Chapter 2

Overview of the bill

2.1        The bill proposes to amend the Income Tax Assessment Act 1997 to insert a new Subdivision 815-A on 'Treaty-equivalent cross-border transfer pricing rules'. It also makes a number of consequential amendments to the Income Tax Assessment Act 1936. The bill addresses four key issues:

• the relationship between tax treaties and Division 13 of the Income Tax Assessment Act 1936;
• the application of OECD guidance on transfer prices in Australian law;
• thin capitalisation; and
• administrative penalties.

2.2        It is proposed that Subdivision 815-A will take effect retrospectively from 1 July 2004. The rationale for this approach is discussed below.

Tax treaties and Division 13 of the Income Tax Assessment Act 1936

2.3        Item 6 of Schedule 1 to the bill inserts proposed Subdivision 815-A intended to address debate on whether a transfer pricing adjustment may be made under either:

• Division 13 of the Income Tax Assessment Act 1936 ; or
• the transfer pricing provisions of a tax treaty, which are interpreted through the framework of OECD guidance on the arm's length principle.[1]

2.4        The Explanatory Memorandum (EM) outlined that the proposed subdivision will ensure that the transfer pricing measures in Australia's tax treaties can be applied independently of Division 13:

In addition to the current law, a transfer pricing adjustment may be made under Subdivision 815-A (which, for practical purposes will give the same result as the application of the transfer pricing provisions of a tax treaty).

The new law addresses the debate under the current law around the application of the treaty transfer pricing articles — it ensures that the transfer pricing articles contained in Australia’s tax treaties are able to be applied and operate to provide independent assessment authority through the rules contained in Subdivision 815-A.[2]

2.5        The EM provides further detail on how proposed Subdivision 815-A will interact with Australia's tax treaties:

A number of provisions in Subdivision 815-A refer to international tax agreements, as well as parts of those agreements, as given effect by the ITAA 1953. These references are important in determining when Subdivision 815-A will apply and ensure that the question of whether an entity gets a 'transfer pricing benefit', and the amount of any such benefit, is consistent with Australia's international tax agreements. Despite drawing upon aspects of the terms and text of Australia’s international tax agreements in this manner, the liability to tax that may be imposed under Subdivision 815-A arises under the domestic law rather than the operation of the relevant tax treaty itself.

Subsection 4(2) of the ITAA 1953 will continue to apply in the (unforeseeable) event of an inconsistency between Australia's international tax agreements and Subdivision 815-A.[3] This Subdivision only allows for upwards adjustments to a taxpayer’s Australian tax position. However, nothing in this Subdivision prevents Australia's international tax agreements from applying in circumstances where the outcome under an agreement could result in a lesser adjustment relative to a taxpayer's position under the domestic law provisions.

Subdivision 815-A will only apply where profits have not accrued to an entity because of non-arm's length conditions and the entity’s Australian tax position is negatively affected from the perspective of the revenue as a result.[4]

2.6        The bill states that an entity may receive a transfer pricing benefit under proposed Subdivision 815-A by satisfying either the:

• requirements in the associated enterprises article of the relevant tax treaty—proposed subsection 815-15(1); or
• the business profits article of the relevant tax treaty—proposed subsection 815-15(2).

2.7        Proposed paragraphs 815-15(1)(d) and 815-15(2)(c) outline that the amount of the transfer pricing benefit is the difference between:

• the amount of the taxable income of the entity for an income year being greater than its actual amount;
• the amount of a tax loss of the entity for an income year of the entity being less than its actual amount; or
• the amount of the net capital loss of the entity for an income year being less than its actual amount.

