pricing benefit, there needs to be a difference between the actual conditions and the arm's length conditions, and that difference must be demonstrated to have resulted in a tax advantage in Australia for an entity.[53]

1.69      To determine what if any transfer pricing benefit has been gained, a comparison is therefore required between the actual conditions between entities and the arm's length conditions.

1.70      The Explanatory Memorandum defines 'actual  conditions' as follows:

Conditions that operate in connection with the commercial or financial relations of two entities are the things that ultimately affect each of the entities' economic or financial positions. Conditions need not be explicit contractual terms, but can include the price paid for the sale or purchase of goods or services, terms of an agreement that have an economic impact (such as the allocation of an expense), the margin of profits earned by one or both the entities, or a division of profits between the entities.[54]

1.71      As noted previously, 'arm's length conditions' refers to 'those conditions that might be expected to operate between entities dealing wholly independently with one another in comparable circumstances.'[55]

1.72      Section 815-130 sets out that the identification of the arm's length conditions must, as the Explanatory Memorandum put it, 'be based on the form and substance of the commercial or financial relations in connection with which the actual conditions operate.' This is known as the 'basic rule.'[56] However, section 815-130 also provides for 'exceptions' to the basic rule (under that heading), and allows for the ability to disregard or substitute (that is, 'reconstruct') dealings in certain instances, for example where:

• the economic substance of the arrangements does not match the legal form; and
• the arrangements, viewed in their totality, differ from those which would have been entered into by independent enterprises acting in a commercially rational manner.

1.73      Determining arm's length conditions, as the Explanatory Memorandum explains:

...involves an analysis of the functions performed, the assets used or contributed, and the risks assumed or managed by entities. From this analysis, the most appropriate and reliable transfer pricing method, or combination of methods, must be selected.'[57]

1.74      The identification of arm's length conditions under subdivision 815-B must be done using a method that best achieves consistency with prescribed guidance material. The OECD Guidelines are included as prescribed guidance material under subdivision 815-B, thereby ensuring that consistency with international standards is achieved.[58] To provide for future flexibility, regulation making powers are also included to allow for modifications to the guidance material.[59]

1.75       The OECD Guidelines contain a range of methods for determining the arm's length conditions. These methods, described in greater detail in paragraphs 3.112 to 3.119 of the Explanatory Memorandum, are the:

(a) comparable uncontrolled price method;

(b) cost plus method;

(c) resale price method;

(d) transaction net margin method; and

(e) profit split method.[60]

1.76      OECD Guidelines also allow that other methods may be used, where those methods provide a more appropriate and reliable assessment of conditions. Again, the method or methods that produce the most appropriate and reliable assessment of arm's length conditions must be selected.[61]

1.77      The Explanatory Memorandum explains that in determining which method will produce the most appropriate and reliable assessment of arm's length conditions, it is necessary to have regard to the degree of comparability between actual circumstance and any circumstances being compared. If differences exist, and reliable comparability adjustments cannot be made, 'this may indicate that another method should be used, which relies on different points of comparison.'[62]

1.78       As the Explanatory Memorandum notes, some aspects of the OECD Guidelines assume that any transfer pricing adjustments would be made by a tax administration, rather than by a taxpayer. However, as noted above, because Australian tax law generally operates on a self-assessment basis, subdivision 815-B also operates on a self-assessment basis. To allow for this difference, the Explanatory Memorandum states that, for the purposes of applying subdivision 815-B:

...where appropriate the references in the OECD Guidelines to tax administrations making adjustments, taking actions, or being prevented from taking actions should be read as references to whoever is applying the rules (which may be the taxpayer or the Commissioner).[63]

1.79      Subsection 815-B is not intended to apply to purely domestic arrangements. As such, an entity can only be considered to have gained a transfer pricing benefit where its dealings with another entity satisfy a cross-border test. Details on this cross-border test are provided in the Explanatory Memorandum (paragraphs 3.59 to 3.70).[64]

1.80      Subdivision 815-B does not limit the application of Division 820 (which relates to thin capitalisation) in reducing an entity's debt deduction.[65] As the Assistant Treasurer, the Hon David Bradbury MP, indicated in his second reading speech, the new rules have been drafted to 'maintain the existing interaction between the transfer pricing and thin capitalisation rules that were developed in close consultation with industry during amendments to the transfer pricing rules last year.'[66]

1.81      Subdivision 815-B introduces a time limit of 7 years in which the Commissioner can make or amend an assessment in relation to a transfer pricing adjustment.[67]

