Transfer pricing includes the pricing of goods, services, or intangible assets exchanged between different entities. It involves determining the prices for these transactions, taking into account the possibility that the relationship between the involved entities might artificially impact the pricing and, consequently, the tax obligations associated with the transaction.
Common transfer pricing scenarios
Transfer pricing typically arises when goods, services, or intangible assets are transferred between entities that share common ownership, management, or control. These scenarios often involve companies within the same corporate group or those connected through significant relationships.
Significance of transfer pricing in multijurisdictional operations
Transfer pricing takes on a heightened significance when the transacting entities operate in different tax jurisdictions.
In such cases, it has a direct influence on how taxable profits are allocated and taxed in each respective jurisdiction. Failure to appropriately address transfer pricing can lead to potential double taxation, where the same economic profit is subject to taxation in more than one jurisdiction.
Ensuring that transfer pricing accurately reflects the economic reality of multinational business operations is vital. It helps prevent tax evasion or manipulation and contributes to the equitable distribution of tax revenues among different countries. Accurate transfer pricing practices play a pivotal role in maintaining transparency and fairness in the taxation of cross-border transactions.
Expanding scope of tax transfer pricing
In recent years, the scope of considerations related to tax transfer pricing has broadened. Initially, the focus was primarily on how the pricing of transactions impacted the tax characteristics of an entity.
However, this focus has now shifted to a more comprehensive assessment of behavior. When the conduct of parties involved in a transaction doesn’t align with what would be expected between independent parties, and this incongruity negatively affects domestic tax implications, it’s possible that tax transfer pricing regulations could come into play.
These regulations may then be applied to determine tax liabilities based on the conduct that would be expected between unrelated entities. An area of particular interest for tax authorities is situations where businesses restructure, potentially leading to reduced economic activity and taxable profits in the local jurisdiction.
Transfer pricing rules
The transfer pricing rules in Australia establish a legal framework for addressing situations in which profits are shifted out of the country, particularly through inter-company or intra-company transfer pricing arrangements.
The current transfer pricing framework is outlined in Subdivisions 815-B to 815-D of the Income Tax Assessment Act 1997 (ITAA 1997).
The primary aim of these rules is to determine whether a taxpayer has received a “transfer pricing benefit” and whether adjustments are necessary for the taxpayer’s tax position.
Determining a transfer pricing benefit
A “transfer pricing benefit” is assessed by comparing the actual conditions of a transaction with hypothetical conditions, assuming that the parties involved are dealing with each other at arm’s length.
This means evaluating whether the transaction would result in a tax advantage that deviates from what would be expected between unrelated parties. In such cases, tax treatment is adjusted to reflect these arm’s length conditions for both income tax and withholding tax purposes.
Policy goals
The overarching policy objective is to ensure that the taxable income reported in Australia is no less than it would be if arm’s length conditions were applied. In the case of a permanent establishment, the intention is to ensure that the income is not less than it would be if the permanent establishment were an independent entity conducting transactions entirely independently with the rest of the corporation.
Transfer pricing benefit in cross-border transactions
There are situations in which an entity would gain a tax advantage in Australia due to cross-border conditions that deviate from internationally accepted arm’s length principles. In such cases, the entity’s Australian tax position is adjusted as if arm’s length conditions were in place.
What is a transfer pricing benefit
A “transfer pricing benefit” is the key concept here. An entity acquires a transfer pricing benefit when:
- The entity has “commercial or financial relations” with another entity.
- The benefit arises from conditions applied between these entities concerning their relations (referred to as the “actual conditions”).
- The actual conditions differ from the “arm’s length” conditions.
- The actual conditions meet the “cross-border” test.
- If arm’s length conditions were in effect:
- The entity’s taxable income for a fiscal year would have been higher, or
- Losses of a particular type (e.g., tax loss, film loss, or net capital loss) for a fiscal year would have been lower, or
- Tax offsets for a fiscal year would have been lower, or
- The entity’s withholding tax liability for interest or royalties would have been greater
In such cases, arm’s length conditions replace the actual conditions when calculating taxable income, losses, offsets, or withholding tax, irrespective of whether the entity had any tax avoidance motive, and irrespective of any associations between the entities involved.
