By Geoff Morris, Transfer Pricing Advisor, Director, Independent Transfer Pricing (InTP), Melbourne, Australia
Australia is one of the Group of Twenty nations that delivers internationally-coordinated economic policies with significant experience in transfer pricing gained over the last 20–plus years. Australia has an active transfer pricing-focused audit, APA, and MAP program, an active treaty network, and contributes to international transfer pricing forums such as the OECD and through an active treaty network.
The Australian approach to managing transfer pricing compliance risks, consistent with the OECD transfer pricing guidelines, is an example that other countries look to in managing transfer pricing. Australia has provided training and other transfer pricing capability support to developing countries through the OECD in the Asia-Pacific region.
In this article, I provide an overview of Australia’s transfer pricing laws and the tax administration’s practices in this area, focusing on the provisions, how Australia monitors transfer pricing risks, and recent experience. The discussion is supported by my 20–plus years of experience as an Australian Tax Office (ATO) economist specialising in transfer pricing and as a competent authority.
Legislative base
Australia’s transfer pricing rules were modified in February 2020 to specify that the OECD transfer pricing guidelines 2017 edition is the relevant guidance material for income years after 2017. That amendment updated the much earlier major changes to Australian transfer pricing laws when subdivision 815-B (general rules), C (permanent establishments), and D (trusts and partnerships) of the Income Tax Assessment Act 1997 apply from 2013. Those rules made it clear that the aim was to ensure that the amount brought to tax in Australia from non-arm’s length dealings should reflect the economic contribution by the Australian activities.
The subdivision 815-B focus is on whether or not an entity gets a transfer pricing benefit (that is, a tax advantage). That benefit arises where entities have “commercial or financial relations,” that the “actual conditions” of those relations are different from “arm’s length conditions,” that the actual condition satisfies a “cross border” test, and either the entities’ taxable income would have been greater or losses would have been less. Through the application of this process, the arm’s length conditions are substituted for the actual conditions to work out the correct amount of taxable income or loss.
The terms “commercial or financial relations,” “actual conditions” and “arm’s length conditions” are defined in the legislation. The “arm’s length conditions” are those that might be expected to apply between independent entities dealing wholly independently with one another in comparable circumstances. In identifying these arm’s length conditions, the method to be used is the method that is most appropriate and reliable in the circumstances, and the accepted methods are those set out by the OECD guidelines.
Coverage
Australia’s transfer pricing rules apply the arm’s length principle to dealings between both associated and non-associated entities so that any non-arm’s length dealings should reflect the economic contribution by the local entities.
Independent parties engaging in some conduct that is not in their own economic self-interest (e.g., collusion to place income in other countries, or other practices) will not avoid the application of these transfer pricing rules by virtue of their non-association. However, the transaction needs to satisfy the cross-border test for the rules to apply, so purely domestic arrangements are not covered by these rules.
Australia’s transfer pricing documentation
Australia doesn’t have a specified level of documentation covering transfer pricing arrangements but normal tax record-keeping requirements apply. However, if a tax liability arises, then the taxpayer will need to show that it had a “reasonably arguable position” by meeting several key documentation requirements. Doing so avoids additional penalties for not having a reasonably arguable position.
Those requirements include contemporaneous documentation, in English or easily convertible to English, the documents should explain how the transfer pricing provisions were applied and why that application is consistent with the OECD guidelines.
While there are no legislative rules that specify the number of days after a request that the documentation needs to be provided, the information and documentation requests will specify a due date but it’s generally expected that documentation prepared contemporaneously with the tax return would be readily available. In Australia, the burden of proof is also on the taxpayer to ensure that the actual conditions of the transaction are consistent with arm’s length conditions. The preparation of transfer pricing documentation is highly recommended.
Australian transfer pricing methods
All five OECD–recognized transfer pricing methods are accepted methods. There is no hierarchy of methods.
