Focus: Tax and Intellectual Property April 2004
Transfer pricing, intellectual property and advanced pricing agreements: how business taxpayers can protect themselves
In brief: What is the width of the definition of a royalty, and what can transfer pricing issues and advanced pricing agreements mean for business taxpayers? Senior Associates Monica Jordan and Marc Johnston look at these questions and provide some suggestions as to what taxpayers should consider if the Australian Taxation Commissioner contacts them with questions regarding their intellectual property dealings.
In his 2004 Compliance Plan, the Australian Commissioner of Taxation, Michael Carmody, identifies international dealings between related parties involving intellectual property (IP dealings) as a focus of audit activities in the coming year.
The Commissioner is concerned that IP dealings are being used to shift profits outside Australia. This can happen through:
excessive royalty payments from Australia to offshore related parties; or
shifting Australian intellectual property offshore in circumstances where the Australian party does not receive full value for the offshore use of that intellectual property.
The Commissioner proposes to address these concerns through a range of methods, including education, rulings, risk reviews, audits and by promoting Advanced Pricing Agreements (APAs). The Commissioner may also seek to make adjustments to IP dealings under the transfer pricing provisions of the tax legislation. Transactions with tax havens will be of particular interest to the Commissioner, who is concerned to see that any profit allocated to a tax haven is commensurate with the economic value added by the tax haven.
For taxation purposes, 'royalty' has an extended statutory definition that is wider than its ordinary meaning of payments for the use of rights owned by another. Among other things, the extended definition covers payments or credits for:
- the use of any intellectual property;
- the use of industrial, commercial or scientific equipment (eg equipment royalties);
- the supply of scientific, technical, industrial or commercial knowledge, information or assistance (eg know-how);
- the supply of any assistance ancillary and subsidiary to, and furnished as a means of enabling the application or enjoyment of, any property, right, equipment, knowledge or information noted above; and
- undertaking that any of the above types of property or rights will not be granted or supplied to any person.
The width of the definition indicates the extensive range of underlying transactions giving rise to a royalty that the Commissioner would target if reviewing a taxpayer's IP dealings. The width of the definition is also important because the Commissioner will seek to impose withholding tax on royalty payments made offshore and would expect to see similar payments being received in Australia by the holders of Australian intellectual property that is used outside Australia.
A related issue is the market valuation of intellectual property. The market value of intellectual property indicates the level of royalties that a user would be expected to pay for the use of that intellectual property. The Commissioner states in the Compliance Plan that the Australian Taxation Office (ATO) will investigate instances where there are discrepancies between the market valuations of the intellectual property in one context and the tax values of the intellectual property in the business in another context. An example of this might be cases where a low royalty is paid on Australian intellectual property used by a related party offshore indicating that the intellectual property has a low market value yet large amortising deductions are claimed for the same intellectual property for Australian tax purposes.
Broadly, the transfer pricing provisions allow the Commissioner to make adjustments to income and deductions for certain international related-party transactions by deeming an arm's-length consideration.
A taxpayer may avoid the operation of the transfer pricing provisions by entering into an APA. In the past, the majority of taxpayers who have entered into APAs have been large business taxpayers. However, the Commissioner is of the view that APAs may also be appropriate for small-to-medium enterprises with cross-border related-party transactions and has stated that the ATO will seek to streamline the process for these businesses.
An APA may be bilateral or unilateral. A bilateral APA is an agreement between the Commissioner, the taxpayer and the relevant foreign tax authority on the income tax treatment of the cross-border transactions between related parties. A unilateral APA is made between the Commissioner and the taxpayer.
An APA generally lasts for three to five years. It sets out the transfer pricing methodology that will be used to establish arm's-length prices for the transactions covered by the APA. The APA also sets out the critical factors and assumptions that underlie it. If these factors or assumptions change, the APA is no longer binding but may be amended by the parties. While an APA is operative, the Commissioner will not seek to apply the transfer pricing provisions to the taxpayer, provided the taxpayer has complied with the APA (the taxpayer is required to submit an annual compliance report detailing compliance with the APA).
