Tax Insight - EY

21 August 2012

Tax Insight

The wait is over – Australia’s new transfer pricing rules passed

At a glance •

Transfer Pricing Bill passed with retro- and prospective application

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Pricing of cross-border financing transactions could be significantly impacted

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Renewed ATO emphasis on profit based approaches

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Cross-border business restructures need to be revisited

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Disclosure of uncertain tax positions in financial statements

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Transfer pricing risk mitigation strategies required, including Advanced Pricing Arrangements

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How Ernst & Young can help

Cross-Border Transfer Pricing Bill ready for Royal Assent: Time to consider actions The Australian Senate passed the Tax Laws Amendment (Cross-Border Transfer Pricing) Bill (No. 1) 2012 (the Bill) on 20 August 2012, following the report by the Senate Economics Committee (SEC) of 14 August 2012. The Bill will receive Royal Assent in the next few days. While this will controversially have retrospective application to 1 July 2004, it is important to note, however, that the law will also apply prospectively. This requires action by all parties with cross-border transactions. The new transfer pricing rules, known as Subdivision 815-A,replace the current Division 13, for transactions with related parties in countries which have Double Taxation Agreements with Australia. An exposure draft of the second tranche of proposed legislation is expected to issue by mid September 2012. The second tranche will apply to non treaty countries and is likely to include some form of mandatory transfer pricing documentation. We identify below the key actions required for current ► Financing arrangements ► Low profits or losses ► Business restructures ► Uncertain tax positions ► Transfer pricing risk mitigation as well as for existing transactions which may be subject to the law.

Arrangements impacted - action required in relation to cross-border transactions Financing arrangements

Pricing of many cross-border financing transactions could be significantly impacted. Businesses will need to consider whether: ►

documentation to further support historical positions should be prepared

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whether any changes to financing arrangements should be made going forward

Low profits or losses

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Business restructures

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Uncertain tax positions

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Transfer pricing risk mitigation

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Businesses with international related party transactions and overall low profit margins or losses should determine the impact of the likely renewed ATO emphasis on profit based approaches. In particular, an analysis of the commercial or ‘nontransfer pricing factors’ that may be contributing to such under performance would be prudent. Finalised and planned business restructures where assets, functions and risks are shifted overseas need to be revisited. Businesses should consider whether additional documentation and analysis should be prepared given the ATO’s ability to more broadly challenge and potentially recharacterise these arrangements. The transfer pricing risk profile of historical transactions may have changed. Businesses will need to reassess uncertain tax positions including whether financial statement disclosures may be required. Additional options are now available to the ATO to challenge the pricing of crossborder transactions. Businesses need to consider the implications of these changes for any current reviews or audits and existing transfer pricing positions. In particular, businesses should consider whether additional analysis may be required or alternative risk management strategies such as Advance Pricing Arrangements (APAs) should be pursued.

Detailed discussion The new transfer pricing rules will apply to international related party transactions involving treaty countries for income years starting on or after 1 July 2004. The greatest impact is expected to be seen in the following areas: ► ► ►

Related party funding arrangements, with gearing near to thin capitalisation limits and/or high interest expense deductions Foreign owned businesses with related party transactions and overall low profit margins or losses in Australia Businesses that have moved or are planning to shift assets, functions or risks out of Australia

The impact for businesses will vary. While the Explanatory Memorandum (EM) asserts that tax treaties have always provided a separate taxing power, the application of the new law to some arrangements is highly controversial. A key feature of the new law is the relevance of the guidance material developed by the Organisation for Economic Co-operation and Development (OECD). The OECD guidance will be relevant if the particular treaty article is the same as (or only deviates in minor respects from) the relevant model article in the OECD Model Tax Convention. For income years prior to 2012, the OECD guidance in place at the start of the income year in question is relevant. The implications of the changes require careful consideration by businesses. Furthermore, the increased disclosures in the new International Dealings Schedule for tax returns and the impacts of likely expansion of the ATO’s Reportable Tax Position pilot program will need to be carefully considered.

Tax Insight: The wait is over – Australia’s new transfer pricing rules passed August 2012

