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Focus: Transfer pricing update – new APA guide and recent ATO rulings

18 March 2011

In brief: The Australian Taxation Office has released a practice statement on its advance pricing arrangement program, following on from other recent tax ruling guidance on the application of Australia's transfer pricing provisions to multinational enterprises. Partner Toby Knight (view CV) and Lawyers Julian Feiner and Claire Nicholson report.

How does it affect you?

  • The creation of three different 'products' within the advance pricing arrangement (APA) program should make the APA application process simpler and less time consuming for some taxpayers, but the practice statement also deals with situations in which the APA application might turn into a risk review on a 'collateral issue', or a Part IVA audit.
  • Recent Australian Taxation Office (ATO) public rulings, concerning business restructuring arrangements and the interaction between Australia's transfer pricing and thin capitalisation rules, will assist multinational enterprises in identifying the aspects of their international related party transactions that are likely to come under scrutiny from the ATO and where the ATO line might be drawn. The retrospective application of these rulings means that multinationals may need to revisit past transactions.

The new APA guide

On 17 March 2011, the ATO released a new comprehensive guide on its APA program, in Practice Statement Law Administration PS LA 2011/1. This practice statement replaces the previous APA ruling, Taxation Ruling TR 95/23.

The APA program's stated aim 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.

The practice statement formalises the following features of the APA program:

  • APAs are processed as 'simplified', 'standard' or 'complex';
  • transfer pricing risk assessment products are available as an alternative to APAs;
  • taxpayers have a right of internal review of decisions relating to the APA process; and
  • the ATO will withdraw from the APA process if Part IVA may apply to the arrangement.

Simplified APAs are available to taxpayers with an Australian tax consolidated group income of less than $250 million, and should be finalised within nine months of pre-lodgment discussions. APAs for complex international related dealings (ie 'where there is a significant amount of tax involved') are expected to be finalised within 24 months of pre-lodgment. All other APAs will be considered 'standard' and should be processed within 12 to 24 months of pre-lodgment.

Large business taxpayers who wish to avoid the cost and time associated with undertaking an APA, but still seek assurance as to the ATO's view of their transfer pricing risk, can request an ATO risk assessment or conduct a self-assessment risk review. The ATO risk assessment product is intended for use for one-off transactions or dealings that have a limited time span.

We note the following additional matters for taxpayers to consider:

  • The ATO may ask taxpayers to provide an independent expert's report in APA cases that involve complex transfer pricing issues. Taxpayers in such cases might engage an independent expert before becoming involved in pre-lodgment meetings, and ensure that the independent expert's analysis is subject to legal professional privilege until such time as it is decided to release the report to the ATO.
  • Where the ATO engages in negotiations with a foreign tax authority in relation to a bilateral APA, taxpayers will need to consider the merits of presenting factual information to both of the competent authorities in order to assist their negotiations.

Transfer pricing and restructuring arrangements

Taxation Ruling TR 2011/1 explains the ATO's views on the application of Australia's transfer pricing provisions to business restructuring arrangements of multinational enterprises.

The ATO confirms in the ruling that the arm's length principle applies to business restructures involving the international transfer of functions, assets and/or risks of a business. Examples of business restructuring arrangements covered by TR 2011/1 include:

  • the conversion of a distributor into a sales agency;
  • the conversion of a manufacturer into a toll manufacturer with management centralised in an entity outside Australia; and
  • business restructurings that involve the transfer of the ownership and management of intangibles such as patents, trademarks and brand names outside Australia.

The ruling emphasises that multinationals should prepare evidence of compliance with the arm's length pricing principle, in order to establish that the transfer price paid between related parties in respect of a restructure is that which might reasonably be expected between independent parties dealing at arm's length.

In those cases where there is insufficient data to apply an arm's length pricing method to business restructuring arrangements, the ATO states that it will determine the arm's length price by considering whether the transfer price 'makes commercial sense for the parties, having regard to what is in their best economic interests and the options realistically available to them at arm's length' (see paragraph 15 of TR 2011/1). The ATO's focus on the 'commercial sense' of the restructure will require a detailed analysis of the commercial rationale for the restructure from each entity's perspective and the overall business objectives being pursued. The ATO also requires multinationals to prepare a detailed functional analysis of the business, to show that the economic outcome of the transaction is consistent with contractual arrangements between the related parties.

The ruling applies both to past and future transactions. Multinationals might seek advice in preparing documentation that complies with the ATO's expectations under the ruling, but also in cases where the Commissioner of Taxation might seek to 'reconstruct' the transaction, consider whether he has legal ability under Australia's transfer pricing provisions to do so.

Interaction between Australia's transfer pricing and thin capitalisation provisions

The ATO also recently restated its views on the interaction between Australia's transfer pricing and thin capitalisation provisions, in Taxation Ruling TR 2010/7.

The ruling stems from the ATO's observation that some foreign parent companies have funded their Australian subsidiaries with a relatively low amount of equity and high amount of debt, and therefore have assumed a higher level of credit risk for that debt than an independent lender might be expected to assume (see paragraph 78 of TR 2010/7). This has led to ATO concerns that higher interest rates, guarantee fees or other support charges are being deducted by Australian subsidiaries of multinationals than would be payable on an 'arm's length amount of debt'.

Although the ruling contains certain concessions compared with a previous discussion paper, the ATO's approach remains controversial, and may present practical difficulties for taxpayers if the ATO seeks to price debt on amounts of debt other than the actual debt, notwithstanding that the actual amount of debt is within thin capitalisation limits. The ruling applies retrospectively, which means that taxpayers may need to revisit past intra-group funding transactions.

New Article 7 of the OECD Model Tax Convention

In other news, the Organisation for Economic Co-operation and Development (the OECD) has revised its approach to the attribution of profits to a permanent establishment under Article 7 of the OECD Model Tax Convention (commonly referred to as the 'business profits article'). Under the new authorised OECD approach, first, a functional analysis is undertaken to define and treat the permanent establishment as a hypothetical functionally separate and distinct entity. Second, transfer pricing principles developed for Article 9 (associated enterprises) are employed by analogy to remunerate the permanent establishment for tax purposes as if it were a distinct and separate enterprise from the remainder of the relevant legal entity. This approach may also encompass notional charges rather than just actual deductions.

Contrary to the new OECD approach, the ATO currently does not accept that the business profits article in Australia's existing double tax treaties operates on a strict separate entity basis (see Taxation Ruling TR 2001/11). None of Australia's treaties have formally adopted the new Article 7; however, Australia may seek to introduce the revised Article 7 in new treaty negotiations or in the renegotiation of existing treaties in the future.

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