When choosing a method, subdivision 815-B provides that one should take into account the strengths and weaknesses of the method, the functions performed, assets used and risks assumed of the entities, availability of reliable information to support the method and the comparability between the actual and comparable circumstances. Comparability is determined by the five factors of comparability: functional analysis, characteristics of the property or services, contractual terms, economic circumstances of the entities, and their business strategies. In practice, the tax office and most Australian taxpayers use the TNMM method.
In the application of transfer pricing methods—and more generally performing the transfer pricing analysis—the approach to be taken is one that best achieves consistency with the OECD guidelines. This means that the legislation doesn’t specify the years for selecting comparables, foreign comparables aren’t excluded, and the tested party need not be an Australian entity. Further, the Australian Tax Office doesn’t express a preference for the databases (whether company, debt instrument, or commodity price) from which comparables should be drawn.
Permanent establishments
Australia’s transfer pricing rules also apply to permanent establishments. Additionally, Australia’s multinational anti-avoidance legislation targets enterprises that avoid a taxable presence by undertaking significant work to generate sales in Australia but book the revenue from those sales offshore. Many multinationals have restructured their operations to establish legal entities and book income onshore in Australia. To support these rules, the goods and service tax applies to cross-border supplies of imported services and digital products, as well as low-value imported goods, sold to Australian consumers.
Country–by–country reporting and other tax return disclosures
Country-by-country reporting applies in Australia to significant global entities that report more than AUD 1 billion in global annual income. The requirements include a master file, a local file, and a CbC report on the global allocation of income and taxes with indicators of the location of economic activity of the global group. The reports must be provided within 12 months of the end of the entities’ income year.
CbC reports are in addition to the tax office’s international dealings schedule (IDS), although some parts of the IDS need not be completed if a local file is lodged. The IDS is an important part of the ATO’s monitoring of related party transactions and the application of the arm’s length principle. It requests significantly more detail on the types of transactions—tangible and intangible property, services, and financial arrangements, as well as restructures and so on—than is found in CbC reports. The ATO uses this data to risk–assess the thousands of entities that lodge IDS and or CbC reports in order to select candidates for further risk review or audit.
Some taxpayers are also required to lodge a reportable tax position (RTP) schedule. These companies are public companies and foreign-owned companies with group income of AUD 250 million or more, or are notified by the ATO that they must lodge the schedule one for some other reason. The lodgment requirement now includes private groups from the 2021-2022 income year. The schedule requires these taxpayers to report on tax positions they’ve taken that are as likely to be correct as incorrect, those that create uncertainty in their financial accounts in relation to taxes, as well as specified “reportable tax positions.” There are currently 35 questions relating to reportable tax positions, some of which relate to tax avoidance, profit shifting, and other practices that pose systemic risk to Australia’s corporate tax base.
The schedules’ transfer pricing questions relate to the use of offshore marketing or procurement hubs, and the profit margins of distributors against a rubric of expected returns, as well as other arrangements that create transfer pricing compliance risks. Many of the required transfer pricing disclosures are supported by the ATO’s practical compliance guides or taxpayer alerts to assist taxpayers in identifying the necessary arrangements.
Thin capitalisation
Thin capitalisation rules in Australia are intended to prevent multinationals from shifting profits out of Australia by funding their Australian operations with high levels of debt and relatively little equity and thereby reducing their Australian taxable income. While the price of that debt is determined by transfer pricing rules, the nature and level of the debt is determined by the thin capitalisation rules. However, these rules are complex. There are specific rules under the regime to determine whether an arrangement is a debt or equity arrangement and thereby calculate their amount of debt or equity, including whether a debt arrangement meets the “arm’s length condition” test for transfer pricing purposes.
Under these thin capitalisation rules, taxpayers have a safe harbor level of debt of 1.5 to 1 of equity, meaning that for every AUD 100 of equity, the entity is allowed AUD 150 of debt. If that level is exceeded, then the entity has recourse to either the arm’s length level of debt test or the worldwide gearing test. Each test has specific rules that need to be met.
