Transfer Pricing and Corporate Tax Developments for Australia

As 2012 draws to an end, transfer pricing continues to be an area of development and surprises. On 22 November 2012 the Assistant Treasurer released an expected but delayed exposure draft of legislation and an explanatory memorandum to replace the current transfer pricing rules in Division 13 of the 1936 Act. Surprisingly on the same day he gave a speech which in effect questioned the current international tax system of which transfer pricing rules are a central part and on 10 December 2012 he appointed a specialist reference group on ways to address tax minimisation by multinational enterprises.

During the year the OECD and UN have been sparring over the future of the international transfer pricing rules which may be about to undergo substantial change. On the domestic front the Government referred the taxation of permanent establishments to the Board of Taxation to determine whether Australia should adopt the 2010 OECD revised version of the business profits article and its "functionally separate entity" approach instead of Australia's current "single entity" approach.

This tax brief explains and draw the links between these various events.

1 Exposure draft legislation

The Exposure Draft (ED) legislation will ultimately replace the current domestic law transfer pricing rules. It is a further result of the consultation paper released in November 2011 which earlier in 2012 gave rise to the controversial legislation designed to buttress retrospectively to 2004 the ATO view that tax treaties contain independent powers to make transfer pricing adjustments. On the earlier legislation, which according to the draft explanatory memorandum (EM) accompanying the ED will be effectively repealed when the ED becomes law, see our tax brief at http://www.gf.com.au/829_1161.htm)

The ED is not exactly new news. Very similar rules were enacted for the minerals resource rent tax and the EM to that legislation provides further examples that are probably relevant to the ED, though not repeated in its EM. The ED replaces the rules for both separate entities and adjustments to profits of permanent establishments (PEs). In regard to the latter the ED maintains the "single entity" approach of current law, which is currently being considered by the Board of Taxation as discussed below.

Transfer pricing rules will be – largely – self operating

The operation of the legislation proposed by the ED is not premised on a determination being made by the Australian Taxation Office (ATO) unlike Division 13, that is, it is self operating which is regarded as appropriate for self assessment. This change which was recommended 13 years ago in the Ralph Review of Business Taxation probably does not make much difference in practice.

A determination is still required for consequential adjustments to disadvantaged taxpayers. Such adjustments will usually be made to foreign associates of the taxpayer, for example, to reduce a withholding tax liability for interest or royalties paid to them and for which deductions are reduced under the transfer pricing rules for the payer. Oddly, although the ED is clear that such a claim should be made by the affected taxpayer, the EM (sensibly) suggests that the Australian taxpayer can make the request. The same taxpayer can be the disadvantaged taxpayer in relation to a later year of income, for example, if an adjustment results only in a timing difference.

How does the ED operate for separate entities?

The ED operates by substituting the "arm's length conditions" for "the actual conditions" prevailing between separate entities. Apart from only operating when the actual conditions are different to the arm's length conditions, two other tests which must be fulfilled before an adjustment occurs are intended to confine it to cross-border situations when Australia is losing revenue.

The revenue test is that if arm's length conditions had operated the taxable income would have greater, losses would have been smaller etc. The crossborder test requires the other entity to be a non-resident or operating through an overseas PE. Thus a resident to resident case can only arise if an overseas PE of a resident is involved. This condition combines with the loss of revenue condition to decide which entity will be subject to adjustment.

The outcome seems intended to be the same as the definition of international agreement in Division 13 and it is not clear why that more elaborate definition was simply not retained. It may be possible under the new legislation that the transfer pricing rules could apply between an Australian PE of a non-resident and the Australian operations of an Australian subsidiary of the non-resident which is essentially a domestic case, not a cross-border one.

As with Division 13, it is intended that the new rules will operate irrespective of whether the separate entities are related. This is not stated directly but simply by the omission of any test that the parties be related.