The Commissioner actively encourages the use of APAs, stating that an APA may:
- provide an agreed pricing methodology where there is no realistic, alternative way of both avoiding double tax and of ensuring that all profits are correctly attributed and taxed;
- provide certainty on an appropriate transfer pricing methodology, therefore increasing certainty in the tax treatment of international transactions;
- substantially reduce the possibility of double taxation;
- limit expensive and time-consuming examinations of major transfer pricing issues arising under an audit and lessen the risk of litigation; and
- place the taxpayer in a better position to predict costs and expenses, including tax liabilities.
Taxpayers should carefully consider whether an APA would be appropriate in their circumstances. The process of applying for an APA may be expensive and time-consuming. This is particularly so because the taxpayer must show that the proposed methodology produces arm's-length results between the taxpayer and the related foreign parties. Additionally, while it is possible for an APA to only deal with certain international transactions, the Commissioner would normally seek to consider all of the taxpayer's cross-border transactions and to consider the taxpayer's business as a whole. This may increase the cost and complexity of the process, and would need to be weighed up against the benefits that the APA may provide.
All taxpayers (whether contemplating entering into an APA or not) need to be able to justify the basis of the pricing of their IP dealings and the market valuation of that property. The greater the taxpayer's contemporaneous records regarding pricing, the easier it will be for the taxpayer to establish that the royalties or other consideration paid or received for the use of intellectual property represents arm's-length pricing.
The best way to deal with a potential tax audit is to minimise the risk of it occurring. Before commencing an audit, the ATO would generally undertake a risk review. If a taxpayer can show at an early stage that it has internal strategies and controls to effectively manage its transfer pricing issues, and there is accurate and timely documentation supporting this, there is a chance that the ATO will move onto a higher risk taxpayer to audit.
If a tax audit is to occur, the taxpayer must implement a strategy to deal with the audit in much the same way as it would deal with any other risk facing the business. An appropriate strategy to manage a transfer pricing audit should involve:
- establishing an audit team comprised of employees of the taxpayer who have knowledge of the various matters that are the subject of the audit;
- appointing a single liaison officer as the sole point-of-contact for the conduct of the audit;
- requesting that the ATO confirm the scope of the audit and the income years covered;
- managing the ATO's access to the taxpayer's premises; and
- keeping records of all documentation supplied to or copied by the ATO and all answers given by employees questioned by the ATO.
The audit team should 'brainstorm' how it perceives the audit will be carried out and how it should be dealt with by the taxpayer, including considering the questions that the ATO is likely to ask and the answers to be given. The ATO has significant access powers and it must be provided with 'all reasonable facilities and assistance for the effective exercise of its powers'. Any failure to do so exposes the taxpayer and its employees to the offence provisions of the taxation legislation.
Prior to the audit occurring, it is vital that the audit team master the facts and analyse the issues to determine the strengths of the taxpayer's position and expose any weaknesses that could hinder successful negotiation or litigation with the ATO. Depending on the level of pricing analysis previously undertaken, it might be appropriate to appoint an independent economist to assist you at this stage.
After the audit, the ATO usually prepares a position paper dealing with its views on the proper taxation consequences of the transactions entered into by the parties. This is when negotiations commence and there will either be a settlement entered into with the ATO or, if negotiations fail, an amended assessment may be issued.
Although taxpayers may have been lulled into a false sense of security over the past two decades that they will not be the subject of a tax audit, the ATO has firmly indicated its intention to escalate the number and extent of audits that will be carried out over the next few years. It is therefore vital that taxpayers implement appropriate strategies to deal with their transfer pricing risks so that they are well-placed to deal with any audit carried out by the ATO.
- Tony SheehanConsultant,
Ph: +61 2 9230 4781
- Peter AllenConsultant,
Ph: +61 7 3334 3350