5 January, 2013

 

 

IN BRIEF

 

• Draft legislation proposes new international transfer pricing rules to replace the longstanding rules in Division 13 and also the rules in Division 815-A which were introduced several months ago.
• Unlike the existing rules in Division 815-A, the new rules proposed in the draft Bill would:
  • apply automatically and would not require the Commissioner to make a determination;
  • apply in non-treaty and treaty situations; and
  • apply not only to arrangements between associated enterprises but also to arrangements with non-associated enterprises.
• The new rules would effectively import OECD transfer pricing principles into the Australian tax law, but add a gloss to those principles, the effect of which is uncertain. In particular, it is not clear whether the new rules would give the Taxation Office more scope to reconstruct transactions than would be available under the OECD guidelines.
• The new rules would also apply to the calculation of profits of Australian permanent establishments of foreign residents and foreign permanent establishments of Australian residents, but the way in which those profits are to be calculated remains uncertain.

 

The Australian Government has released draft transfer pricing legislation and explanatory material for comment. Draft Tax Laws Amendment (Cross Border Transfer Pricing) Bill 2013: Modernisation of Transfer Pricing Rules proposes the introduction of Divs 815-B, 815-C, 815-D and 815-E of Income Tax Assessment Act 1997 (“ITAA 1997“). Submissions on the draft Bill are due by 20 December 2102.

 

History and context

 

The proposed measures were foreshadowed in a discussion paper entitled Income tax: cross border profit allocation – Review of transfer pricing rules published by the Australian Treasury on 1 November 2011. Treasury stated in the paper that two recent transfer pricing cases, both of which were lost by the Australian Taxation Office, had “highlighted two key areas for further consideration: the role of the arm’s length principle in the domestic law; and the role of OECD guidance in interpreting these rules”.

 

• Role of the arm’s length principle in the domestic law: In relation to the first issue, that is, the role of the arm’s length principle in the domestic law, Treasury’s concern was that “Division 13 [the Australian transfer pricing regime at the time] focuses on pricing individual transactions. . . Yet 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”.
• Role of OECD guidance in interpreting these rules: In relation to the second issue, Treasury observed that “there is uncertainty over the role of the OECD Guidelines [that is, the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations] in applying the profit allocation rules. 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. . . 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.”

 

It is immediately obvious, in relation to both “areas for consideration” noted above, that a primary concern of Treasury was to ensure that new laws be enacted to allow the ATO to argue for the use of profit based methods, rather than transactional methods, in determining the taxable income of Australian resident enterprises which deal with foreign associated enterprises.

 

Although it is true that the OECD officially embraced the use of profit-based methods in its 2010 Guidelines, it urged caution in the use of such methods, stating that:

 

“Methods that are based on profits can be accepted only insofar as they are compatible with Article 9 of the OECD Model Tax Convention, especially with regard to comparability . . . In no case should [such] methods be used so as to result in over-taxing enterprises mainly because they make profits lower than the average, or in under-taxing enterprises mainly because they make higher than average profits”.

 

In addition, the Guidelines establish a clear priority in the application of alternative methods. Traditional transactional methods are stated to be preferable to profit based methods “where each can be applied in an equally reliable manner”.

 

The first stage in the implementation of new transfer pricing rules was the introduction of Div 815-A of the Income Tax Assessment Act 1997 (Cth) in September this year. Div 815-A operates with retrospective effect from 1 July 2004. The retrospective operation of the measures was strongly criticised by business groups, the Law Council and others, and resulted in a Senate Enquiry which, on party lines, endorsed the passage of the legislation.

 

Div 815-A provided the ATO with an alternative basis for making transfer pricing determinations where the “Associated Enterprises” or “Business Profits” article of a treaty applied and, on the basis of relevant OECD Guidelines, would produce a greater amount of taxable income or a lower loss than that reported by the taxpayer. 

 

Div 815-A requires the Commissioner to base transfer pricing determinations on the OECD Guidelines. Consequently, if the Commissioner makes a profit-based adjustments to an entity’s taxable income under that Division, it is open to the entity to argue that the use of a profit-based method is inappropriate if a transactional method of determining the taxable income of the entity can be applied in as reliable a manner as, or in a more reliable manner than, a profit-based method.

 

Scope of the proposed measures

 

The main objective of the transfer pricing regime proposed in the draft Bill is to ensure that the transfer pricing rules in domestic Australian tax law give effect to 2010 OECD Transfer Pricing Guidelines. As in the case of existing Div 815-A, the proposed rules would incorporate the OECD Guidelines by reference into the Australian income tax law. The proposed measures would replace Div 815-A and differ from Div 815-A in the following respects:

 

• they would apply in both treaty and non-treaty situations;
• they would apply to cross-border dealings with associated and non-associated enterprises;
• they would apply automatically and will not be activated by the Commissioner making a determination;
• they would set out the type of documentation that will be required to substantiate an argument that an entity has taken a reasonably arguable position in relation to transfer pricing, thus ensuring that penalties are minimised if the position taken by the entity is successfully challenged by the ATO;
• they provide that no administrative penalty will be imposed if transfer pricing adjustments fall below de minimis thresholds (being the greater of $10,000 and 1% of the entity’s taxable income for an entity other than a trust or partnership, and the greater of $20,000 and 2% of net income for a trust or a partnership); and
• they provide a time limit of 8 years for the making of a transfer pricing adjustment from thetime that the ATO gives a notice of assessment to the entity. The current law provides no time limit for making transfer pricing adjustments under Div 13 or Div 815-A.

