A new Division 815 – Cross-border transfer pricing is to be inserted into the Income Tax Assessment Act 1997 (ITAA 1997). The new Division :
- ensures that the treaty transfer pricing rules are able to be applied independently of existing 'domestic' transfer pricing rules and should provide a separate assessment authority. An express reference to the treaty transfer pricing rules is to be included in the ITAA 1997; and
- requires the arm’s length principle to be interpreted as consistently as possible with relevant guidance issued by the Organisation for Economic Cooperation and Development (OECD) - by providing direct access to OECD guidance material when interpreting Australia's enacted transfer pricing rules; and
- clarifies how the transfer pricing rules will interact with Australia's thin capitalisation rules.
Australia's transfer pricing rules, as set out in Division 13 of the Income Tax Assessment Act 1936 (Division 13) were introduced in 1982 to address emerging concerns about cross-border profit shifting, and to coincide with new guidance by the OECD on this global tax concern.
Each of Australia’s tax treaties contains articles that deal with transfer pricing, including the associated enterprises article and the business profits article (the treaty transfer pricing rules). The treaty transfer pricing rules, interpreted through the framework of the OECD guidance, require profits which relate to cross-border intra group dealings to be calculated consistently with the ‘arm’s length principle’. This internationally accepted principle is set out in the OECD Model Tax Convention on Income and on Capital (OECD Model) and explained in associated guidance material. Australia incorporates its international tax treaties into domestic law through the International Tax Agreements Act 1953 (ITAA 1953).
Related party trade was valued at approximately $270 billion in 2009, representing about 50 per cent of Australia’s cross-border trade flows. Accordingly, transfer pricing rules are a critical element in the integrity of the Australian tax system.
The new Division will have operative effect from 1 July 2004 (that is, retrospectively) but administrative penalties may only apply from 1 July 2012. The Commissioner of Taxation maintains that he has long held and publicly expressed a view that the treaty transfer pricing rules, as enacted, provide an alternate basis to Division 13 for transfer pricing adjustments.
Transfer pricing cases have rarely been litigated in Australia. In June 2011, the Full Federal Court considered its first substantive transfer pricing case in Commissioner of Taxation v SNF (Australia) Pty Ltd  FCAFC 74 (SNF).
The SNF Group is a French based multinational conglomerate, manufacturing and distributing industrial chemicals. SNF is an Australian distributor which purchased the chemicals at prices determined by SNF head office in France from related party suppliers in each of France, the USA and China. SNF persistently made tax losses. The trial judge found that these losses were not the result of excessively high supply costs from related parties.
The Commissioner argued:
- the arm's length consideration required consideration of comparable transactions in which the purchaser shared each and every quality of the taxpayer bearing on price (save for the solitary fact of its having been under the control of SNF France);
- a 'comparable' must consist of an arm's length purchaser in identical circumstances to the taxpayer; and
- support for this view was found in the OECD Transfer Pricing Guidelines for Multinational Entreprises and Tax Administrations.
The taxpayer argued:
- it had paid less for its supplies than other third parties had paid for their supplies; and
- since the third party transactions (the 'comparables') were between arm's length parties, it had therefore paid an arm's length price.
The Full Federal Court found:
- the Commissioner's view was not supported by the text of Division 13;
- the requirement that consideration must be at arm's length was not overlaid with a requirement that the arm in question must be attached to the taxpayer;
- the Commissioner's approach was deeply impractical and problematic where (for example) there does not exist any other business sharing all the same features of the taxpayer since this would suggest that the taxpayer can never succeed; and
- the Commissioner's approach should not be adopted because whenever it was not possible or practicable to ascertain the arm's length price or where there is more than one arm's length price, the Commissioner would get to determine which amount shall apply.
This case was argued only on the basis of Division 13. The Court did not have to decide whether the Commissioner could apply the relevant treaty rules as an alternate basis for transfer pricing adjustments. Importantly, the Court found that there was no evidence that OECD member States had adopted a practice of applying OECD guidelines. Accordingly, they were not a legitimate aid to construe the treaties and there is no principle of statutory construction that requires domestic legislation to be read as if it were an international agreement.
