Chapter 9
Transaction based arm's length assessments
9.1
Many submitters expressed concern that proposed Subdivision 815-A
favoured a profit based approach to arm's length assessments. Submitters
advocated for a transaction based approach to be given equal consideration in
ATO arm's length assessments of transfer pricing. This issue will be explored
in this chapter, as well as the interaction of the proposed transfer pricing
rules with customs laws.
The description of 'profits' in the
object of the bill
9.2
The object provisions of the bill in section 815-5 outline that:
The object of this Subdivision is to ensure the following
amounts are appropriately brought to tax in Australia, consistent with the arm's
length principle:
(a) profits which would have
accrued to an Australian entity if it had been dealing at *arm's length, but,
by reason of non-arm's length conditions operating between the entity and its
foreign associated entities, have not so accrued;
(b) profits which an Australian
permanent establishment (within the meaning of the relevant *international tax
agreement) of a foreign entity might have been expected to make if it were a distinct
and separate entity engaged in the same or similar activities under the same or
similar conditions, but dealing wholly independently.[1]
9.3
The Federal Chamber of Automotive Industries (FCAI) expressed concern
that the object of proposed Subdivision 815-A was too broad in its description
of 'profits':
The objects clause fails to link the concept of dealing at
arm's length with either a specific person or persons, or a specific transaction
or transactions. As there is no link to an underlying transaction or specific
activity, the concern is that the term "profits", used in this
context, may be construed very broadly to include a consideration of overall
profitability, and to permit the imposition of additional income tax without
reference to any specific dealing or dealings of the taxpayer.[2]
Definition of transfer pricing
benefit
9.4
According to the bill a transfer pricing benefit is the difference
between the profits made by an entity, having regard to the arm's length
principle, and the amount it actually made.
9.5
The Australian Bankers' Association (ABA) argued that this definition
could 'skew' transfer pricing analysis towards a profit-based method rather
than a transaction method:
The use of this term in the Bill runs the risk of unduly
skewing the analysis now required (in order to be able to comply) towards a
profit-based transfer pricing method instead of transactional transfer pricing
methods. Introducing such a skew has the potential to put Australian transfer
pricing methodologies out of step with the intention and impact of the OECD
international standards, which require the "most appropriate" method
to be adopted and do not prescribe a hierarchy of methods.
This concern is referred to on pages 8 and 9 of our 2
December 2011 submission, in relation to 'Broadening of scope' and 'Transfer
pricing methods', and has a real and practical impact on banks and financial
institutions who mostly utilise the traditional transactional methods (and not
the profit methods) to support their internal transfer pricing outcomes.[3]
Determinations negating transfer
pricing benefit
9.6
Similarly, a number of submitters expressed concern that the
Commissioner's determinations to make adjustments under proposed subsection
815-30(1) do not adequately require the Commissioner to specify what particular
item of income, expenditure or capital gain/loss is affected and that 'it
departs from the principle that transfer pricing should be primarily concerned
with the pricing of transaction/s'.[4]
The Law Council of Australia asserted that this approach was not equitable or
transparent.[5]
9.7
Proposed subsections 815-30(1) and 815-30(2), 'Determinations negating transfer
pricing benefit' state:
(1) The determinations the Commissioner may make are as
follows:
(a) a determination of an amount
by which the taxable income of the entity for an income year is increased;
(b) a determination of an amount
by which the tax loss of the entity for an income year is decreased;
(c) a determination of an amount
by which the *net capital loss of the entity for an income year is decreased.
(2) If the Commissioner makes a determination under
subsection (1), the determination is taken to be attributable, to the relevant
extent, to such of the following as the Commissioner may determine:
(a) an increase of a particular
amount in assessable income of the entity for an income year under a particular
provision of this Act;
(b) a decrease of a particular amount
in particular deductions of the entity for an income year;
(c) an increase of a particular
amount in particular capital gains of the entity for an income year;
(d) a decrease of a particular
amount in particular capital losses of the entity for an income year.[6]
9.8
Deloitte suggested that paragraph 1.53 of the Explanatory Memorandum (EM)
outlined that subsection 815-30(1) only takes into account 'an overall
adjustment' which does not apply to individual items of the entity's assessable
income, particular deductions or capital gains/losses. It argued that
individual transactions are only addressed at the general discretion of the
Commissioner as stipulated in subsection 815-30(2), with no direct link between
the two subsections:
In our view the Commissioner should be required in all cases
to identify and characterise what specific item is being adjusted so as to link
that adjustment to the other provisions of the Act. We recommend that
s.815-30(2) be amended to require that the Commissioner make determinations in
all cases attributing the adjustment under 815-30(1) to a particular amount of
assessable income, deduction or capital gain/loss.