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Implications for ATO precedential documents (Public Rulings & Determinations etc. ) It is expected that the ATO will now look to review the many ATO transfer pricing rulings that have issued in the last 15-20 years and perhaps consider issuing new rulings. We note that the ATO deferred the first meeting of the newly formed Transfer Pricing Advisory Group (TPAG) to September 2012, until the legislation was enacted. The TPAG is expected to discuss the significant interpretative, procedural and administrative implications of the new legislation. Related party funding arrangements A specific provision in the new rules deals with related party financing arrangements. The provision is intended to be consistent with the ATO’s view in Taxation Ruling TR 2010/7 and allows the ATO, in certain situations, to use a hypothetical arm’s length debt amount for the purpose of determining the appropriate interest rate. That interest rate is then applied to the taxpayer’s actual amount of debt. This approach is highly controversial and can be applied retrospectively back to 2004 to loans that were entered into having regard to the rules that existed at that time. We understand that there are several loan pricing cases underway involving several billions of dollars of tax revenue. This issue was a central concern raised in the submissions lodged and considered by the SEC; however the SEC did not seek to recommend a change to this aspect of the legislation. Retrospective application – practical and risk management issues Practical issues remain despite the statement to the SEC from Mr Bruce Quigley (Second Commissioner, ATO), that the ATO ―will not be changing our compliance approach, nor expanding our audit activity in this area as a result of this bill because it merely confirms longstanding practice". The SEC noted the submissions which expressed concerns about retrospectivity. In addition, Ernst & Young’s submission also highlighted the need for clearer transitional penalty provisions and the potential increase in numbers of audit adjustments. In our submission to the SEC we sought an explicit statement that Subdivision 815-A would not be used to reopen any closed or substantially completed ATO reviews, audits, Advanced Pricing Arrangements or Mutual Agreement Procedures on the basis that this would be inconsistent with the ATO’s stated policy and to do otherwise would be grossly unfair. Similarly, given the assertions that the proposed legislation simply clarifies how the law operated in the past, taxpayers would be rightly concerned if the ATO was to now embark on a large transfer pricing risk review and audit program with the express intent of retrospectively applying Subdivision 815-A. No further assurances from the ATO, other than the comment from the Second Commissioner noted above, have been forthcoming. Transitional penalty provisions We think that the proposed transitional penalty provisions are problematic and administratively burdensome for both the Commissioner and taxpayers. The provisions provide for an alternative hypothesis in cases where a determination is made under Subdivision 815-A for income years before 1 July 2012, as if Subdivision 815-A had not been enacted. Presumably, the alternative hypothesis will be based on the Commissioner’s use of either Division 13 or the asserted separate treaty power to establish the notional tax shortfall or scheme benefit. We are not aware of another situation by which an administrative penalty is calculated by reference to a notional tax shortfall or scheme benefit amount. The approach is confusing and problematic and would appear to be designed as a ‘back door’ approach to ensure that penalties are imposed when Subdivision 815-A is retrospectively applied, unless taxpayers are able to effectively argue that there would not have been a transfer pricing adjustment if only Division 13 would have applied. Given the overlap between Division 13 and Subdivision 815-A, the time and resources required to establish the alternative hypothesis would represent a significant hurdle.


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Interaction with customs duty valuations The SEC also acknowledged the inherent tension between transfer pricing and customs pricing approaches with respect to imported goods. Following the greater focus on profit based methods under Subdivision 815-A, this issue will only become more significant and requires some form of resolution. The SEC noted that while the mutual agreement procedure can provide relief from income tax double taxation, there is no mechanism to refund customs duty where a transfer pricing adjustment is made by the ATO.

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The SEC noted the work of the former ATO National Tax Liaison Group Sub-Committee on Transfer Pricing and the positive dialogue between Australian Customs Service and ATO officials and urged Treasury to consider addressing these tensions through a similar body such as the ATO's Large Business Advisory Group. We are hopeful that there will be some movement in this area to better align Australia with emerging global initiatives.

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An exposure draft of the second tranche of legislation is expected in mid September 2012. It will cover the pricing of international related party transactions with non-treaty countries on a prospective basis and is expected to include some form of mandatory transfer pricing documentation.

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How Ernst & Young can help

For more information, please visit www.ey.com/au.

The impact of the new transfer pricing legislation is both broad and far reaching with the potential to substantially impact taxpayers’ past, present and future transfer pricing positions. Ernst & Young can help you navigate through this difficult time by identifying potential exposures and developing appropriate strategies to mitigate transfer pricing risk. For more information please contact: Adelaide Chris Sharpley Tel: +61 8 8417 1686 [email protected]

Sydney Paul Balkus Tel: +61 2 9248 4952 [email protected]

Brisbane Kevin Griffiths +61 7 3243 3754 [email protected]

Jesper Solgaard Tel: +61 2 8295 6440 [email protected]

Canberra Chris Thomas +61 3 8650 7529 [email protected]

Perth Joe Lawson Tel: +61 8 9429 2489 [email protected]

© 2012 Ernst & Young Australia All rights reserved SCORE NO AU00001448 This communication provides general information which is current as at the time of production. The information contained in this communication does not constitute advice and should not be relied on as such. Professional advice should be sought prior to any action being taken in reliance on any of the information. Ernst & Young disclaims all responsibility and liability (including, without limitation, for any direct or indirect or consequential costs, loss or damage or loss of profits) arising from anything done or omitted to be done by any party in reliance, whether wholly or partially, on any of the information. Any party that relies on the information does so at its own risk. Liability limited by a scheme approved under Professional Standards Legislation.

Melbourne Keir Cornish Tel: +61 3 9288 8051 [email protected]


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