The ED does not specify exactly what is adjusted – taxable income or assessable/exempt/NANE income or deductions. The ED elsewhere and the EM refer to components of taxable income indicating that it is intended to operate at the assessable income etc levels but this lack of precision may well lead in future to similar kinds of debates as recently bedevilled Division 13, for example, what is adjusted when a profit method is used. The new rules no longer identify a particular international agreement as the unit whose pricing is to be adjusted, but require consideration of the entirety of the commercial and financial relations between international parties and allow an overall net profit adjustment. The signals sent by the ATO in recent years indicate that it would like to use profit methods more broadly. This may change the approach required for importers and exporters of tangible goods, which typically price on a transaction basis – rather than working forward from price to profit (taxable income), they may have to work backwards from profit to price (and hence income or deductions).

Relationships to other parts of the income tax legislation

The ED adopts the kind of awkward over-arching drafting of Division 13 that the new rules trump everything else in the income tax legislation. This is a drafting device that can only sensibly be used once yet it is present in a number of forms in the income tax, for example, in the TOFA rules. What happens when two parts of the legislation with such drafting potentially operate in a given case?

Even if this issue is fixed (or ignored as it generally is), the ambiguity in Division 13 has always been to what extent it operates for detailed provisions like Division 40 and CGT which themselves have similar language. ATO rulings, perhaps wisely, have avoided answering this kind of problem fully. In practice this will remain an uncertain issue for taxpayers which will continue to have implications for penalties.

Surprisingly the relationship to tax treaties is left up in air, particularly on the vexed issue of whether treaties contain independent adjustment powers or whether they simply authorise such provisions in domestic law. As already noted it seems that the recent legislation to deal with this issue, albeit by an indirect means, is to be repealed (the transitional provisions are to be drafted so we do not have draft legislation for this situation as yet but the EM indicates this intention). The impression is given by the EM that tax treaties give independent powers but the EM example is inconclusive as it is consistent with either view. One suspects that it is hoped that the much closer alignment of domestic law with tax treaties will render the issue moot in the future.

Unlike Division 13, the ED does not contain a sourcing rule for the amounts that are adjusted. The EM simply suggests that sourcing follows from the substitution of the arm's length conditions but it is unclear how this can be so. Source generally depends on the facts and circumstances which can include where contracts are entered into. How can "arm's length conditions" tell taxpayers where contracts would be entered into? Moreover the current source rule for profit allocation to PEs is to be kept in place.

The one bright spot on relationship issues concerns thin capitalisation. Like the recently enacted transfer pricing legislation, the ED helpfully enshrines the result reached by an ATO ruling that (in simple terms) the transfer pricing rules relate to the interest rate while the thin capitalisation rules determine the amount of permitted debt for generating interest and similar deductions.

Consistency with OECD

One of the main purposes of the ED is to align Australia's transfer pricing rules with the international norms generated by the OECD to achieve certainty and international consistency. The ED requires that the transfer pricing rules it enacts "be interpreted so as best to achieve consistency with the documents covered by this section (except where the contrary intention appears)", the major document being the OECD 2010 Transfer Pricing Guidelines (TPG).

In fact Australia's usual associated enterprises article in its tax treaties is different from the OECD version, in that the former requires that "conditions operate between the two enterprises in their commercial or financial relations which differ from those which might be expected to operate between independent enterprises dealing wholly independently with one another". The difference relates to the italicised words and the Treasury suggested in its November 2011 consultation paper that the "departures impose a slightly more objective test on the 'conditions' than the OECD". The ED adopts these Australian treaty words rather than the OECD wording so it is important to know precisely what the difference is.

The ED in addition adds the words "in comparable circumstances" which are not found in the OECD Model or Australian treaties. The EM has extensive material on comparable circumstances which in part seems just to be summarising the TPG but in other cases may go further.

Further the TPG are not to be applied if "the contrary intention appears." There are a number of respects where there may be such a contrary intention though not explicitly recognised as such in the EM. The ED contains some confusing provisions on economic substance taking priority over legal form, including disregarding legal transactions. The OECD makes clear that disregarding transactions is a very exceptional case, whereas this is not the impression given by the ED. Is this context otherwise requiring?

The OECD currently says safe harbours are not to be used while the ATO has a ruling with some safe harbours for services. Is this enough to exclude current OECD guidance? If not the matter is complicated by the fact that the OECD issued a draft revision of the safe harbour material in June 2012 which almost certainly will lead to a reversal of its current view. Will Australia be stuck with the current OECD view until a regulation is made adopting the new view? Will the ATO retain its current safe harbours in place?