Requiring the Commissioner to identify the particular item(s)
to which the profits that are subject to a s.815-30 adjustment are attributable
would accord with subsection 815-22. Subsection 815-22 essentially defines
"transfer pricing benefit" as an amount of profits within the meaning
of the applicable treaty article, interpreted so as to best achieve consistency
with the OECD Model Tax Convention and the OECD Transfer Pricing Guidelines.
Both the Commentary to Article 9 of the OECD Model Tax Convention and the
Transfer Pricing Guidelines make clear that the amount of "profits"
to which Article 9 applies is determined by reference to transactions.[7]
9.9
Deloitte argued that the approach taken in section 815-30 could prove to
be inadequate for tax-payers seeking clarity on a determination by the
Commissioner and provided the following example:
Say the taxpayer has various categories of cross-border
dealings, including trading stock purchases, with numerous related parties resident
in numerous offshore jurisdictions. The ATO conducts an audit and makes an
adjustment under s.815-30 applying a transactional net margin method on a whole
of entity basis. The issues raised for the taxpayer by its lack of knowledge of
the basis for the adjustment, if the Commissioner in this case does not make
determinations under s.815-30(2) attributing the adjustment to particular
items, include:
- The extent to which the
adjustment is referrable to an applicable Associated Enterprises Article for
purposes of s.815-22 and knowing whether the adjustment relates to a
"transfer pricing benefit" as defined for Subdivision 815-A, so that
the Commissioner has authority to make the adjustment under that provision;
- The extent to which the
adjustment is referrable to an applicable Associated Enterprises Article for
purposes of requesting correlative relief or Mutual Agreement Procedure under
that treaty;
- The extent of the effect of the
adjustment, if any, on the treatment of deductions for trading stock under
other provisions of the Act;
- The extent of the effect of the
adjustment, if any, on the valuation of the trading stock purchases for other
purposes, eg. customs duties payable.[8]
9.10
The ABA emphasised that using transactional transfer pricing was the
preferred method for Australian banks. It outlined that establishing an arm's
length profit for a range of diverse entities within a multinational enterprise
requires considerable resources:
Australian banks who (in line with OECD guidance) typically
deal with transfer pricing on a separate transaction basis using transactional
transfer pricing methods... There is very good reason that they do so: it is
often difficult for financial service entities to determine the overall arm's
length profit allocation for each entity within their group which is
attributable to inter-group dealings. Each entity in a group may comprise
several business units and a combination of back, middle and front office
functions and will enter into numerous transactions both with external and
group counterparties. Given the diverse nature of each entity, it would be
practically difficult and require significant time and effort resulting in material
compliance costs to seek to identify an arm's length 'profit' outcome for a
full range of material intra-group dealings. It is important to note that
financial services entities operate in a significantly different manner than
other businesses which means that an overall profit outcome is not as easy to
establish as it may be for taxpayers with business operations similar to those
in the SNF case.[9]
OECD Guidelines on transaction
based methods
9.11
In the context of the adjustment powers given to the Commissioner under
the bill, the Institute of Chartered Accountants outlined that the Organisation
for Economic Co-operation and Development, Transfer Pricing Guidelines for
Multinational Enterprises and Tax Administrations (OECD Guidelines) state
that reconstruction of transactions should only occur in two circumstances:
- Where the economic substance of a transaction differs from its legal
form; and
- Where the arrangements made in relation to a controlled transaction
differ from those which would have been adopted by independent enterprises
behaving in a commercially rational manner.[10]
9.12
A number of submitters also noted the 'cautionary words' in the OECD
Guidelines which place an emphasis on transactional arm's length methods.[11]
The guidelines state:
In other than exceptional cases, the tax administration
should not disregard the actual transactions or substitute other transactions
for them. Restructuring of legitimate business transactions would be a wholly
arbitrary exercise the inequity of which could be compounded by double taxation
created where the other tax administration does not share the same views as to
how the transaction should be structured.[12]
9.13
RSM Bird Cameron is concerned that the bill represents 'a significant
departure from the internationally accepted arm's length principle' and has a
focus on profits rather than transactions.[13]
The Business and Industry Advisory Committee to the OECD (BIAC) also commented
on this apparent 'departure' from OECD Guidelines:
Sub-division 815-A refers to the arm's length profit accruing
to an entity, and does not necessarily require that this profit be referenced
to a specific underlying transaction. This is not in alignment with OECD which
looks to transactions rather than a broader profit concept. This will lead to
significant practical difficulties and may preclude the ability to contemporaneously
set prices as arm's length parties would. In the not uncommon circumstance
where an entity has dealings with multiple associates in multiple countries or with
a mixture of 3rd party and connected party dealings, it will not be practical
to determine a broad profit outcome. This is a common problem with
multinationals setting up global service centres or global hub operations to
services multiple local operations to maximise value add, efficiency,
standardisation and control. To overcome this issue the legislation needs to
refer to the profit in relation to a transaction or set of similar
transactions. The UK has recently changed its transfer pricing rules (2010) and
they have effectively brought in the concept of profit in relation to a
transaction or series.[14]
Recommended approach for
re-characterisation of transactions
9.14
The Minerals Council of Australia recommended that section 815-30(2)
should be amended to require the Commissioner to specify which specific item is
being adjusted.[15]
9.15
Deloitte also recommended that subsection 815-30(1) should be amended to
require the Commissioner to ensure all determinations attribute the adjustments
to a particular amount of assessable income, deduction or capital gain/loss as
specifically provided in subsection 815-30(2). It asserted that this is in line
with subsection 815-20(2) which requires a transfer pricing benefit to be
determined in line with a number of documents, including the OECD Guidelines
and Model Tax Convention:
Both the Commentary to Article 9 of the OECD Model Tax
Convention and the Transfer Pricing Guidelines make clear that the amount of
"profits" to which Article 9 applies is determined by reference to transactions.
