Australia’s New Transfer Pricing Laws

Australia’s new transfer pricing rules were introduced in June 2013 and now enable the Australian resident entity to self-assess whether there is a transfer pricing benefit for the purpose of their tax returns. There are two new draft tax rulings Draft TR 2014/D3 and Draft TR 2014/D4 as well as practice statements Draft PSLA 3673 and Draft PSLA 3672. These outline the ATO’s approach and views on how the transfer pricing laws apply and what taxpayers need to do and the new penalty regime.

With effect from 29 June 2013 there were several new Subdivisions of the ACT enacted including Subdivisions 815-B, 815-C and 815-D into the ITAA 1997 and Subdivision 284-E into Schedule 1 to the Taxation Administration Act 1953 (TAA 1953). Also repealed was Division 13 and subsections 170(9B) and (9C) of the Income Tax Assessment Act 1936 (ITAA 1936). These new subdivisions of the Australia's transfer pricing rules better align with the arm's length principle and the internationally consistent transfer pricing approaches as set out by the Organisation for Economic Cooperation and Development (OECD).

ATO have become increasingly aggressive on transfer pricing issues and we do expect to see a surge in ATO compliance activities.  In order to manage the additional risks and uncertainty that arise from Subdivisions 815-B and 815-C, affected companies need to have a clear framework and process for managing tax transfer pricing issues.

• A key part of the framework will be the use of contemporaneous transfer pricing documentation to explain the approach companies have followed and its consistency with the law.
• The documentation will also be relied upon to mitigate the extent of penalty tax in the event that the approach does not satisfy the arm's length principle.
• Companies should review their readiness for the new transfer pricing legislation and the new documentation rules. The ATO expectations expressed in the draft Rulings and Practice Statements should be thoroughly considered in this regard.

Transfer pricing: documentation requirements

Drafts TR 2014/D4 and PSLA 3673 set out the ATO's view on the transfer pricing documentation requirements that must be satisfied in order for a taxpayer to potentially have a Reasonably Arguable Position (RAP) for penalty reduction purposes.

Draft TR 2014/D4 sets out how taxpayers and the ATO should interpret and apply the tax law. Draft PSLA 3673 sets out a process for ATO officers to follow in administering the law. In practice, Draft TR 2014/D4 and Draft PSLA 3673 should be read together.

Draft TR 2014/D4 articulates the ATO's views on the interpretation and practical application of key concepts in the new law relating to transfer pricing documentation:

• Whether documentation will be taken to have been "prepared before the time by which the entity lodges its income tax return".
• What is required to "explain the particular way in which the law applies".
• What is required to "explain why the application of the Subdivision in that way best achieves the consistency" with the relevant OECD guidance material.
• What is required to "explain the particular way in which the Subdivision applies" in the context of the reconstruction provision (discussed below).
• What is required to "explain the particular way in which the Subdivision applies" in the context of the provision dealing with the interaction with the thin capitalisation regime.
• What it means for the required records to be able to be "readily ascertained".

A key point made in Draft TR 2014/D4 is that transfer pricing documentation prepared after the income tax return has been lodged cannot be taken into account in meeting the requirements in order to potentially have Reasonably Arguable Position (RAP) for penalty reduction purposes. As such, a taxpayer will not have a RAP in the event of a transfer pricing audit, even where documentation has been prepared unless it is prepared prior to lodgement of the company's tax return. This represents a strict view by the ATO and means taxpayers should ensure that documentation is prepared prior to lodging a tax return. For those companies with a 30 June 2014 year end, this will mean that documentation will need to be prepared by 15 January 2015. Practically, this means that should a transfer pricing adjustment occur as a result of ATO review activity and there is no contemporaneous documentation, an automatic penalty of 25% (or more for cases of recklessness or intentional disregard) of the adjustment will apply.

Draft PSLA 3673 sets out the ATO's new "5-step" process for taxpayers to follow when preparing transfer pricing documentation. It sets a higher standard for documentation in respect to a taxpayer's internal procedures and controls, management performance systems, divisional business plans, reports recommending strategies, and the balance and sources of debt and equity. The 5 steps are:

• Step 1: Identify the actual conditions in connection with the commercial or financial relations.
• Step 2: Select the most appropriate and reliable method to be used to identify the arm's length conditions.
• Step 3: Identify the comparable circumstances relevant to identifying the arm's length conditions.
• Step 4: Application of the transfer pricing rules so as best to achieve consistency with the relevant guidance material.
• Step 5: Monitor, review and update transfer prices, as necessary.

Transfer pricing - the application of section 815-130 of the Income Tax Assessment Act 1997

Central to the operation of Subdivision 815-B is the identification of the arm's length conditions which, in relation to conditions that operate between an entity and another entity, are the conditions that might be expected to operate between independent entities dealing wholly independently with one another in comparable circumstances (see subsection 815-125(1)).

Draft TR 2014/D3 provides the ATO's view on the application of s 815-130 of ITAA 1997. The ruling sets out the relevance of the actual commercial or financial relations in determining the arm's length conditions. The basic rule requires that the identification of the arm's length conditions must be based on the commercial or financial relations in connection with which the actual conditions operate, having regard to both the form and substance of those relation. However, the section provides 3 exceptions where arm's length conditions must be based on alternative commercial or financial relations. This is referred to as the reconstruction provision.

The reconstruction provision is not a power reserved for only the ATO to apply. Draft TR 2014/D3 states it must be considered in every case by taxpayers self-assessing whether or not they have received a transfer pricing benefit. Due to the complex nature of related party dealings this may be a difficult process for many taxpayers in particular whereby they may have numerous, unique and varied dealings. The ruling considers in detail the concept of economic substance of the commercial and financial relations prevailing over form, and follows the 2010 OECD TP Guidelines to achieve consistency in international standards. It is will be important for companies to carefully consider annually whether the substance of their relations is the same as the form as under the new provisions of the act the reconstruction provisions would apply so that the entity would not be rewarded for assuming any risk.  The key issue with the new provisions is that expects taxpayers (and allows the ATO) to test the individual elements of the actual relations, so as to determine which should be retained or rejected, and whether any additional elements should be included. This selective approach, under which the ATO can seek to choose individual elements to accept or disregard, potentially ignores the overall commerciality of the relations between entities.