Risk assessment
Australia generally adopts a staged approach in selecting taxpayers with transfer pricing issues for further risk review and audit. The ATO has a well-developed data-driven approach to identifying different kinds of transfer pricing risks at several levels, including algorithms that apply profits tests, identify restructures and transfers of IP, transactions with low-tax countries, cost of services, excessive interest rates on debts, and so on.
Candidates for further review are normally allocated to a risk-assessment process where the taxpayer is often contacted for their transfer pricing documentation or questions asked to clarify their transfer pricing arrangements. Concerns raised at that stage may be addressed in an audit where further questions of the functions performed, assets used, and risks assumed are raised and interviews are usually undertaken with company personnel usually undertaken. A transfer pricing audit often—but not always—results in a tax adjustment, where penalties and interest also apply.
Taxpayers may adopt positions that have low risk of noncompliance
As can be seen, the ATO requests significant information on taxpayers’ transfer pricing arrangements and uses that information to undertake risk assessments and audits. The ATO has also been active in publishing practical compliance guidance on what transfer pricing arrangements and outcomes represent regarding are regarded as presenting a low risk of noncompliance.
These guides cover such topics as returns for distributors dealing in different tangible goods from motor vehicles to pharmaceuticals, the percentage mark-ups on cost for corporate and other services, interest rates for the cost of debt, and returns for marketing and procurement hubs.
While these positions don’t operate as safe harbours, the ATO has stated that it won’t apply audit resources to arrangements that adopt one of these positions. The use of these low-risk options has strict eligibility criteria that need to be carefully checked.
Additionally, the ATO recently published comments about the application of transfer pricing rules in relation to financial arrangements that migrate away from LIBOR–based pricing. The tax office has said that it expects a low likelihood of the transfer pricing rules applying if certain conditions are met. These conditions include if the taxpayers’ approach is in line with market practice and the most recent recommendations published by the relevant industry and regulatory body industry guidance, such as from the Alternative Reference Rates Committee and others; if the taxpayer’s approach is consistent with its transitioning of its third-party financing arrangements; and where the contractual changes are limited to those necessary to implement the transition.
APA and MAP programs
In fiscal year 2021, the ATO had over a hundred active APAs and completed 32 MAP cases. However, this is far less than the 150 or so active APAs from between 2010 to 2015. The time taken to conclude a unilateral APA has also risen to nearly 33 months, up from around 12 months in 2010 to 2015. Part of the reason for the delay and lower APA numbers may be the greater scrutiny that the ATO has been placing on APA applications following the revelations of base erosion and profit shifting. Also, as mentioned above, the ATO has published transfer pricing positions with a low risk of noncompliance. These may allow some taxpayers—for example, those acting as a distributor—to achieve a similar level of tax certainty over their transfer pricing risk as from the APA program but with lower costs of compliance.
The ATO started a review of the APA in early 2022 focusing on the efficiency of the program in assuring transfer pricing compliance risk and suitability of the program for taxpayers.
As mentioned above, the ATO has published transfer pricing positions with a low risk of non-compliance. These may allow some taxpayers—, for example, those acting as a distributor—to achieve a similar level of certainty over their transfer pricing risk as from the APA program but with lower costs of compliance.
Recent court cases
In the last year or so, Australian courts have passed judgment on two cases that have involved transfer pricing: Optus and Glencore.
Last year, the federal court dismissed an appeal by Singapore Telecom Australia against the denial of AUD 895 million of intra–group interest deductions. The dispute concerned interest deductions arising from loan notes issued between related parties as part of the acquisition of the Australian Optus business, in light of a series of amendments to the original arrangement. The court accepted that the original interest rate of BBSW + 1.00% was arm’s length, given it was consistent with the group’s borrowing costs. The court also found that the hypothetical loan transaction included a parent company guarantee. Further, the court did not accept that independent parties would have agreed to amendments that deferred, but increased, interest payments. In short, the decision confirmed the authority of the ATO to alter both the prices and terms of the related-party arrangements to apply the arm’s length standard. Regarding the facts and evidence of this case, it also suggests the court’s willingness to intervene where there is a suggestion that there may be a tax motivation for the arrangement.