Thus, for instance, paragraph 1 of the Commentary to Article 9 states:
"This Article deals with
adjustments to profits that may be made for tax purposes where transactions
have been entered into between associated enterprises (parent and subsidiary
companies and companies under common control) on other than arm's length
terms."
In accordance with this, the Guidelines recognise five arm's
length pricing methods to be used in applying Article 9, with these methods
categorised as "traditional transaction methods" and
"transactional profit methods". Under the Guidelines, the
comparability analysis prescribed for applying those methods is performed at
the level of individual transactions or an appropriate level of aggregation of
transactions. The Commentary and the Guidelines do not contemplate the arm's
length principle under Article 9 being applied to adjust profits in a way that
does not attribute that adjustment to particular transactions between the
associated enterprises. Accordingly, we do not see how the Commissioner can
satisfy s.815-22(3) and hence make a valid adjustment under s.815-30 unless he
determines the transfer pricing benefit by reference to the profits in respect
of a particular transaction or transactions.[16]
9.16
Similarly, Ernst and Young recommended that there should be
clarification that the references in sections 815-20 and 815-30 'do not endorse
the departure by the Commissioner from the pricing of
transaction/s':
Consistent with the OECD Transfer Pricing Guidelines [see
paragraph 1.65], the proposed legislation should clearly reflect the
circumstances under which the reconstruction principle may be applied [see also
example 1.4 in the EM]... In this regard, the fundamental principle that should
be used as the basis for determining the arm's length principle is that the
actual transactions should be recognised unless:
1. the
legal form of the transaction does not match the economic substance; or
2. there
is no evidence of similar arrangements (as opposed to the transaction) between
unrelated parties, and the arrangement when viewed in its totality would not
reasonably be expected to exist between unrelated parties dealing in a
commercially rational manner, and the actual structure practically impedes the
Commissioner from determining an appropriate transfer price for the
transaction.[17]
9.17
In its submission to the Consultation Paper, PwC made the following
recommendations on arm's length method selection:
- A 'most appropriate method' approach is suitable.
- There should be no bias for any one particular approach.
- There should be no requirement to use a profit based method to test the
arm's length nature of the outcome where a transactional method has been
selected as most appropriate.
- Legislation should reference OECD guidance rather than provide prescriptive
rules on method selection.[18]
9.18
In response to these concerns, Treasury asserted that the bill does not
prioritise profit methods. It outlined that the bill has provisions which
require that OECD Guidelines are considered and, therefore, that the 'most
appropriate' method be adopted. It conceded that where a range of methods are
available, transaction based methods should prevail.[19]
Treasury's response is discussed further below.
Customs laws
9.19
A number of submitters perceived that the bill will have difficulties interacting
with Customs valuation rules. Submitters highlighted the potential for
taxpayers to be required to defend transfer prices under the two
different sets of rules.[20]
For example, GM Holden stated:
Holden submits that there should be a "whole of
Government" approach in respect of the drafting of revenue laws. It is
unfair and unreasonable to place a company in the position of having to defend
the transfer price of the importation of a product under two separate sets of
transfer pricing valuation rules.
Whilst Holden acknowledges that there has been some
disconnect between income tax and Customs Duty valuation rules for some time,
the Bill, if enacted, will only serve to widen the chasm between the two sets
of valuation rules. The Bill will bring in a "profits-based"
approach, whereas the Customs Duty rules are very much based on a transactional
approach to valuation.