Treatment for trusts and partnerships
For trusts and partnerships, references to “taxable income” are interpreted as references to net income. In the case of partnerships, references to tax losses are understood as references to partnership losses. These adjustments are largely terminological in nature and do not affect the practical operation of the provisions.
Timeframe for assessments
Amendments to assessments that implement this provision can be made within 7 years from the date when the concerned entity is notified.
Key terms in transfer pricing regulations
Commercial or financial relations
This term is not explicitly defined in the legislation but includes the entirety of arrangements governing interactions between two entities.
It can include single transactions, a series of transactions, practices, agreements, available options, unilateral actions, strategies, or the overall profit outcomes achieved by the involved parties.
Actual conditions
Actual conditions refer to the real conditions in effect within the commercial and financial relations between parties, which ultimately impact the economic or financial positions of each entity.
These conditions are not limited to contractual terms. For instance, they may encompass the prices paid for goods or services, terms of an agreement affecting profit margins, or profit division between entities.
Arm's length conditions
Arm’s length conditions are those that would be expected to operate between independent entities dealing wholly independently in comparable circumstances
In the identification of arm’s length conditions, it’s essential to employ methods suitable and reliable in the given circumstances. Internationally accepted arm’s length methodologies are grounded in comparability, comparing prices or margins achieved by associated enterprises with those of independent enterprises for similar transactions.
Accepted methodologies include:
- Comparable Uncontrolled Price (CUP) Method
- Resale Price Method
- Cost Plus Method
- Profit Split Method
- Transactional Net Margin Method
The choice of method should consider factors such as the suitability of methods in specific circumstances, functions performed, assets used, and risks borne by the entities, the availability of reliable information, and the degree of comparability between actual and comparable circumstances.
Establishing comparable circumstances
Circumstances are considered comparable if differences between them do not significantly impact relevant conditions or if reasonably accurate adjustments can eliminate differences.
When identifying comparable circumstances, factors to consider include functions performed, assets used, risks, property or service characteristics, contractual terms, economic circumstances, and business strategies. I
In cases where making reliable comparability adjustments is not feasible, an alternative method based on different points of comparison may be appropriate.
Determining arm’s length conditions
When establishing arm’s length conditions, the process is typically based on the commercial or financial relations of the parties involved, considering both the form and substance of these relations.
However, certain exceptions to this rule exist, allowing the officials to disregard actual conditions and compare them with “reconstructed” conditions to determine the arm’s length conditions. These exceptions are:
Inconsistency between Form and Substance: When a discrepancy arises between the form and substance of relations between entities, the substance prevails.
Independent Entities in Comparable Circumstances: If independent entities in comparable circumstances would not have entered into the specific commercial or financial relations but would have chosen different relations in substance, the identification should be based on those alternative relations.
Absence of Relations: In cases where independent entities in comparable circumstances would not have entered into any commercial or financial relations, the identification is based on the absence of such relations.
Cross-border test
Conditions are considered to satisfy the cross-border test if they operate in connection with a business carried out by the entity in an area covered by an international tax sharing treaty that Australia has with another country.
Alternatively, the conditions also meet the test if the involved entities meet specific criteria related to their residency and the location of operations.
Consequential adjustments
The application of cross-border rules may have ripple effects on other aspects of an entity’s tax position or the tax position of another entity.
The Tax officials have the authority to make consequential adjustments to these positions if it is deemed “fair and reasonable” to do so.
For instance, if the application of the rules reduces a deduction for foreign interest paid by the entity, it may be decided to correspondingly reduce the withholding tax payable on that interest. Adjustments can be made at any time.