Subdivision 815-C: Arm's length rule for permanent establishments

1.82      Subdivision 815-C amends Australia's transfer pricing rules in respect of the attribution of profits between a permanent establishment (PE) and the entity of which it is a part. Just as the object of subdivision 815-B is to ensure that the arm's length principle is properly applied to the cross-border dealings of separate legal entities, the object of subdivision 815-C is to 'ensure that the amount brought to tax in Australia by entities operating at or through permanent establishments is not less that it would be if the permanent establishment were a distinct and separate entity engaged in the same or comparable activities under the same or comparable circumstances, but dealing wholly independently with the entity of which it is a part.'[68]

1.83      In terms similar to subdivision 815-B, subdivision 815-C defines a tax benefit as arising when the profit calculated under arm's length conditions differs from the actual profit.[69]

1.84      While subdivision 815-B requires that separate legal entities determine arm's length conditions consistent with the OECD Guidelines, guidance material for subdivision 815-C (section 815-235) includes both the OECD Guidelines and the OECD Model Tax Convention on Income and on Capital. Like subdivision 815-B, subdivision 815-C also includes a regulation making power to allow for modifications to the prescribed guidance material.

1.85      The Explanatory Memorandum states that consistent with Australia's current treaty practice, 'the relevant business activity approach (also known as the single entity approach) must be followed in applying subdivision 815-C.'[70]

1.86      The Explanatory Memorandum notes that in recent years the OECD has revised its approach to the attribution of business profits of PEs, so that it now reflects a 'functionally separate entity' approach. As the Government is yet to determine whether it will change its tax treaty practice to adopt the functionally separate entity approach, subdivision 815-C reflects the approach to the attribution of profits to PEs that is currently incorporated into Australia's tax treaties (that is, the relevant business activity approach).[71]

1.87      Like subdivision 815-B, subdivision 815-C introduces a time limit of 7 years in which the Commissioner can make or amend an assessment in relation to a transfer pricing adjustment.[72]

Subdivision 815-D: Special rules for trusts and partnerships

1.88      The Explanatory Memorandum explains that because trusts and partnerships do not have taxable income and partnerships do not have tax losses, subdivision 815-D includes special rules to ensure that trusts and partnerships are assessed in the same way as legally separate entities (subdivision 815-B) and PEs (subdivision 815-C). These rules address the differences in terminology, but do not otherwise change the substance of subdivisions 815-B and 815-C.[73]

Amendments to the TAA 1953: Record keeping and penalties

1.89      The introduction of subdivision 284-E of schedule 1 to the TAA 1953 sets out the type of documentation an entity may prepare and keep in self-assessing its tax position under new subdivisions 815-B and 815-C of the ITAA 1997.

1.90      In order to satisfy the requirements of subdivision 284-E, transfer pricing documentation must be prepared before the lodgement of the relevant tax return.[74]

1.91      As the Explanatory Memorandum explains, subdivision 284-E does not mandate the preparation or keeping of transfer pricing documentation, but:

... failing to do so prevents an entity from establishing a reasonably arguable position. Establishing a reasonably arguable position is one avenue through which an entity can lower administrative penalties. However, nothing in these amendments prevents the Commissioner from exercising a general discretion to remit administrative penalties where appropriate (as currently available under the law).[75]

1.92      Other amendments to TAA 1953 ensure that administrative penalties can apply to tax liabilities that arise from the Commissioner adjusting a taxpayer's position under subdivision 815-B or 815-C. No administrative penalties will apply, however, if the additional tax liability is under the de minimis threshold.[76]

1.93      The Explanatory Memorandum includes a direct comparison of the key features of the new law and the current law, which is reproduced below in Table 1.2.

Table 1.2: Comparison of key features of new law and current law[77]