In the event that the ATO adjusts a company's transfer price,
there is no guarantee that an equal and offsetting adjustment will be made for
Customs Duty purposes...[21]
9.20
The Corporate Tax Association of Australia (CTAA) also highlighted the
tensions between the two sets of rules:
In relation to imported goods, there is a tension between the
two, in the sense that tax administrators would be concerned that the price
goods imported from a foreign associate may be overvalued, while Customs
officials would be concerned that those goods may be undervalued. Where the ATO
rules that the imported goods were overvalued, the taxpayer should not then
also be liable to import duty on the higher unadjusted amount...
More broadly, we note that despite various efforts made over
a number of years to achieve better alignment between income tax and Customs
valuations in respect of the same imported goods, very little progress has so
far been achieved. The CTA appreciates there is an inherent inconsistency
between profits based and transactions base methods. Given that we are likely
to see an increase in profits based transfer pricing adjustments if the draft
legislation is passed, however, it is in our view imperative that a more
effective mechanism be developed for harmonising the two where possible.[22]
9.21
Ms Vanda Davis, Chair of the Taxation Committee of the FCAI, described
the process that both Customs and the ATO currently take when assessing
transactions. She highlighted the collaboration that has been undertaken to
reach the current 'harmony' that exists between the two regulatory bodies:
As the act stands, it is fine for us from a customs duty
perspective because our cars come in off the ship and it is the price paid or
payable, unless the relationship influences the price. My understanding from
Customs is that something like 95 per cent of world trade comes in at transaction
value, which means the price paid or payable on the invoice—unless the
relationship influences the price. The CEO of Customs will then look at the
relationship between the parties. He would look at the position of the seller,
or the exporter, as well as the position of the importer. Once Customs is
satisfied the relationship did not influence the price, the commissioner again
looks at the arm's-length standard—very similar to what the CEO does. As the
rule is currently enacted, there is a wonderful bridge and there is quite good
harmony. That is not to say that in some instances that there has not been
tension, and everyone will accept that. But, generally speaking, it has been my
understanding over the years I have been practising that, provided the commissioner
is concentrating on those transactions—looking at the transactions, the
arm's-length nature of the transactions and the pricing of those
transactions—he will satisfy both the Customs Act and the Income Tax Assessment
Act.[23]
9.22
CTAA argued that the ATO and Customs should be compelled to mutually
agree on a transfer price in the case of tangible property:
It is unacceptable for a business to be required to satisfy
two arms of the same government, one demanding a higher price and the other a
lower price in respect of the same transaction.
In addition, the OECD guidelines express a higher level of
preference for the use of traditional transaction methods for testing the arm's
length character of transfer prices for transfers of tangible property. Where
the importation of tangible property is involved the ATO and Customs should be
compelled to reach agreement of what the arm's length price is, with
appropriate input from the taxpayer.[24]
9.23
In addition, PwC and FCAI noted that time limits for seeking duty
refunds (four years) are likely to have expired.[25]
9.24
The Australian Customs and Border Protection Service (Customs) concurred
with submitters' concerns on the 'disconnect' between the two sets of rules:
In summary, the position of submitters who refer to Customs
and Border Protection is that the passage of the Bill will confirm in
legislation the disconnect between transfer pricing rules for income tax
purposes and those for customs valuation purposes. The submitters further
submit that the retrospective application to 2004 of the amendments could mean
that price adjustments for purposes that result in an increase in income tax on
profits may be out of time for customs duty refund applications (generally 4
years) in relation to the imported goods the subject of the price adjusted
transactions.
Customs and Border Protection considers that the factual
analysis of the submitters in relation to the disconnect between the tax and
customs rules and the availability of refunds is accurate.
Customs and Border Protection would not, however, support any
amendments to Customs valuation rules, which are consistent with Australia's
obligations under the World Trade Organization (WTO) Customs Valuation
Agreement.[26]
9.25
Customs referred the committee to pages 84 to 86 of the WTO publication A
Handbook on the WTO Customs Valuation Agreement as a guide to the treatment
of transfer pricing in a customs valuation context.[27]
Treasury's response
9.26
Treasury outlined that taxpayers with related party dealings are
required to disclose transfer pricing documentation in a schedule to tax
returns. This includes the type of transfer pricing methodology applied by the
taxpayer. Treasury noted that while ATO fieldwork indicates significant
variability in the quality of transfer pricing documentation, it indicated that
85 per cent of the 6,720 taxpayers disclosing related party dealings applied a
transfer pricing method to price dealings. Treasury provided the following
table on method usage among taxpayers.