OECD guidance

2.8        Federal Commissioner of Taxation v SNF (Australia) Pty Ltd  (SNF case) (as discussed in chapter 1) found that 'the Guidelines are not a legitimate aid to the construction of either Division 13 or the treaty transfer pricing articles'.[5] Under proposed section 815-20 on 'Cross-border transfer pricing guidance', the determination of a transfer pricing benefit is based on the application of the arm's length principle 'which is to be determined consistently with the relevant OECD guidance (or other prescribed documents)' these include:

• the Model Tax Convention on Income and on Capital and its Commentaries as last amended on 22 July 2010 by the OECD Council;
• the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations as last amended on 22 July 2010 by the OECD Council; and
• any other documents prescribed by regulations.[6]

2.9        The EM outlined the rationale for using this guidance material  to determine when an entity gets a transfer pricing benefit, and the amount of the benefit:

The use of OECD material in relation to parts of Subdivision 815-A is potentially available under the ordinary rules of treaty interpretation. To provide a more direct legal pathway for accessing certain guidance material, two new rules will supplement the general rules of treaty interpretation: one rule applies to income years starting on or after 1 July 2012, and a transitional rule applies for prior income years from 1 July 2004.

Australia’s international tax agreements are negotiated on the basis of the OECD Model and associated guidance material. The OECD is the primary international tax forum for Australia. The OECD material — the Model, its Commentaries and the Guidelines — are initially developed by working parties of the Committee on Fiscal Affairs, vetted by that Committee, and finally approved or adopted at OECD Council level. Australia is represented at each of these stages and the OECD consults extensively with the international business community as part of this process.

Most of Australia’s trading and investment partners look to OECD material to ensure consistent application of transfer pricing rules. This consistency improves certainty of application of these rules for enterprises operating across borders. Further, if different standards were used, there would be a greater risk that jurisdictions might each tax the same amount under their transfer pricing rules (resulting in double taxation), or not tax an amount at all (leading to double non-taxation).[7]

Thin capitalisation

2.10      When the capital of a company is made up of a much larger contribution of debt than equity it is said to be thinly capitalised. This form of leveraging may be utilised where the distribution of interest on debts may be deducted as interest and this could be compared favourably to the distribution of stock that has non-deductible dividends.[8]

2.11      Currently within Australia's regulatory framework, there is no specific legislative provision that addresses the relationship between transfer pricing and thin capitalisation rules. The EM noted, however, that Taxation Ruling TR 2010/7, finalised in October 2010, addressed this issue and gave the same outcome as the proposed law will provide.

2.12      The ruling outlined the Australian Taxation Office's (ATO's) views on how the thin capitalisation provisions in Division 820 of the Income Tax Assessment Act 1997 interact with the transfer pricing provisions as set out in Division 13 and Australia's tax treaties:

It is clear from the wording of paragraph 820-40(1)(b) that the operation of Division 820 is limited to costs incurred by an entity in relation to a 'debt interest' issued by the entity, that it can otherwise deduct from its assessable income. Accordingly, all provisions relevant to deductibility, including the transfer pricing provisions, must be applied before Division 820 comes into operation.

Therefore, the transfer pricing provisions apply firstly to require an arm's length consideration for debt funding that is provided on a non-arm's length basis, with the thin capitalisation provisions then operating on the amount of debt deductions determined based on that consideration.

The purpose of Division 820 is to set an upper limit, in the case of a non-Authorised Deposit-taking Institution (ADI), on the amount of debt in respect of which an entity can claim tax deductions. Where an entity's level of debt (that is, the 'adjusted average debt') exceeds its statutory upper limit (the 'maximum allowable debt'), Division 820 achieves this outcome by denying a proportion of the otherwise allowable debt deductions of the entity...