In late 2020, the tax commissioner’s appeal to the federal court to review an earlier decision in the Glencore case was dismissed. The transaction under review involved the related-party sale of copper concentrate, where treatment costs and refining costs were set at 23% of the copper price, and which had the effect of sharing risk between the parties. After a series of amendments to the related-party contract, the offshore purchaser was given an option to select a quotational period on a shipment-by-shipment basis from a number of options, rather than annually, with the effect that the purchaser had knowledge of the average price in at least one of the quotational periods available to be selected, before each shipment.
In its decision, the court confirmed that the OECD transfer pricing guidelines required the arm’s length principle to be applied to the transaction actually undertaken. The federal court noted that the OECD guidelines had allowed limited explicit exceptions—for instance, where substance differs from form, and where the arrangements differ from those an independent enterprise is likely to have adopted. However, the OECD guidance was considered to be inadequate in assisting the court. The TPG court noted that the guidance was said to have been written in language that is highly generalised, frustratingly opaque, only a guide, and may not be of much real assistance. In any case, the court decided that, in fact, the commissioner has the power, where a price under an agreement is specified as a formula, to replace it with a different formula where arm’s length parties would have used that different formula.
In the appeal, the taxpayer’s evidence from expert and company witnesses was sufficient for the court to be satisfied that the arrangement was one which where arm’s-length taxpayers might reasonably enter into, and that the price paid was in the arm’s length range. This suggests that arrangements that are reasonably consistent with commercial practices—and are supported by evidence—will be upheld.
Diverted profits tax
In addition to its transfer pricing and anti-avoidance rules, Australia has a diverted profits tax applying to certain structuring arrangements that appear to shift significant profits offshore. One of the aims of the diverted profits tax is to ensure that the Australian tax paid by significant global entities properly reflects the economic substance of the activities that those entities carry on in Australia. The diverted profits tax imposes a 40% tax rate on profits from arrangements where the diverted profits tax applies.
These rules contain provisions so Australia can act on limited information to address information asymmetries and encourage taxpayer transparency and cooperation. Some arrangements where the diverted profits tax may arise include offshore procurement hubs, the transfer of intellectual property, restructures that transfer functions offshore to a centralized regional entity, and financing arrangements through interposed entities in treaty partner countries. An exception to the application of the tax is where the arrangement has sufficient economic substance, as determined by the economic and commercial reality of the arrangements, with regard to the functions performed, assets used, and risks assumed by the parties. The OECD guidelines are the specified guidance material in applying this economic substance test. The OECD’s process of selecting a transfer pricing method, undertaking a functional analysis and search for comparables, and so on is used to assist in showing that the profits reflect the substance of the relevant activities. The ATO also considers whether or not the diverted profits tax applies to an APA application or not.
Related developments
Australia is also actively involved in the OECD’s Pillar One and Pillar Two initiatives, which are designed to meet the 2023 implementation deadline for the so-called two–pillar solution, including the aim to finalize a multilateral convention to implement Pillar One by July 2022.
Australia is also actively developing rules to establish a patent box regime for medical and biotechnology innovations, lowering the tax on related income to 17 percent from July 2022. This should support the development and exploitation in Australia of those innovations supported by Australian R&D tax concessions, which may previously have been sold offshore. The government announced in March 2022 an extension of this patent box regime to some low emissions technology, agricultural products, and plant breeder’s rights.
Taxpayers could consider the effect of this regime when considering the development, exploitation, management, protection, and enhancement of Australian intangibles.
To sum up
Australia’s transfer pricing approach is consistent with the OECD transfer pricing guidelines. Australia has the authority to restructure transactions so that they accord with arm’s length conditions and has shown an appetite for using the courts to resolve disputes. Overall, Australia has a well-developed risk management capability that allows it to direct compliance resources to manage important parts of its transfer pricing–risk landscape.
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Geoff Morris is a transfer pricing advisor and director with Independent Transfer Pricing (InTP) in Melbourne, Australia.
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