Table 9.1: Percentages on arm's length method usage among
taxpayers
Source: Treasury, answer to
question on notice, 26 July 2012, (received 9 August 2012), p. 6.
9.27
Treasury argued that the bill does not prioritise profit methods. It
agreed that the OECD approach 'requires the "most appropriate" method
to be adopted and provides that where a range of methods are equally
appropriate, that transaction based methods prevail'. It explained that
Subdivision 815-A provides an interpretative provision 'to ensure consistency
between the proposed rules and the OECD approach':
The interpretive provision applies to the evaluation of
whether an entity gets a transfer pricing benefit, as well as the
interpretation of the provisions of an international agreement insofar as it
relates to Subdivision 815-A (to the extent such guidance material is
relevant). The selection and application of different methodologies in a given
case falls squarely within the scope of this interpretive provision.[28]
9.28
Ms Kristen Baker, Manager of the International Tax Integrity Unit at
Treasury, provided further comments on the 'interpretative provision':
In terms of any emphasis given to the profit methodologies,
these amendments certainly were not drafted with that intention in mind. The
rules seek to allow the full suite of OECD methodologies to be available, which
includes the traditional transaction based methods and the profit based
methods. The key provision that does that in the amendments is section 815-20.
That is the provision that requires that the rules be interpreted consistently
with the OECD guidelines. As Mr McDonald pointed out, the OECD guidelines
require that the most appropriate method be applied.
To add to that comment, the OECD guidelines also require that
where methods are equally appropriate the transaction based methods are in fact
to be preferred over the profit based methods. So these rules would give effect
to the guidelines in that way. Rather than giving an emphasis to profit
methods, they are simply ensuring they are available. Profit methods are very
important in a number of instances, particularly in terms of our Advance
Pricing Arrangement Program, where comparables in terms of future transactions
often will not be available. So profit methods are an important element in the
suite of methods available.[29]
9.29
The Advance Pricing Arrangement Program (APA program) 'involves a
mixture of education and enforcement activities'.[30]
The guide to the APA program states:
6. The aim of the APA Program is to give taxpayers the
opportunity to reach agreement with the ATO on the method of application of the
arm's length principle to their international related party dealings on a
prospective basis, thereby resolving any uncertainty around those dealings.
7. Taxpayers who require a level of assurance as to the ATO
view of their transfer pricing risk without the cost and time associated with
undertaking an APA have access to the ATO risk assessment and self assessment
risk products.[31]
9.30
Mr Michael Jenkins, Assistant Commissioner at the ATO, challenged
assertions that most companies use transaction based methods and noted that the
dominant method used in the APA program is the profit based method:
One example would be the functioning and functional APA
program that the ATO has. Over a long period of time, a number of taxpayers
have accessed that program, and when the three- to five-year period expires
they will come back into the program. The dominant method that is used in the
APA program is the profit based method.[32]
9.31
Treasury provided a table (below) that highlighted the use of profit
based methods in the APA program and stated:
Taxpayers seeking clarity in respect of their transfer
pricing arrangements always have the option of seeking an APA with either the
ATO or the ATO and other tax administrations.
The ATO publishes an annual 'APA Program Update' which
includes information regarding transfer pricing methods. In APAs, profit based
methods (and the transactional net margin method (TNMM) in particular) are
consistently the most frequently used methods. This reflects that APAs are
forward looking, and that taxpayers and administrators can often more readily
obtain and verify profit related data rather than data on comparable prices for
transactions that have not yet occurred.[33]
Table 9.2: Profit based methods in the APA program
Source: Treasury, answer to
question on notice, 26 July 2012, (received 9 August 2012), p. 7.
Committee view and concluding comments
9.32
The committee acknowledges the inherent tensions between ATO and Custom's
arm's length assessments and submitters' concerns on this issue. The committee
notes previous successful measures taken to overcome these tensions through the
former National Tax Liaison Subcommittee on Transfer Pricing and the resultant
dialogue between Customs and ATO officials. The committee urges Treasury to
revisit this approach and consider addressing these tensions through a similar
body such as the Large Business Advisory Group.[34]
9.33
The committee reiterates its position, as expressed in previous
chapters, that the bill does not deviate from Parliament's long-stated position
on treaty based transfer pricing rules and highlights the following statement
from Mr Bruce Quigley, Second Commissioner at the ATO:
...we will not be changing our compliance approach, nor
expanding our audit activity in this area as a result of this bill because it
merely confirms longstanding practice.[35]
Recommendation 1
9.34
The committee recommends that the bill be passed.
Senator Mark Bishop
Chair
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