Australian transfer pricing documentation: penalty reduction and simplification concessions – but not what it seems
May 2015 | EXPERT BRIEFING | CORPORATE TAX
From 29 June 2013, Transfer Pricing Rules in Australia morphed into version 3 (now covered principally in Subdivision 815-B and 815-C of the Income Tax Assessment Act 1997) to determine if a ‘transfer pricing benefit’ exists and needs adjustment. They were accompanied by new administrative practices that required transfer pricing documentation to be prepared (Subdivision 284-E of the Taxation Administration Act 1953) at the option of a taxpayer company, which if prepared and cover off specific matters, may give penalty reduction in a transfer pricing audit conducted by the Australian Taxation Office (ATO) where a transfer pricing benefit is in fact adjusted.
In addition, record-keeping simplification concessions were subsequently published on the ATO website in December 2014 that purport to reduce the burden on companies who meet specific criteria and who elect one or more of the four ‘safe harbour’ options offered by the ATO: Small Taxpayers, Distributors, Intra-group Services and Low-Level Loans (inbound).
Taxation Rulings TR2014/6 and TR 2014/8, also issued in late 2014 to explain the ATO interpretation of the application of 815-B (how to work out if a transfer pricing benefit exists), and the tests that will operate to determine if transfer pricing documentation presents a ‘reasonably arguable position’ to permit, under 284-E, penalty reduction if an ATO audit subsequently disagrees with the company’s transfer pricing position in its Australian income tax returns.
An ATO auditor (maybe three years after the tax return under review was lodged) is now required to review transfer pricing practice and methodology used by a company in presenting its annual income tax return, and if the auditor disagrees, assess if the documentation explaining that position covers off specific matters and meets the legal test of a ‘reasonably arguable position’.
In effect, the auditor has to disagree on the transfer pricing outcome of applying a methodology, and agree the way the company documented its application was reasonable and if applicable reduce the accompanying penalty. The auditor may of course agree no transfer pricing benefit exists and walk away. How this will play out in future audits is uncertain so the quality of documentation needs to be focused on now, when it is finalised.
To complicate the process, one of the matters to be satisfied for penalty reduction is that the company prepared and signed off the transfer pricing documentation, at or before the income tax return for the applicable year was lodged with the ATO.
This is a tight timeframe for a major document (which may be between 100 and 400 pages), and in the first year (2014 tax returns for the year ending 30 June 2014 or substituted accounting period) may place considerable pressure on a company (and its public officer who signs the tax return) to meet their tax lodgement timetable obligations. Many companies may have missed this issue altogether, or are currently facing it, or need to catch up in 2015 lodgements.
Hence the ATO initiative for a documentation record keeping simplification process to allow certain taxpayers an ‘easing-in’ to preparing full documentation that is expected to cover a functional analysis, characterisation of related party dealings, industry and market analysis, benchmarking to support the pricing outcome reflects the arm’s length principal, and a conclusion comparing actual financial outcomes to the supporting benchmarking and why it is supported or not supported but still arm’s length.
The simplification options set out specific criteria to be satisfied and a warning: the devil is in the definitions behind each option.
Taxpayers are still required to prepare simple documentation
If a company elects an option it is still required to prepare simple documentation, which outlines its relationship with related parties and how the option criteria have been considered, and being applicable, have been elected (generally less than 50 pages per option).
In 2014, simple documentation needs to be a record available to the ATO upon request. In 2015, a specific box needs to be ticked in the International Dealings Schedule that accompanies the tax return at lodgement, and again simple documentation be available upon request.
Be aware that financing transactions (and capital transactions covering, for example, sale or purchase of major assets) are carved out of the safe harbour options and if significant debt financing or other capital transactions have occurred, separate ‘full’ documentation covering this transaction is required to be prepared (separate or incorporating the simple documentation) if penalty protection is seen as necessary.
The ‘full’ documentation of financial transactions needs description of the review carried out, and analysis covering thin capitalisation issues and the arm’s length nature of interest, guarantee fees and other associated expenses, supported by benchmarking evidence.
The Small Business option is available where Turnover of the Australian Economic Group (AEG) – defined under the Accounting Standard AASB 10 and is broadly a parent/subsidiary consolidated accounts test – is between $A0 and $A25m and: (i) the company has not derived sustained losses (three consecutive years including current year and previous two); (ii) does not have dealings with specified countries (a list of low tax countries which does not include Singapore and Hong Kong); (iii) has not been part of a current year restructure (as defined); (iv) has no related party dealings involving royalties, licence fees or R&D arrangements (such as Cost Sharing Arrangements); (v) intra-group service dealings are not greater than 15 percent of turnover (as disclosed in the relevant box in the tax return for the current year); (vi) the business covered is not a distributor; and (vii) separate documentation is created covering financing and capital transactions.
The Distributor option has a turnover test of between $A0 and $A50m, similar exclusion criteria as above and specifically a criterion that the profit-before-tax ratio (as defined) is more than 3 percent. This rationale is based on figures disclosed in the tax return and is a weighted three-year average calculation – three years of tax return data needs to be in front of the person assessing this (and other) options.
The Intra-Group Services option criteria apply to whether received as income or paid as an expense to related parties and does not have a general turnover criteria but rather: (i) for received services, the charge in financial accounts of the company is not greater than 15 percent of total expenses of the AEG; (ii) for provided services, the receipt in the financial accounts of the company is not more than 15 percent of total revenue of the AEG; and (iii) there are no sustained losses, or dealings with specified countries, or the company was part of a restructure during the year (same as for small business and distributor options) but also that there are no ‘specific service’ related party dealings (as defined – any strategic activity that contributes significantly to the creation, enhancement or maintenance of value in the AEG).
Care is needed as specific services include development of IP and know how, financial trading and execution activities, insurance activities, investment and asset management activities, R&D and software development activities and strategic sales, marketing and relationship management activities.
If all these criteria are satisfied then the concession to be adopted as a safe harbour is a mark-up on intra-group service costs of 7.5 percent or less for services received and 7.5 percent or more for services provided by the Australian company. This means no supporting benchmarking analysis need be documented if these safe harbours are the underlying basis for the tax return lodged.
The Low-level inbound loan option is far more restrictive as a safe harbour in that its overriding criteria applies only to Australian dollar denominated inbound interest bearing related party loans which are reflected in a written loan agreement and where the combined cross-border loan balance (add inward and outward together to calculate a total) is $50m or less for the AEG at all times during the year. The same criteria of not having sustained losses or dealings with specified countries or involvement with a restructure during the year, also apply to this option.
Loan means a ‘debt interest’ as defined in Division 974.
If all the criteria are met, then the safe harbour interest rate to be applied without the need for benchmarking analysis is the interest rate that is no more than the Reserve Bank of Australia indicator lending rate for ‘small business; variable; residential-secured; term’ as defined. The simple documentation is required to document the concessional interest from the RBA website on a progressive monthly basis and compare it to the contracted rate in the loan agreement to show the latter is less than the former.
Obviously you have to consider how safe is your use of a safe harbour and how much work do you need to do to secure it or do you do full documentation?
Chris Bowman is lead director and consultant at ConsultTPAustralia Pty Ltd and Shannon Smit is lead director and consultant at Transfer Pricing Solutions. Mr Bowman can be contacted on +61411 366 691 or by email: email@example.com. Ms Smit can be contacted on +613 5911 7001 or by email: firstname.lastname@example.org.
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