New law	Current law
Transfer pricing adjustments
A transfer pricing adjustment may be made under Subdivision 815‑B, Subdivision 815‑C, or the relevant transfer pricing provisions of a tax treaty.  Subdivision 815-B applies to certain conditions between entities and Subdivision 815-C applies to the allocation of actual income and expenses of an entity between the entity and its permanent establishment.  To the extent they have the same coverage as the equivalent tax treaty rules, an adjustment under Subdivision 815-B or Subdivision 815-C gives the same result as the transfer pricing provisions of a tax treaty.	A transfer pricing adjustment may be made under Division 13, the transfer pricing provisions of a tax treaty, or Subdivision 815-A.  Subdivision 815-A, for practical purposes, generally gives the same result as the application of the transfer pricing provisions of a tax treaty by adopting the terms and text of the relevant parts of the transfer pricing articles contained in Australia's tax treaties.
Assessment of transfer pricing adjustments
Subdivisions 815‑B and 815‑C apply on a self-assessment basis.	The Commissioner must make a determination under Division 13 or Subdivision 815-A in order to give effect to a transfer pricing adjustment.
New law	Current law
Application of the rules to conditions between entities
Subdivision 815-B applies to conditions that satisfy the cross‑border test, irrespective of whether entities are associated or not and/or operating in treaty or non‑treaty countries. The transfer pricing provisions of a tax treaty may apply in the event of an inconsistency with Subdivision 815‑B.	Division 13 applies to international agreements between both associated and unassociated entities irrespective of tax treaty coverage (although the transfer pricing provisions of a tax treaty may apply in the event of an inconsistency). Subdivision 815-A and the tax treaty transfer pricing provisions apply in treaty cases and in respect of associated entities only.
Allocation of profits between entities and their permanent establishments
Subdivision 815-C applies to the allocation of actual income and expenses of an entity between the entity and its permanent establishment.  Subdivision 815‑C applies to a foreign permanent establishment of an Australian resident and to an Australian permanent establishment of a foreign resident entity, irrespective of whether a tax treaty applies.  The transfer pricing provisions of a tax treaty may apply in the event of an inconsistency with Subdivision 815‑C.	Subdivision 815-A and the relevant tax treaty transfer pricing provisions allocate profits (the income and expenses) to the Australian permanent establishment of a foreign resident entity in treaty cases only. The transfer pricing provisions of a tax treaty may apply in the event of an inconsistency with Subdivision 815‑A.
Arm's length principle
Subdivisions 815‑B and 815‑C and the tax treaty transfer pricing provisions apply the internationally accepted arm's length principle which is to be determined consistently with the relevant OECD Guidance material.	Division 13 operates to ensure that for all purposes of the Act, an arm's length amount of consideration is deemed to be paid or received for a supply or acquisition of property or services under an international agreement. Subdivision 815-A and the tax treaty transfer pricing provisions apply the internationally accepted arm's length principle which is to be determined consistently with the relevant OECD Guidance material.
New law	Current law
Record keeping
Subdivision 284-E of Schedule 1 to the TAA 1953 sets out optional record keeping requirements for entities to which Subdivision 815-B or 815-C applies.  Records that meet the requirements are necessary, but not sufficient to establish a reasonably arguable position for the purposes of Schedule 1 to the TAA 1953. If the documentation as specified in the Subdivision is not kept in respect of a matter, an entity is not able to demonstrate that it has a reasonably arguable position in relation to that matter for the purposes of Schedule 1 to the TAA 1953	The general record-keeping provisions of the tax law apply to the transfer pricing provisions.
Administrative penalties
Administrative penalties may apply if an assessment is amended by the Commissioner for an income year to give effect to Subdivisions 815‑B or 815‑C and the provisions of section 284-145 of Schedule 1 to the TAA 1953 have been met.	Administrative penalties may apply where a transfer pricing adjustment has been made by the Commissioner under Division 13 or Subdivision 815-A and the provisions of section 284-145 of Schedule 1 to the TAA 1953 have been met.  This is subject to the operation of a transitional rule where the Commissioner makes a determination under Subdivision 815‑A in respect of income years prior to the first income year starting on or after 1 July 2012.
Amendment period
An amendment to give effect to Subdivision 815‑B or Subdivision 815‑C can be made within seven years after the day on which the Commissioner gives notice of the assessment to the entity. Some tax treaties impose specific time limits in relation to transfer pricing adjustments under the tax treaty.	Subject to subsection 170(9C), subsection 170(9B) of the ITAA 1936 provides an unlimited period in which the Commissioner may amend an assessment to give effect to a transfer pricing adjustment under Division 13, the tax treaty transfer pricing provisions, or Subdivision 815-A. Some tax treaties impose specific time limits in relation to transfer pricing adjustments under the tax treaty.

Consultation in relation to schedule 2: Transfer pricing

1.94      On 1 November 2011, the then Assistant Treasurer, the Hon Bill Shorten MP, announced that the Government would 'reform the transfer pricing rules in the income tax law and Australia's future tax treaties to bring them into line with international best practice, improving the integrity and efficiency of the tax system.'[78]

1.95      At the same time, Mr Shorten released the abovementioned 2011 consultation paper, Income tax: cross border profit allocation – Review of transfer pricing rules, which highlighted a range of issues, the central one being the extent to which Australia's transfer pricing rules should align with international standards. The Consultation Paper canvassed a number of options and invited comments from interested parties.[79] Treasury received 28 submissions in response.[80]

1.96      An exposure draft on the proposed amendments was released on 22 November 2012, and submissions were again invited. Treasury received 24 submissions by the 20 December 2012 closing date, and conducted a consultation with peak body, industry and corporate representatives on 7 December 2012.[81]

1.97      Treasury has indicated that substantive changes were made to the Bill in response to these consultations, and the explanatory material was updated to provide clarification on a range of issues raised in submissions received.[82]

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