 

In common with Div 815-A, the proposed provisions would apply not only to dealings between two separate enterprises but also to the determination of profits attributable to permanent establishments of enterprises. However, unlike the corresponding provisions in Div 815-A, the permanent establishment profit attribution measures in proposed Div 815-C would apply:

 

• in both treaty and non-treaty situations; and
• not only to the calculation of the taxable income of the Australian permanent establishments of foreign residents but also to the calculation of the taxable income of Australian residents with foreign permanent establishments.

 

Division 13, containing the existing transfer pricing rules, will be repealed when the new rules are enacted, and it is proposed that Div 815-A (introduced several months ago) will have “no further application” from that time.

 

Initial observations on the proposed rules

 

The inclusion of OECD transfer pricing guidelines in the Australian domestic income tax law, by reference, would seem to be a positive step towards establishing international best practice and minimising the scope for conflict between principles applied in Australia and other countries, particularly OECD member countries.

 

For reasons mentioned below, however, it remains to be seen whether there will in fact be conflicts in some cases between the operation of the proposed provisions and the operation of equivalent provisions in tax treaties.

 

Use of transactional and profit-based measures

 

As noted above, Treasury made it clear from the beginning of the transfer pricing reform process that, in its view, a significant benefit of adopting the OECD transfer pricing guidelines is that the ATO will have more scope to argue for the use of profit based methods rather than transactional methods to determine the profits of an enterprise that are subject to Australian tax.

 

As mentioned above, Div 815-A does not allow profit-based adjustments to be made to an entity’s taxable entity if a transactional method can be applied in at least as reliable a manner as a profit-based method. It is not entirely clear whether the measure proposed in the draft Bill would make it easier for the ATO to raise profit-based transfer pricing adjustments.

 

The draft Bill repeats (using slightly different words) the criteria in the Guidelines for determining which transfer pricing method is the most appropriate for a particular situation. The last criterion is “the degree of comparability between the actual circumstances and the comparable circumstances, including the reliability of any adjustments to eliminate the effect of material differences between those circumstances”. The draft Bill then:

 

a) states when circumstances will be regarded as “comparable”; and

 

b) requires that regard be had to the economic substance of what was actually done, in identifying what might be expected to have been done by two independent entities dealing wholly independently with one another.

 

The description of when circumstances will be regarded as “comparable” reflects a similar description in the OECD Guidelines. The description of when regard must be had to “the economic substance of what was actually done” corresponds to a similar description in the OECD Guidelines but ignores initial words to the effect that “other than in exceptional cases, the tax administration should not disregard the actual transactions or substitute other transactions for them”.

 

It seems to us that the wording of the proposed Bill in this regard may result in a reading of the Guidelines that would favour the use of a profit-based method in some circumstances, where a contrary interpretation may have prevailed if only the Guidelines themselves had been relied upon.

 

Interaction with treaties

 

To the extent that the requirement in the proposed Bill to have regard to “the economic substance of what was actually done” might be regarded as amending the meaning of the OECD Guidelines for the purposes of the Australian domestic transfer pricing law, a question may arise as to whether the effect of the proposed law is in accordance with the effect of a particular tax treaty which, under general principles of international law, is to be interpreted in accordance with the ordinary meaning of the text of the treaty.

 

There is also a question as to whether the 2010 OECD Guidelines are relevant to the interpretation of treaties concluded before 22 July 2010.

 

In the event of any conflict between the result produced by the proposed new transfer pricing law and the result produced by a tax treaty, a taxpayer is entitled to rely on the latter.

 

Permanent establishments

 

The proposed rules in Div 815-C for determining the profits attributable to a permanent establishment have some puzzling aspects.

 

The rules require that those aspects of the 2010 OECD Model Tax Convention (“MTC“), including the related OECD Commentary, dealing with the attribution of profits to permanent establishments be given effect to the extent that they relate to the text of Article 7 (the Business Profits article) of the MTC and its Commentary as they read before 22 July 2010.

 

The 2010 OECD Commentary on the pre-2010 Article 7 encourages member states to interpret the Business Profits article in the MTC (which is the model for the Business Profits articles in Australia’s tax treaties) so as to give effect to the “functionally separate entity” approach to the calculation of the profits of a permanent establishment. This approach treats dealings between a permanent establishment and other parts of the enterprise as giving rise to income and expenses for the permanent establishment.

 

The explanatory materials accompanying the draft Bill state, however, that proposed Div 815-C “reflects the approach to the attribution of profits to permanent establishments that is currently incorporated into Australia’s tax treaties (the relevant business activity approach)”. Under this approach, only actual income and expenditure of the enterprise can be allocated, and intra-entity dealings are not regarded as giving rise to income or expenditure for the permanent establishment.

 

There would seem to be a difference, therefore, between the wording of the draft explanatory materials and the effect of the relevant Commentary in the 2010 MTC. Consequently, it is not clear whether the “relevant business activity” approach that the draft explanatory materials suggest should be used is the only method available for calculating the profits of a permanent establishment under proposed Div 815-C.

 

It should be noted that the Board of Taxation is due to report to the Government in April 2013 on the advantages and disadvantages of adopting the “functionally separate entity” approach to the attribution of profits to permanent establishments.

 

Dates from which the new rules operate

 

The draft Bill and explanatory material do not provide a start date for the proposed provisions. There is a statement to the effect that Div 815-A will have no application from the date of application of the proposed changes. This may mean that Div 815-A’s retrospective operation from 1 July 2004 will be taken on by Divs 815-B to 815-E, or that Div 815-A will apply to arrangements entered into from its date of application (1 July 2004) to the date of enactment of the new provisions. This issue is significant mainly for those taxpayers affected by the retrospective operation of Div 815-A. Will the retrospective rules be those contained in Div 815-A, or the rules proposed by the draft Bill?