Administrative issues

The ED adopts an 8 years limitation period for transfer pricing adjustments as has now been signalled several times by Treasury. While an improvement on the current unlimited period, this is still too long particularly compared to other countries.

The separate penalty regime for transfer pricing is retained and that regime is under the ED to be applied (though to a reduced amount) even if there is no subjective purpose to get a scheme benefit. A minor de minimis rule is also proposed for the regime. Moreover, transfer pricing documentation (going way beyond normal income tax documentation requirements) is made "elective" for taxpayers, the downside being that a reasonably arguable position defence will not be available to taxpayers if the documentation is not kept.

These administrative changes apply both to separate entities and in relation to attribution of profits to PEs.

2 Board of Taxation Discussion Paper on permanent establishments

The reason for referring the issue to the Board was the adoption by the OECD in 2010 of a new business profits article in its Model treaty, a new Commentary and a 240 page report on attribution of profits to PEs. The major difference to the former approach is that the PE is treated much more like a separate company than was previously the case, and specifically the reversal of the long established approach that deductions were not available to PEs for interest on notional loans from head office, royalties on notional licences and mark-ups on notional management fees – all the PE could deduct was an appropriate share of the external interest, royalty and service fees of the enterprise (with an exception for PEs of financial institutions in the case of interest).

The new OECD approach is referred to as the "functionally separate entity" approach and has been the subject of considerable differences among countries. A number of major OECD countries like the US and UK are following the new approach but many OECD countries (including New Zealand) and more importantly the UN and major non-OECD countries like China have rejected it. The DP is concerned with what approach Australia should take in the light of these developments, given that it currently adopts the different single entity approach. While the OECD work was designed to produce greater international consensus for the time being it has had exactly the opposite effect, an issue we return to below.

The Discussion Paper (DP) released at the end of October 2012 as usual is mainly descriptive and raises questions, rather than taking positions, on these issues. Essentially it asks whether Australia should change its current approach of allocating income and deductions to PEs (with some flexibility and special rules for financial institutions) in favour of the OECD approach of accepting notional transactions between a PE and the rest of the company in calculating the profits of the PE. If Australia does decide to change, the further issue is whether this should be by treaty, applied to all countries with which Australia currently has tax treaties, or adopted as the general standard in domestic law. Whichever route is taken (including the status quo) it will not be possible to prevent differences of approach with other countries given the lack of international consensus on the issues.

One important issue that is muted in the DP may become more lively given that the Business Tax Working Group subsequently abandoned its attempt to reduce the corporate tax rate funded by possible changes amongst others to Australia's thin capitalisation rules. The issue if Australia adopts the new OECD approach is whether it should change its thin capitalisation rules for PEs (with possible flow-on effects to other areas).

Another important issue is the OECD so called "same creditworthiness" rule, that is, that treating a PE as in effect a separate entity does not have the result that it has a different credit rating than the company overall. The OECD seems to regard this largely as a matter affecting financial dealings of the PE, but the DP seems at some points to regard it as a general issue with the possible result that it would be very difficult to find real world transactions as comparables for PE dealings (as the real world transactions may incorporate an assessment of credit risk in their pricing).

Of particular interest to Australian banks, the DP goes further than the OECD which was only concerned with taxation of the PE and double tax relief in the residence country. It also considers whether the head office country should be taxing any notional interest etc on dealings between the head office and PE.

In terms of foreign banks with PEs in Australia, the DP raises whether the LIBOR cap should be removed as required by the terms of reference but apart from noting that the Johnson Report recommended removal of the cap and asking whether there are alternative "benchmarks" or pricing information does not give any indication of direction. The discussion referred to in the previous paragraph of also taxing the head office is relevant here – Part IIIB already levies a withholding tax on notional interest from the PE to head office and that may become a more general approach to notional transactions.

3 OECD faces off with UN

The UN rejection of the OECD new business profits article is but one manifestation of a more general face off between the organisations. After years of following in the shadow of the OECD, the UN largely with the support of China, India and Brazil has begun to challenge OECD norms more aggressively (or perhaps more accurately the "new" economic powers are flexing their muscles against the "old" economic powers in North America and Europe). Two other events reflect the tension and the potential breakdown in international tax consensus that it may produce.

