On 12 November 2014 the ATO issued its long awaited Taxation Ruling TR 2014/6 titled: “Income tax: transfer pricing – the application of section 815-130 of the Income Tax Assessment Act 1997” (the “Act”). The ruling provides the Australian Taxation Office’s (“ATO”) view on how it will determine whether an entity derives a transfer pricing benefit from the “actual” commercial or financial cross-border dealings of a taxpayer when compared to the outcomes from those same dealings that “might be expected” to have arisen between independent entities dealing at arm’s length.
TR2014/6 addresses the Commissioner’s controversial power to reconstruct a taxpayer’s actual transactions. The ruling was originally issued in draft 1 form in April 2014 and we then stated, oftentimes there are no comparable transactions (with arm’s length parties) against which a taxpayer may benchmark its dealings simply because a parent company will generally only deal with a subsidiary. It follows that hypothesising what independent parties would or would not have done at the time of the taxpayer’s ‘actual’ transactions will, no doubt, lead to some highly controversial transfer pricing disputes.
The challenges with hypothesising what independent parties would or would not have done in comparable circumstances are many. On the one hand, the hypothesis will take place with the benefit of hindsight, many years after the event; further, as alluded to above, it is exceptionally challenging and subjective to make comparisons and draw conclusions in relation to transactions where there are no arm’s length comparables; and arguably, most importantly, underlying every business decision is an appetite for risk and this appetite differs from one taxpayer to the next. The potential for dispute is real and substantial.
2. Section 815-130 and the ‘basic rule’
The objective of Subdivision 815-B is to ensure that the amount brought to tax in Australia reflects the arm’s length contribution that might be expected to be derived by comparable independent entities.
The key provision is Section 815-130(1), this section sets down the so-called “basic rule”. The basic rule, has regard to both the form and substance of a transaction and requires the identification of arm’s length conditions based on the “actual” commercial or financial relations as they operated; that is, in essence, one determines an arm’s length price based on the actual dealings as transacted.
The ruling states: “In most cases, it is expected that the identification of the arm’s length conditions will be able to be accomplished by applying the ‘basic rule’ and determining the arm’s length contribution made by the Australian operations based upon the form and substance of the commercial or financial relations in connection with which the actual conditions operate.” 2
3. Arm’s Length Conditions, Form and Substance
The identification of arm’s length conditions, conditions being the commercial or financial arrangements which ultimately affect the entity’s economic or financial position, is critical as it is this process that evaluates the form and substance of the commercial or financial relations and determines the conditions that independent entities dealing wholly independently in comparable circumstances “might be expected” to have operated under 3 . This evaluation is to the completed so as to achieve the highest level of consistency with OECD Guidelines 4 .
The “form” of the commercial or financial relations describes the legal characteristics of the dealings between entities; generally, although not always, these are the documented contractual terms of the arrangement.
The ruling states that the “substance” of the commercial or financial relations “…describes the economic reality or essence of those dealings and is determined by examining all of the relevant facts and circumstances…from a practical and business point of view…” 5
4. Exceptions to the “basic rule”
As noted, the ruling states that in most cases the form of transactions will be consistent with their substance and the basic rule will apply; like the OECD Guidelines, however, the ruling states that in “…exceptional circumstances…” the basic rule, will not apply.
In the case of the OECD Guidelines we note that the word ‘exceptional’:
“…is similar in meaning to ‘rare’ or ‘unusual’. It reflects that in most cases it is expected that the arm’s length principle…can be satisfied by determining arm’s length pricing for the arrangement as actually undertaken and structured.” 6
Whilst the language of the OECD Guidelines appears to closely align with Section 815-130 I suggest that the OECD Guidelines, as presently drafted, would be less likely to countenance reconstruction than appears to be the case in TR 2014/6.
The exceptions to the basic rule, there are three of them, only come into play if a taxpayer derives a transfer pricing benefit or advantage from the dealings. The exceptions operate to potentially disregard the actual transaction, or part thereof, and enable the ATO to hypothesise and substitute what it believes are arm’s length dealings. The three exceptions are:
- First Exception: Where the legal “form” of the actual commercial or financial relations is inconsistent with the “substance” of those relations. In these circumstances the form of the actual dealings are “recharacterised” or “disregarded”, to the extent of the inconsistency and arm’s length conditions are based on the ‘modified’ commercial or financial relations that accurately reflect their substance7.