Interaction of transfer pricing and thin capitalisation rules
Thin capitalisation rules are applicable to Australian entities under foreign control or with international operations, and to foreign entities operating in Australia. These rules disallow deductions when excessive debt capital is used to finance Australian operations.
An interaction rule governs the interplay between the transfer pricing and thin capitalisation rules in cases where both are potentially applicable.
In such cases, the arm’s length rate determined under the transfer pricing rules is applied to the entity’s actual debt amount to ascertain the transfer pricing benefit.
The thin capitalisation rules are then used to assess the amount of debt deductions remaining after the transfer pricing benefit is negated.
If deductions are still excessive under these rules, further reductions apply. Even if no excess debt is found under thin capitalisation rules, transfer pricing rules may still be applicable.
Transfer pricing benefit and permanent establishments
There are rules under Australian tax laws that specifically deal with cases where an entity operates a Permanent Establishment (PE) in Australia and gains a tax advantage it wouldn’t have if the PE functioned as a separate entity engaged in arm’s length transactions with the main operating entity.
Consequently, the tax position of the operating entity in Australia is determined as if all dealings adhered to arm’s length principles.
A transfer pricing benefit arises when:
- The actual profits attributed to the PE differ from what arm’s length profits for the PE would be.
- If arm’s length profits were applied instead of actual profits, it would lead to higher taxable income, reduced losses, or lower tax offsets for the entity.
In such cases, the arm’s length profits are conceptually substituted for the actual profits when calculating taxable income, losses, or tax offsets.
Importantly, this applies regardless of whether the entity’s actions were driven by any tax avoidance motives.
Amendments to assessments to implement these provisions can be made within seven years from the date when the ATO provides notice of the assessment to the entity concerned.
Arm’s Length Profits
Arm’s length profits for the PE are determined by allocating the actual expenses and income of the operating entity between the PE and the entity based on a notional arm’s length approach.
This means that the profits attributed to the PE are the profits that the PE would be expected to generate if:
- The PE was regarded as a distinct and separate entity.
- The activities and circumstances of the PE, including its functions, assets, and risks, were similar to those of a separate entity.
- The conditions governing dealings between the separate entity and the operating entity conformed to “arm’s length conditions”.
In this calculation, the actual expenses of the operating entity include losses and outgoings, and the actual income includes any amounts that would typically be considered assessable income of the entity.
This approach aligns with the “relevant business activity” approach used for attributing profits to PEs, which is currently part of Australia’s tax treaties.
For tax purposes, the arm’s length profits attributed to the Permanent Establishment (PE) in Australia are regarded as sourced in Australia, and the arm’s length profits for the PE in a country with a tax treaty are viewed as sourced in that country.
Transfer pricing penalties and thresholds
When a taxpayer in Australia finds themselves liable for extra tax due to adjustments made by the tax officials in accordance with transfer pricing regulations, they are also subject to administrative penalties.
These penalties come into play when a notice is issued indicating the need for additional withholding tax.
Determining the penalty amount
The penalty amount is computed based on what is termed the “transfer pricing shortfall amount.” This shortfall amount corresponds to the additional tax and withholding tax that the taxpayer owes as a consequence of either the assessment adjustments or the notice served by the tax officials.
The standard penalty calculation typically constitutes 25% of this shortfall amount. However, the penalty percentage can be reduced to 10% under specific conditions.
This reduction occurs when the taxpayer can reasonably argue that they have adhered to the transfer pricing rules as they should.
Conversely, if it is evident that the taxpayer entered into a scheme with the primary or dominant objective of gaining a transfer pricing benefit for themselves or another entity , the penalty is heightened to 50%, with a 25% penalty applying to reasonably arguable positions.
Exemption for low shortfall amounts
It is important to note that no penalty is enforced when the “scheme shortfall amount” is equivalent to or less than what is known as the “reasonably arguable threshold.”
The reasonably arguable threshold is set at $10,000 or 1% of the income tax that the entity is obliged to pay for the relevant income year.
