By Dixon Hearder
Australia's transfer pricing rules are undergoing material amendment. According to the Australian Government, the changes are merely supposed to clarify how the rules work, and bring them more in line with the OECD. In reality, if the new rules become law in their current form, they are likely to create more uncertainty for the Government and its taxpayers.
Background
Australia's transfer pricing rules are contained in Division 13 of the Income Tax Assessment Act 1936, and have not been significantly amendment since their introduction in 1982.
In the last 20 years, the Commissioner of Taxation ("Commissioner") has dominated the Australian transfer pricing landscape based on extensive public rulings in the area. However, when taxpayers finally litigated, most recently in Roche Products Pty Ltd v FCT [2008] AATA 639 and FCT v SNF (Australia) Pty Ltd [2011] FCAFC 74, it was confirmed that the rules did not always operate the way the Commissioner said they did. The cases have had the effect of raising questions about many aspects of the Australian transfer pricing practice.
What drives the amendments
Transfer pricing has reached a tipping point in Australia, as a consequence. Naturally concerned about its revenue position, the Australian Government responded by first releasing, on 1 November 2011, a Consultation Paper discussing proposed changes to Australia's domestic transfer pricing rules. After a significant number of submissions, the Government has now followed up by releasing on 16 March 2012 an Exposure Draft of proposed amendments.
Broadly, the Exposure Draft changes are intended to be "for clarification" only. This is said to justify the proposal for the rules to have retrospective application from 1 July 2004.
Retrospective application raises the spectre of double taxation risk on positions previously settled in other countries, as well as penalties and interest. This has caused great controversy with taxpayers and advisers, given the widely held view that the Commissioner's interpretation on a number of fundamental aspects of the rules was simply wrong at law and that the Court decisions have merely confirmed this.
As an example, the Commissioner has a long-held view that Tax Treaties offer an alternate source of taxing power to domestic law. However, the weight of case authority in recent years has been that Treaties simply provide for an allocation of taxing rights between countries.
Another example is that the Commissioner has contended that applying TP methods correctly, such as transactional net margin method ("TNMM"), a truly independent party would not have recurring losses over an extended period in Australia. However, the SNF decision found that as long as the pricing of the transaction could be demonstrated to be arm's length, the fact that a loss was made in Australia was not relevant.
A very controversial view of the Commissioner in recent years has been that if a transaction does not make "commercial sense," then the Commissioner can "reconstruct" the transaction to one that truly independent parties dealing at arm's length would have done, and price that hypothetical transaction instead. The Commissioner has claimed the source of this power is the domestic transfer pricing rules themselves, as well as from OECD principles. Many disagree with this view of domestic law, also pointing out the OECD position that this should be limited to very exceptional circumstances.
Further, the Commissioner has at different times stated that Division 13 and the Associated Enterprises Article in Tax Treaties apply the same test, being the "internationally accepted arm's length principle." However, this position was far from clear with Roche most recently suggesting this might not be the case. In fact, the Commissioner must now take the view that Treaties provide him with powers domestic law does not, as this is essentially the focus of the new amendments.
Key features of the proposal
The proposal under the Exposure Draft is to introduce new subdivision 815-A into the Income Tax Assessment Act 1997 as a first phase of amendments to domestic transfer pricing rules. The principal focus is on the interaction between Treaty rules and domestic rules.
Under the proposed new rules, where a Tax Treaty applies, the Treaty will apply and operate independently of the domestic legislation, by incorporating the relevant Treaty Articles for Business Profits of a Permanent Establishment ("PE"), and Associated Enterprises, into domestic law. Secondly, the arm's length principle must be interpreted in a manner that is most consistent with applicable OECD guidance.
A new concept of a "transfer pricing benefit" is also proposed. Essentially, this focuses on the situation where as a result of a transaction between an Australian tax resident and a foreign related party, the amount of profit that might have been expected to accrue to the entity has not so accrued. An equivalent test applies for an Australian PE of a foreign resident, under which the Australian PE is treated as a "distinct and separate" enterprise.
The amount of the difference in profit is the transfer pricing benefit. In that case, the Commissioner is empowered to make determinations so that the taxpayer's tax liability properly reflects the benefit received, for instance by increasing a taxpayer's taxable income or reducing a loss.
The Government has also taken the opportunity to ensure that adjustments that can be made to a taxpayer's position under proposed subdivision 815-A extend to the arm's length cost of debt under the domestic thin capitalization rules. This follows current Commissioner's practice in Taxation Ruling 2010/7, despite having a dubious foundation under the existing transfer pricing rules.
The focus on "profits" is, broadly, intended to re-align Australian practice with the OECD, re-establish TNMM as a viable TP method and ensure that a case like SNF would be decided differently in the future. It is based on the Commissioner's view that if SNF had been decided on Treaty principles rather than domestic law, the outcome would have been different. However, this is not a view that is widely shared, which means the proposed reliance on OECD principles may be misguided.
The focus on profits also begs the question as to whether the Commissioner will administer the new rules by second guessing business outcomes in Australia, essentially a "back-door" reconstruction power. It also raises the issue of the hierarchy of TP methods, given the formulation of subdivision 815-A presumably reflects the Commissioner's desire to reinstate the legitimacy of profit methods like TNMM, if not establish their pre-eminence. Relevantly, sub-division 815-A is intended to take precedence over Division 13.
OECD Sources
The SNF decision found that the OECD TP Guidelines had no legal status and were, at best, guidelines only. The Exposure Draft therefore includes a proposed rule that allows reliance to be placed on the most recent versions of the OECD Model Tax Convention and the OECD TP Guidelines, as well as any other documents prescribed by regulation. For years prior to 2012-13, but after 1 July 2004, the relevant OECD guidance is the version of these documents last published before the start of the relevant year.
Further reform
Issues left outstanding from the Consultation Paper include profit attribution to Australian PE's, minimum documentation rules, TP method hierarchy, and time limits on TP adjustments. The Government is yet to provide any indication of what we can expect next in terms of TP reform.
Conclusion
While better aligning Australian TP practice with that of the OECD makes sense, the manner in which it is proposed this will be done may in fact only cause more uncertainty. In this sense, it is difficult to conclude at this stage to what extent the proposals represent a step forward for Australian transfer pricing.