- Second Exception: Where independent entities “would have” entered into other commercial or financial relations which differ in substance from the actual dealings the behaviour of independent entities, acting in a commercially rational manner in comparable circumstances, is hypothesised and may replace the actual arrangements.8
- Third Exception: Where independent entities in comparable circumstances “would not” have entered into any commercial or financial relations, one disregards the actual conditions with the result that one hypothesises that “nothing would have occurred”9and this scenario may replace the actual dealings.
The reconstruction provisions make clear the fact that taxpayers are well advised to address their possible application; to this end taxpayers should consider evaluating:
- Whether the substance of their business dealings accords with that documented;
- Why it is they have continued to suffer losses (perhaps by illustration to forecast results, new competitive forces and so on);
- How their business strategy, perhaps a market penetration strategy, may justify their current year’s operating performance;
- What are the business options realistically available and why does the option adopted make ‘commercial sense’;
- Whether independent parties dealing at arm’s length might reasonably be expected to have entered into the transactions in question and whether the basic rule or one or other of the three exceptions applies or does not apply.
Taxpayers should address issues such as those above, where relevant, in their transfer pricing documentation when they self-assess whether or not a transfer pricing benefit has or has not been derived. This documentation will comprise a critical element of a taxpayers transfer pricing ‘risk assessment’ process as a failure to comprehensively review and document this analysis will result in significantly greater penalties in the event that an adverse transfer pricing adjustment is successfully prosecuted against them.
ATO representatives have stated that the evidentiary requirement for it to apply Section 815-130 is a ‘pretty steep hurdle’ (insofar as it requires one to conclude that independent parties ‘would‘ or ‘would not‘ have done something); the process that taxpayers are effectively required to follow is somewhat opaque, tortuous and lacking in guidance 10 . There is an argument, however, that if a taxpayer satisfies the ‘basic rule’ one should not be required to evaluate the three exceptions thereto. The appendix to the ruling does not support this view; it states that:
“The use of the word ‘despite’ in subsections 815-130(2) to 815-130(4) means that entities must determinewhether the circumstances described in one of those subsections apply and, as a result, whether the commercial or financial relations in connection with which the actual conditions operate are disregarded for the purposes of identifying the arm’s length conditions.” 11
Having regard to the great controversy surrounding Section 815-130 and TR 2014/6, the ATO today announced that it is currently preparing a practice statement requiring the approval of an ATO senior executive prior to the use of that provision. The practice statement will further require the ATO senior executive to consult with the International Division of the ATO before agreeing to the use of 815-130. 12 It is to be hoped that this development will temper the otherwise potentially inadvertent application of this provision.
In the final analysis, the relevant question for taxpayers is whether independent entities behaving in a commercially rational manner and acting in their own best commercial and economic interests would have dealt with one another in the same way they have actually acted having regard to the options realistically available to them; if they satisfy this hurdle and the transacti ons have substance, they should make ‘commercial sense’ and not fall foul of Section 815-130.
5. Arm’s Length Debt Deductions and Thin Capitalisation
The interaction of Subdivision 815-B with the thin capitalisation provisions is dealt with in the ruling and restates the legislative position in relation to the pricing of debt deductions.
Section 815-140 modifies the debt deduction calculation methodology (where a transfer pricing benefit has been derived) and details how Division 820,(dealing with the thin capitalisation provisions), interacts therewith.
Section 815-140 requires that the interest rate to be applied is determined on the basis that the arm’s length conditions operated; the arm’s length rate so determined is then applied to the debt “actually” issued by the entity. Following this analysis, Division 820 may then apply to further reduce debt deductions (if and to the extent the thin capitalisation provisions have been breached). A good example of this interaction is provided in the ruling.
6. Examples and Consequential Amendments
Many examples illustrating the ATO interpretation of Section 815-130 are provided in the appendix to the ruling and two examples are enshrined within the ruling itself. One of the examples in the ruling, (adopted from a like example in the OECD Guidelines), is illustrated in further detail later in the Appendix (as Example 5) to the ruling.
This example deals with the sale, under a long term contract, of intellectual property rights arising from future research, for a lump sum payment and seeks to illustrate the second exception noted above. Based on the analysis in the ruling the ATO states that it is reasonable to conclude that independent entities would not have entered into the actual commercial and financial relations, rather it would have entered into other arrangements. The example proceeds to state that it could be the case that the taxpayer’s taxable income was less that it should be and that a transfer pricing benefit was derived. Accordingly, “…it might be appropriate to adjust the terms of the agreement in a commercial and rational manner as a continuing research agreement and identify the arm’s length conditions on that basis.” 13 This position is justified 14 on the basis that:
- There is no market based evidence of comparable transactions;
- The unusual nature of the ‘lump sum’ pricing arrangement;
- It does not make commercial sense to sell the IP for a lump sum; and
- The structure of the transaction impedes the identification of an appropriate transfer price.