For trusts and partnerships, this threshold is raised to $20,000 or 2% of the entity’s net income for that year.
Increased penalties for large multinational companies
Large multinational companies that engage in tax avoidance or profit-shifting schemes face doubled administrative penalties. These enhanced penalties are applicable to scheme benefits obtained by “significant global entities” and take effect for income years commencing on or after July 1, 2015.
Notably, the heightened penalties do not come into play when the taxpayer can reasonably argue their position.
Late lodgment penalties for significant global entities
The administrative penalties imposed on significant global entities for failing to lodge returns, notices, statements, and other documents with the ATO on time is significant.
The base penalty amount is multiplied by 500 if the entity qualifies as a significant global entity at that time.
In the case of lodgment more than 16 weeks late, a maximum penalty of $525,000 could be imposed. These penalties also doubled for statements and the failure to provide necessary documents to determine tax-related liabilities in this same timeframe.
Mandatory documentation for transfer pricing compliance
Proper documentation is a vital requirement for compliance with transfer pricing regulations and the standard tax record-keeping rules.
In cases where the entity could potentially face administrative penalties under the transfer pricing rules, obtaining a reduction in these penalties based on a “reasonably arguable position” is contingent on adhering to specific documentation requirements.
These requirements necessitate that the entity maintains records that meet the following criteria:
- Records should be prepared before the tax return for the relevant income year is lodged. This contemporaneous nature means that the records must genuinely exist and be within the entity’s possession or readily accessible.
- Records must be in English or readily convertible into English.
- The documentation should explain how the transfer pricing provisions apply, or don’t apply, and justify the application in a manner that aligns with the pertinent OECD guidelines and regulations.
For instance, the records must offer insights into aspects such as arm’s length conditions, actual conditions, comparable circumstances, details of the method employed, and its impact in the specific context.
Country-by-country reporting
Significant large multinational companies are obligated to furnish “country-by-country” (CbC) statements to the tax officials on an annual basis.
CbC reporting aligns with OECD standards and aids the authorities in conducting risk assessments related to transfer pricing.
For companies considered “significant global entities” with a global annual income exceeding $1 billion, the following statements must be submitted within 12 months of the end of the relevant income year (or within an approved replacement reporting period):
- A “master file” that offers an overview of the multinational enterprise group’s operations, including global business activities, transfer pricing policies, and the allocation of income and economic activity.
- A “local file” that zooms in on specific transactions between the reporting entity and its associated enterprises in other countries. This file must detail transaction amounts and provide the entity’s analysis of transfer pricing determinations.
- A “CbC report” that includes certain data concerning the global allocation of the multinational enterprise’s income and taxes paid. It also provides indicators of the location of economic activity within the multinational enterprise group.
Exemptions and penalties
To qualify as a “significant global entity,” a company must either be an Australian resident or a foreign entity with a permanent establishment in Australia.
The tax officials hold the discretion to exempt specific entities or a class of entities from the CbC reporting requirement. This exemption can pertain to one or more of the three reports required.
For instance, a local entity may be exempt from providing a CbC report if their parent entity has submitted it in another jurisdiction, and can be obtained through an information-sharing arrangement.
Entities failing to meet reporting deadlines or providing statements containing false or misleading information are subject to penalties.
Proposed transparency measure
The Treasury has introduced an exposure draft legislation for a transparency measure. This measure calls for multinational enterprises to disclose specific tax information on a CbC basis to the public and provide a statement outlining their approach to taxation for income years commencing from July 1, 2023.
International dealings schedule
Taxpayers involved in international transactions surpassing defined thresholds are required to submit additional documentation with their annual tax returns. This documentation takes the form of an International Dealings Schedule (IDS), and comes with instructions pertinent to the applicable year.
There are also simplified options for transfer pricing record-keeping suitable for eligible taxpayers. These options are tailored for transactions or activities considered low risk in the context of dealings with international related parties.
Failure to adhere to these documentation requirements may trigger the attention of tax audits.
This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.