In June 2012 the OECD produced a number of discussion drafts for revising the TPG, the safe harbour material noted above and related drafts on the taxation of intangibles and valuation, as well as information on simplification measures being adopted by different countries in the transfer pricing area. At one level the OECD work is a response to the way in which technology companies are using the transfer pricing rules to pay little or no tax anywhere, an issue which has received a lot of international press coverage in 2012. In this regard the OECD has general agreement among transfer pricing delegates that profits from intangibles should not end up in tax havens:

At another level it is a response to the view of the new powers that the TPG on intangibles are deeply flawed, while the emphasis on safe harbours and simplification is a broader appeal to developing countries which rightly complain that transfer pricing has been made an impossibly complex exercise by the TPG for their tax administrations (not to mention taxpayers).

This kind of reason for the change in direction by the OECD became more evident when the second event occurred, the release of the UN Practical Transfer Pricing Manual in late October 2012, see http://www.un.org/esa/ffd/tax/documents/bgrd_tp.htm. While in part purporting to follow the TPG, the Manual in chapter 10 sets out the "country experiences" of China, India and Brazil which show scant regard for the TPG, in particular its treatment of intangibles. China indicates how it taxes "location specific advantages" which includes taxing foreigners using its large manufacturing base on "the additional profit derived by a multinational company by operating in a jurisdiction with unique qualities impacting on the sale and demand of a service or product." India indicates that it does not accept the cost plus approach to contract researchers while Brazil shows how it uses fixed percentage mark-ups for cost plus and retail price methods while rejecting profit methods.

The OECD clearly has a lot of work to do to rebuild the international transfer pricing consensus which requires changing the rules to get the new powers on board. This seems unlikely to occur in the short term given that the disagreements seem to be part of strategic positioning of the new powers on international economic issues.

4 Australia reacts

Australia may be between a rock and a hard place in trying to navigate these current international choppy waters as the Board of Taxation's DP suggests. On the one hand Australia is trying to indicate to the old powers that it follows the TPG (through the ED). On the other hand it realises that through geography and its comparative advantage in resources its future is closely bound to the new powers and needs to accommodate their views.

The Assistant Treasurer was partly reacting to these issues when he gave a speech on 22 November in which he announced the release of the ED, named names of taxpayers apparently engaging in shifting profits, explained some of the problems in the existing international tax system (without discussing the likely underlying politics) and presaged the future release of a scoping paper by Treasury on the sustainability of the Australian corporate tax base and potential solutions, informed by a reference group drawn from business, professionals, academics and the community sector. The membership of the group was announced on 10 December 2012 and the target publication date for the paper is mid 2013.

In a narrow sense the paper will deal with the application of transfer pricing to technology companies but the language of the speech indicates that it is likely to pick up from the work of the Business Tax Working Group (BTWG) which terminated unsuccessfully in early November. The BTWG was tasked with finding ways of reducing Australia's corporate tax rate by finding offsetting revenue in the business tax base and spending measures and was unable to do so. There has been a clamour for further work including in the GST Distribution Review Final Report released at the end of November.

The various BTWG publications repeated the analysis in the Henry Review drawing from modern economic literature which argues that in today's globalised open economy it is not possible to tax corporate income at source except to the extent that the income arises from immobile rents like natural resources and some other location specific advantages (recall China's use of this idea above). The analysis leads to the view that the corporate tax should in part be replaced by taxes on immobile rents and immobile factors (such as the MRRT), and in part be converted to a destination based consumption type corporate tax (effectively an indirect increase in GST).

As the Government has consistently rejected any changes to the GST, it will not be surprising if the destination corporate tax gets a run. Already, however, one of the members of the reference group prior to his appointment had responded to the Assistant Treasurer's speech with a caution to be careful what you wish for. Given Australia's large trade with China, much of Australia's corporate tax base could disappear to China if this style of tax were adopted by Australia and China directly, or indirectly such as through recognition of location specific advantages in a transfer pricing framework.

2013 looks set to be interesting and perhaps surprising for transfer pricing in particular and the corporate tax in general.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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