This begs the question: what about the actual transactions that have taken place (recognition of assessable income or capital gain on the sale of the contractual rights, potentially royalty payments for the right to use IP etcetera). In the ruling compendium 15 the ATO states: “…it may be the case that the Commissioner would make a determination under Section 815-145 to provide a consequential adjustment to a disadvantaged entity.” 16
We submit that if a transfer pricing benefit is found to have been derived by the taxpayer the example should provide greater clarity and certainty as to how and under what circumstances the ATO proposes to make a consequential adjustment. Having said that, taxpayers have the right, under Section 815-145, to request that the Commissioner make such a determination and they have rights of objection and appeal in relation thereto. 17 In addition, taxpayers can take some solace from OECD Guidelines or ‘guidance’ (that the Commissioner is directed 18 to consider), wherein it states: “…any non-recognition of the restructuring arrangement would need to reflect that a transfer of such property occurred between the two parties, although it may be appropriate to replace the character of the transfer with an alternative characterisation thatcomports as closely as possible with the facts of the case…” 19 .
7. The Double Taxation Quandary
On the other side of each and every reconstruction, annihilation, substitution or restatement of a taxpayer’s transfer pricing business arrangements resulting from the application of Section 815-130 is another taxpayer and a foreign tax jurisdiction(s). The potential for disagreement with the foreign jurisdiction is readily apparent and the OECD recognises the restructuring dilemma in the OECD Guidelines wherein it states:
“In other than exceptional cases, the tax administrations should not disregard the actual transactions or substitute other transactions for them. Restructuring of legitimate business transactions would be a wholly arbitrary exercise the inequity of which could be compounded by double taxation where the other tax administration does not share the same views as to how the transaction should be structured.” 20
In the absence of relevant tax treaties containing compulsory binding arbitration clauses, and very few do so 21 , in the author’s view the possibility of double taxation will prove not only a frustration but a serious financial burden faced by taxpayers. This is so given nearly all Australia’s tax treaties include a mutual agreement article that merely requires that competent authorities “…shall jointly endeavour to resolve by mutual agreement…” or “…endeavour… to arrive at a satisfactory conclusion…” and so on. There is no requirement to come to an agreement (and, in the author’s experience, agreement by Competent Authorities is not always reached in transfer pricing disputes).
One possible way to address the want of an arbitration clause in our tax treaties is for the Australian Government to agitate in its various roles at appropriate OECD and G20 meetings for inclusion of an arbitration clause in the “multinational instrument” proposed by the OECD as a part of Action 15 of the OECD Action Plan on Base Erosion and Profit Shifting. The intention is that a proposed multinational instrument in question would amend all bilateral tax treaties in one fell swoop.
We note that the OECD has concluded that it is both desirable and feasible to develop and introduce a multinational instrument which will have the same effect as the “…simultaneous renegotiation of thousands of bilateral tax treaties”. 22Whether or not our Government (and treaty partners) have the ‘willpower and metal’ to enter into such an ‘instrument’ remains to be seen.
8. Date of Effect
The ruling applies to income tax years commencing on or after 29 June 2013. More importantly, Subdivision 815-B “…applies to transactions or arrangements that occurred “before” 29 June 2013, to the extent that those transactions or arrangements affect an entity’s Australian tax position on or after 29 June 2013.” 23
The fact that subdivision 815-B applies to transactions that have a “flow-through” impact to taxpayers for years commencing on or after 29 June 2013 creates a very onerous obligation upon taxpayers; that being, to give some consideration as to whether a transaction that may have taken place some years earlier, such as the sale of intellectual property rights, has or may have resulted in a transfer pricing benefit in the current year. Arguably, the possibility of such adjustments raises the question as to the legitimacy of such legislation as in essence it is retrospective in effect 24 .
The reconstruction powers enshrined in Subdivision 815-B of the Act introduces a power that is expected to prove both highly contentious, time consuming and complex to administer as taxpayers self-assess whether or not they have derived a transfer pricing benefit and, in particular, whether any of the reconstruction provisions may apply (in the current year or, because of the flow-through effect of a transaction or transactions, entered into in some prior year).
The provisions are contentious because of the inherently subjective nature of any reconstruction of actual dealings to purportedly align them with ‘hypothetical’ arm’s length dealings and because they will lead to double taxation as the OECD Guidelines and our tax treaties presently stand; in this regard, the ATO is to be commended for advising that the use of these provisions will be restricted to senior officers of the ATO and that consultation within the ATO International Division is required before the provisions can be applied.