As noted above, the Commissioner of Taxation (the Commissioner) maintains that he has long held and publicly expressed a view that the treaty transfer pricing rules, as enacted, provide an alternate basis to Division 13 for transfer pricing adjustments (see for example, TR 97/20).
Transfer Pricing Benefits may be negated
New Division 815 will authorise the Commissioner to make a determination to negate a transfer pricing benefit for an Australian resident entity where the requirements of an associated enterprises article (or the business profits article) are met. That is, the new Division only applies where there is a relevant tax treaty. Broadly, a ‘transfer pricing benefit’ is based on the difference between the profits that an entity would have made having regard to the arm’s length principle, and the amount it actually made. The Commissioner may make a determination under Subdivision 815-A to adjust the entity’s tax position in order to ‘negate’ this benefit.
These rules require an allocation of profits consistent with the conditions that might be expected to have operated between independent parties in comparable circumstances dealing on a wholly independent basis. Although the appropriate allocation of profits may be achieved by determining the arm’s length price for particular transactions, this may not always be the case. Presumably, based on the outcome in SNF, there is concern that the determination of an appropriate price for an individual transaction considered in isolation may not of itself produce an outcome consistent with the arm’s length principle as articulated in Australia’s international tax agreements. As noted above, new Division 815 will apply retrospectively (from 1 July 2004) to ensure that there is alignment between Division 13 and the treaty transfer pricing rules. Somewhat curiously however, this means that entities trading with treaty partners are subject to stricter transfer pricing rules than those that apply to non treaty trading partners.
Interaction between the Transfer Pricing and Thin Capitalisation Rules
The interaction between Australia's thin capitalisation and transfer pricing provisions has also been addressed in new Division 815. The new Division 815 makes clear that a transfer pricing benefit relating to debt deductions only arises in relation to an adjustment to the rate of interest and not the level of debt (the thin capitalisation rules operate to determine the maximum level of debt). However, in determining the arm's length rate of interest, it is necessary to have regard to the level of debt that is likely to exist where the parties were independent of each other.
The Explanatory Memorandum outlines the interaction of the transfer pricing and thin capitalisation rules as follows:
Determine the arm’s length interest rate applying to a debt interest in accordance with the transfer pricing rules contained in section 815-15.
- For these purposes, it will be necessary to consider (for an associated entity) the conditions operating between the entity and its associate(s) in their commercial and financial relations. The arm’s length rate may need to be determined by having regard to the conditions which could be expected to operate between entities dealing wholly independently with each other.
- For example, in some exceptional cases (as mentioned in the relevant OECD guidance material), it may be appropriate to determine the arm’s length rate having regard to the amount of debt the entity is likely to have had, had the conditions operating between it and its associate(s) been aligned to what they would have been if the entities had been independent of each other. Alternatively, it may be possible to determine an arm’s length rate, directly or indirectly, by some other means without having to determine an arm’s length amount of debt.
- Whether an entity’s amount of debt meets the safe harbours provided for the purposes of the thin capitalisation rules is not relevant for this first step.
Apply the arm’s length rate to the entity’s actual amount of debt.
- The result of this second step would be used by the Commissioner in determining the amount of the transfer pricing benefit (if any) to be negated. The amount of debt deductions of the entity remaining after the transfer pricing benefit has been negated is the amount which would be otherwise allowable under this Subdivision, and which then becomes the amount of debt deductions to be considered for the purposes of Division 820.
The thin capitalisation rules in Division 820 may reduce an entity’s otherwise allowable debt deductions if in the case of a non-Authorised Deposit-taking Institution, the entity’s adjusted average debt exceeds its maximum allowable debt (this is after the consideration of any other part of the income tax law as may be necessary).
The position adopted is conceptually consistent with the 1986 OECD report on thin capitalisation and the ATO position as set out in Taxation Ruling TR 2010/7. Accordingly, where an entity has deeply subordinated or mezzanine finance which would not be advanced where the parties were dealing on arm's length terms, then the interest rate which should apply (even where the actual debt is within permissible limits for the purposes of the thin capitalisation rules) may be lower than the actual interest that is accruing on that debt. The Commissioner is authorised to negate this transfer pricing benefit under new Division 815.