Final Australian inbound distributor rules detail risk of tax office scrutiny

By Leslie Prescott-Haar, Stefan Sunde, and Sophie Day of TP EQuilibrium, AustralAsia LP, New Zealand

The Australian Tax Office (ATO) 13 March published its final Practical Compliance Guideline (PCG) 2019/1 concerning transfer pricing issues related to inbound distribution arrangements, effective on the publication date.

The ATO’s final guidance is markedly similar to the draft PCG released on 23 November 2018, with the ATO adopting only some of the public feedback into the final PCG. 

For purposes of defining an Australian inbound distributor [paras. 16-18], the PCG states:

“An inbound distributor is an intermediary between the producer of a good and another entity in the distribution channel or supply chain. A distributor earns a gross profit from the difference between the price at which they sell the good, and the price which they pay. A distributor will typically incur various selling and administrative costs that must be covered by this gross profit in order for it to make a net profit.

In relation to the distribution of digital products and services, an inbound distributor is an intermediary between the intellectual property owner and the customer or end user of the digital product or service. We consider you to be an inbound distributor irrespective of whether you distribute digital products or services by granting rights to end users directly, or by facilitating the grant of rights to end users by related foreign entities.

[…] An inbound distributor may have some retail operation but their primary sales channel is not their own retail activity.”

The PCG includes a general distributor risk assessment framework (1), alongside three industry-specific risk assessment frameworks (2)-(4):

1. General distributors
2. Life sciences
3. Information and communication technology
4. Motor vehicles.

Each of the four risk assessment frameworks above appear as separate schedules to the PCG and each carry a separate set of earnings before interest and tax (EBIT) margin frameworks for purposes of the risk assessment categories of low, medium, or high risk (refer below).

For general distributors, an EBIT margin exceeding 5.3% is considered low risk, whereas an EBIT margin below 2.1% is considered high risk.

Taxpayers should consider these PCG schedules in detail, and appreciate that the ATO may add further schedules and/or revise the PCG in time. 

Australian inbound distributors

It is noteworthy that the ATO recognises that inbound distributors are not uniform entities, and each will perform differing support functions, own differing assets, and bear differing risks [para. 21]:

“The role of an inbound distributor can include a range of functions that support the primary activity of distribution. Many of these functions will be associated with sales, after sales support, procurement and administration. An inbound distributor may also undertake functions involving transportation, warehousing, inventory management and regulatory matters. The specific nature and combination of these functions will be unique to the inbound distributor’s business.”

The ‘range of functions’ referenced above can and will affect the ATO’s profit expectations for a given inbound distributor.

As such, some of the above-referenced schedules sub-categorise inbound distributors based on the additional support functions the Australian entity may perform as part of its inbound distribution arrangements and adjusts the EBIT margin risk ranges accordingly.

Taxpayers operating within one of the industry-specific risk assessment frameworks (not general distributors) will likely need to make some judgement calls with respect to any subcategory(ies) that may be applicable.

For example, a life sciences entity which, to support its inbound distribution activities, undertakes marketing and regulatory approval functions in Australia, may be considered a ‘Category 2’ life sciences distributor under the risk assessment schedule related thereto, with an accordingly higher EBIT margin risk assessment framework.

The ATO generally expects the EBIT margin to be applied in risk assessment, computed on a five-year weighted average basis, unless industry or taxpayer circumstances suggest alternative approaches are more appropriate.

For larger inbound distributors, such risk assessment will likely be disclosed on the taxpayer’s Reportable Tax Positions schedule filed with the tax return.

The ATO generally expects similarity between an inbound distributor’s EBIT margin and net profit before tax — that is, the ATO does not expect inbound distributors to be a party to substantial debt arrangements, which may raise questions in respect of post-acquisition indebtedness of inbound distributors.

The risk framework does not apply in circumstances where: (i) an advance pricing agreement (APA) is in place; (ii) the ATO and taxpayer have an agreed settlement; (iii) a court ruling applies; or (iv) a review has been conducted which confirms the ATO’s comfort with the arrangement. 

APAs and inbound risk

In recent years, taxpayers have found engagement and agreement on APA matters with the ATO increasingly challenging.

However, importantly, the PCG reassures that “no matter what risk zone your inbound distribution arrangements are in, you are able to seek to enter into discussions with us as part of the early engagement stage of the APA process.” [para. 56]

Although, this does not assure that taxpayers will be accepted into the ATO’s APA program.  

As with the ATO’s other risk-assessment PCGs issued in recent times (i.e. hub arrangements, intercompany finance arrangements), PCG 2019/1 stresses some key procedural factors intended to reflect the ATO’s intentions and to give taxpayers and interested parties transparency around the PCG’s application.

The PCG indicates that a ‘low risk’ rating under the assessment criteria “does not necessarily mean that your transfer pricing outcomes are correct or that you have a reasonably arguable position. Equally, having a high risk rating under this Guideline does not necessarily mean that your inbound distribution arrangements fail to comply with Australia’s transfer pricing rules. […] You should not rely on the profit markers to determine arm’s length conditions.” [paras. 8-9]

The PCG should also not be applied nor interpreted as constituting a set of transfer pricing safe harbours.

Until 13 March 2020, the ATO is offering a partial ‘amnesty’ for taxpayers who adjust their inbound distribution arrangements (i.e., historic and prospective pricing) following the PCG’s publication, which potentially includes remittance of shortfall penalties and penalty interest rates where certain conditions are satisfied.

— Leslie Prescott-Haar is managing director at TP EQuilibrium, AustralAsia LP.

— Stefan Sunde is a manager at TP EQuilibrium, AustralAsia LP.

— Sophie Day  is a transfer pricing consultant at TP EQuilibrium, AustralAsia LP.