Heightened public and political awareness has brought greater scrutiny
In recent years, the topic of transfer pricing has never been far from the front page of business and increasingly, mainstream news.
Continued globalisation and the ever-increasing importance of geographically-mobile intellectual property in value chains have meant that in Australia, across the OECD and beyond, many initiatives and compliance resources are being dedicated to tackling perceived deliberate profit-shifting to lower tax jurisdictions.
Given the scale of its potential impact on tax bases and public finances globally, it’s perhaps unsurprising that harsh penalty regimes have been introduced as deterrents. In Australia, penalties now range from 10% to 50% of the tax shortfall - plus interest.
In last month’s budget announcements, penalties of 100% of the tax shortfall were proposed to apply in certain circumstances from 1 July 2015.
Unfortunately, transfer pricing is not a precise science, and for those taxpayers who unknowingly fall foul of the rules, such a penalty regime may seem draconian. Nevertheless, all taxpayers engaged in cross-border supplies of goods or services with related parties need to be able to demonstrate that such supplies are made at arm’s length prices.
We have seen a marked increase in ATO risk reviews in this area in the last 12 months since the new rules were introduced.
Australian-specific documentation now required
For most Australian companies and branches, new transfer pricing rules took effect from 1 July 2013. In addition to the new penalty regime, these place new responsibilities on the local Australian company and its public officer to consider and document its transfer pricing rationale.
The rules make it clear that it is now not acceptable for an Australian subsidiary of a multinational enterprise to rely solely on its parent company’s global documentation. Rather, the Australian entity must demonstrate how that overall global business model applies in reality in Australia - accounting for the specifics of the Australian context such as the local economy, market strength and strategies.
The new rules also give the Commissioner of Taxation new powers to ‘reconstruct’ certain related party transactions where their structure is considered uncommercial.
However, perhaps the most important change is that, if taxpayers wish to be able to mitigate penalties on subsequent review by the ATO by claiming it had a ‘reasonably arguable position’, it is now mandatory to have documentation in place by the time the taxpayer lodges its tax return. That is, this cannot be argued after the fact should the taxpayer come under ATO review.
Whilst the intent is clearly to encourage taxpayers to have contemporaneous documentation so that transfer pricing is considered in real-time, this can place a significant compliance burden on smaller businesses and those with genuinely-simpler international affairs.
Accordingly, the key question for taxpayers is to what extent will they need to consider and document the arm’s length nature of their transfer pricing to be able to mitigate any penalties on subsequent review?
Documentation Requirements
The ATO has stated that in order to satisfy the above documentation requirements, taxpayers must complete a five-step process to substantiate their transfer pricing as being at arm’s length.
In principle, the ATO recognises that the resource and effort taxpayers dedicate to this process should be in proportion to the degree of complexity and quantum of tax at risk. However, the onus is very much on the taxpayer to determine the level of documentation required based on the ’materiality’ of its related party dealings to its overall tax position.
Smaller companies with relatively simple arrangements may need a minimum of documentation. Those with more complex affairs and / or a larger quantum at risk should consider more extensive documentation. Again, the burden of proof rests with the taxpayer.
The key then, is for the taxpayer to establish this materiality through a comprehensive functional analysis of its business model to identify the nature and size of individual risks and then prepare a risk-appropriate level of documentation.
A Practical Approach
Our approach is to work with clients to create a robust yet commercial transfer pricing framework. The critical first step is to assess their transfer pricing risk through a comprehensive functional analysis of the group’s functions, assets and risks.
This is the foundation upon which a taxpayer’s transfer pricing framework rests and it is this same analysis that, when documented, will enable taxpayers with relatively simple affairs to scale back the degree of resources allocated to documentation.
In some cases, the nature or size of transactions may lend themselves to simplified documentation concessions or alternatively, generally-accepted ‘safe harbour’ approaches. However, the key lies in demonstrating through the functional analysis that such simplified treatments are warranted and available to the taxpayer - as the consequences of self-assessing their eligibility incorrectly can be severe.
Alternatively, the functional analysis may identify that further work needs to be performed; in for example, benchmarking related party dealings to independent arm’s length pricing.
Clearly, notwithstanding the complexity or otherwise of a taxpayer’s affairs, carrying out a comprehensive functional analysis is the critical first step in identifying risk and opportunities
Once complete, we work with clients so they can make an informed value judgement as to what level of risk they bear; the level of documentation appropriate to that risk; and thus the resources they will allocate to its completion.
Contact Us
If you would like to discuss how transfer pricing affects your organisation, please contact a Nexia Advisor.
In addition to our team having significant cross-border tax experience, our international network means we can offer a business-wide view to ensure alignment with global corporate and tax structures.