Division 820 addresses only the amount of debt an entity can have for purposes of deductibility of its debt deductions, while the transfer pricing provisions alone deal with the pricing of the consideration given for this debt.[9]

2.13      Schedule 1, item 6, (proposed subsection 815-25(1)) and item 7 (note to section 820-30) to the bill propose amendments to clarify how Subdivision 815-A will interact with Division 820 of the Income Tax Assessment Act 1997:[10]

Where Division 820 (about thin capitalisation) applies to a taxpayer and the transfer pricing benefit relates to profits (or a shortfall of profits) that is referable to costs that are debt deductions, the calculation of the amount of the taxpayer’s transfer pricing benefit is modified to ensure that Subdivision 815-A applies to establish an arm’s length rate in relation to a debt interest before Division 820 applies.[11]

Administrative penalties

2.14      Currently an administrative penalty may apply to a tax payer where a transfer pricing adjustment has been made by the Commissioner. These penalty provisions are set out in Subdivision 284-C of Schedule 1 of the Taxation Administration Act 1953. The guide to subdivision 284-C states:

You are liable to an administrative penalty if you attempt to reduce your tax-related liabilities or increase your credits through a scheme. This Subdivision sets out when the penalties apply and how the amounts of the penalties are calculated.[12]

2.15      Items 13 and 14 of schedule 1 of the bill make amendments to the Taxation Administration Act 1953 so that penalty provisions apply to a scheme benefit calculated under proposed subdivision 815-A of the bill for a particular income year starting on or after 1 July 2012.[13]

2.16      Under the bill, it is proposed that penalties that relate to proposed Subdivision 815-A, will not apply retrospectively. That is, even though Subdivision 815-A will apply to income years starting 1 July 2004, the penalties under the proposed subdivision will only apply in respect of income years beginning on or after 1 July 2012:

Generally, additional penalties (such as administrative penalties) will be inappropriate in cases where amendments have application to prior years. In this case the application of that general principle is less clear as there is an argument that the law already applies in a way consistent with these amendments.

To the extent these amendments have retrospective application penalties will be calculated as though Subdivision 815-A had not applied. That is, penalties in relation to income years commencing prior to 1 July 2012 will be limited to amounts that can be substantiated under the provisions existing immediately prior to the enactment of Subdivision 815-A.[14]

2.17      As aptly expressed by the Assistant Treasurer, '[a] transitional rule is included in these amendments to ensure the penalty provisions of the income tax law apply as though this bill was never enacted.[15]

Retrospective application

2.18      Item 12 of Schedule 1 of the bill inserts proposed section 815-1 into the Income Tax (Transitional Provisions) Act 1997 which states that proposed Subdivision 815-A of the bill applies to income years starting on or after 1 July 2004.

Financial impact and parliament's intention

2.19      The Assistant Treasurer explained that 2004 'is the first income year following the parliament's last statement [on the matter], demonstrating the longstanding legislative intent that the law operated in this way'.[16]

2.20      The EM outlined that the 'introduction of retrospective legislation is not done lightly... only where there is a significant risk to revenue that is inconsistent with the Parliament's intention'. The EM states that the 'measure has no revenue impact as it is a revenue protection measure'.[17]

2.21      The EM sets out in some detail 'evidence that Parliament understood the law to operate consistently' with the amendments set out in the bill:[18]

Given the consistent assumption by Parliament since at least 1982 that treaties provided a separate basis for making transfer pricing adjustments, the proposed amendments could apply from the commencement of Division 13 and the accompanying changes to section 170 and former section 226 of the ITAA 1936.

Subdivision 815-A, however, will only apply to income years commencing on or after 1 July 2004. The 2004 income year commenced immediately after the Parliament’s most recent amendment to the income tax laws in 2003 which again evidenced the Parliament's understanding that tax treaties could be used as a separate basis for making transfer pricing adjustments. The 2003 amendments included a modification to the definition of 'relevant provision' contained in subsection 170(14) of the ITAA 1936 and contained explicit statements as to the ability for such provisions to allow for adjustments to the profits of permanent establishments or associated enterprises on an arm’s length basis (see paragraph 3.5 of the Explanatory Memorandum relating to Act No 123 of 2003).[19]

2.22      Chapter 3 will discuss submitters' views on the retrospective application of the measures in the bill in relation to the impact on revenue. Chapter 4 will explore ATO rulings in greater depth followed by discussions on Parliament's intention in subsequent chapters.

Navigation: Previous Page | Contents | Next Page