By David Lewis, Managing Director of Duff & Phelps Australia Pty Ltd., Melbourne, Australia
The Australian Taxation Office (ATO) has, for many years, been concerned about the migration of intangible assets out of Australia, which they suspect is encouraged by Australia’s differentially high corporate tax rates.
To this end, the ATO has been reviewing international arrangements to determine if they mischaracterise Australian activities connected with the development, enhancement, maintenance, protection, and exploitation (DEMPE) of intangible assets.
In particular, the ATO is concerned that some arrangements may not be arm’s length resulting in inappropriate outcomes for Australian tax purposes. As a result, the ATO on 22 January issued Tax Alert 2020/1 outlining their concerns to facilitate a risk assessment by taxpayers.
While the tax alert raises issues concerning capital gains tax and Australia’s general tax anti-avoidance provisions, our comments on this alert are limited to transfer pricing.
In the tax alert, the ATO outlines examples of arrangements that are concerning them. While these arrangements are not uncommon, the alert emphasises in our view more extreme aspects to demonstrate the ATO’s concerns.
Australia’s reconstruction provision
The important thing to note is that Australia has included within its taxation law the so-called ‘reconstruction provision’ first raised within the OECD Transfer Pricing Guidelines, which in Australian law empowers the Commissioner to disregard actual commercial and financial relations for purposes of determining the arm’s length conditions.
A taxpayer needs to satisfy three exceptions so that the actual conditions apply. These are that the form of the commercial or financial relations is consistent with the substance, that independent entities would have entered into the actual commercial or financial relations rather than different arrangements, and that independent entities would have entered into the commercial or financial relations rather than avoiding them altogether.
A key way of managing these risks is to monitor these arrangements to ensure that mismatches of contributions to value creation do not arise, there is a clear commercial justification for any such arrangements entered into, and that the Australian entity is acting in its economic interest considering all the options realistically available to it.
The alert advises that the ATO is currently reviewing these arrangements and engaging with taxpayers who have entered into them or are considering doing so.
It also advises that the ATO’s assurance activities will continue as they develop their technical position on these arrangements.
The alert comes with a clear warning that taxpayers and advisers who enter into these types of arrangements will be subject to increased scrutiny. Accordingly, the alert encourages taxpayers to approach the ATO to discuss their situation if they are contemplating entering into these arrangements.
If a taxpayer has any of these arrangements in its transfer pricing infrastructure, it should assess the inherent risks to determine if they can be commercially justified and, if so, this should be clearly documented and maintained to support the company’s tax filing and to defend an ATO risk assessment.
Approaching the ATO to discuss their situation is an option to consider in our view after carrying out a risk assessment.
The ATO provides examples of problematic arrangements in the alert which are summarised under the following headings.
Bifurcation of intangible assets and mischaracterisation of Australian DEMPE activities
The first example refers to contract research and development (R&D) and discusses an Australian company entering into a contract R&D arrangement with a foreign related company.
Pursuant to this arrangement, the Australian company provides services to a foreign company associated with the DEMPE of potentially new or future intangible. The Australian company is remunerated by the foreign company on a cost-plus basis. All new intangibles produced under the arrangement are owned by the foreign company and it derives all income generated from the exploitation of the new intangibles but manages and performs limited activities and assumes limited risks in connection with the new intangibles.
The new intangibles are intrinsically linked to the Australian company’s existing intangibles comprising updated versions and enhancements of the patents, trademarks, know-how, copyright, and like assets, which form part of, and are connected to, the Australian company’s existing intangibles.
The functions performed, assets used, and risks assumed by the Australian company do not materially change in substance following the execution of the contract R&D arrangement. The Australian company continues to employ the same specialised staff and use its expertise and assets associated with the existing intangibles to manage, perform, and control DEMPE activities associated with the new intangibles.
The Australian company’s remuneration under the contract R&D arrangement does not reflect the extent or character of functions performed, assets used, and risks assumed by the Australian company in connection with the new intangibles or the connection between the new intangibles and Australian company existing intangibles, which are intrinsically linked.
In these circumstances, the ATO expresses the view “…that the conditions operating in connection with the arrangement may not be consistent with arm’s length conditions for the purposes of Australia’s transfer pricing laws.”
These arrangements are not uncommon and can occur for commercial reasons but clearly create risk where there is a mismatch of functional contributions to value creation.
Non-recognition of Australian DEMPE activities
The ATO is concerned that entities may enter into arrangements connected with the DEMPE of intangible assets that do not appropriately recognise Australian contributions to DEMPE functions for tax purposes.
This is of particular concern for the ATO where the division of the right(s) to exploit intangible assets associated with these arrangements does not result in Australian entities receiving an appropriate or proportionate share of global income from the exploitation of such assets.
The first example provided under this heading is where an Australian entity is party to a cost contribution arrangement where they receive the right to exploit the intangibles in their local market but where the Australian entity makes a greater contribution to the cost contribution arrangement relative to other contributors due to its DEMPE activities.
In this example, an Australian company’s proportionate share of overall contributions to the cost contribution arrangement is not consistent with the expected benefits received. Specifically, the Australian company does not obtain benefits proportionate with its contributions to the derivation of global income from the exploitation of the intangible assets covered by the cost contribution arrangement, where those intangible assets are used and exploited by the foreign company and related companies in other jurisdictions.
In these circumstances, the ATO states that the Australian company’s entry into the cost contribution arrangement agreement may not be commercially rational or consistent with its best economic interests having regard to the commercial options realistically available.
“The arrangement may therefore be inconsistent with that which might reasonably be expected to be agreed between independent parties dealing at arm’s length for the purposes of Australia’s transfer pricing laws,” the ATO said.
While with a cost contribution arrangement it is typically difficult to perfectly align functional contributions with exploitation rights, we feel the ATO is focusing on more extreme misalignments to make a point about their concerns while not ceasing to respect cost contribution arrangements or regarding all cost contribution arrangements as high risk.
The second example covers situations where an Australian company has substantial operations in Australia, licenses the use of patents, trademarks and knowhow stored in an online data base, and is obliged to record in the database all knowhow developed and obtained by it in the course of its Australian operations.
The Australian company also performs all contract R &D services for, or on behalf of the foreign company and is remunerated on a cost-plus basis. The foreign company does not have substantial business operations and it employs a limited number of suitably qualified staff.
The Australian company frequently performs the R&D and commercialisation activities said to be performed on behalf of, or at the request of the foreign company. The foreign company does not possess enough assets or employ sufficient suitably qualified staff to primarily manage, perform, and control the DEMPE of the intangibles.
This is similar to the first arrangement, but core intangible assets are already owned offshore, so it focuses on disproportionate incremental contributions to the intangible assets by focusing on the DEMPE activities.
The ATO comments that the Australian company’s remuneration under the arrangement with the foreign company does not reflect the extent or character of functions performed, assets used, and risks assumed by the Australian company in connection with the arrangement.
“In these circumstances, the conditions operating in connection with the arrangement may not be consistent with arm’s length conditions for the purposes of Australia’s transfer pricing laws,” the ATO said.
— David Lewis is Managing Director of Duff & Phelps Australia Pty Ltd., Melbourne, Australia.
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