The Issue of Transfer Pricing
The issue of transfer pricing (and avoiding transfer mis-pricing) is critical to the Australian Taxation System and therefore a key focus for the ATO.
Our tax system, like all others, is about collectively sharing our resources for the benefit of all Australians. We are very fortunate to have a robust tax system and an effective tax administration board within the ATO, which supports the social benefits we all benefit from as a result of a prosperous community.
However, it is important to understand that whilst the number of large corporate groups in Australia is comparatively small, the impact they have on our revenue pool is significant.
Taxation of Large Corporates
Australia’s 1,500 odd large corporate groups contribute around 60% of all corporate income tax reported, which equates to roughly $50 billion per annum. This equates to more than 10% of total tax collections each year. It is estimated that the level of compliance from those large corporate groups is over 95%, with taxes being paid voluntarily.
But beyond tax compliance and their contribution, large corporates also play a very important role in the community – with perceptions about their compliance underpinning the willingness of other businesses to contribute to the community through the payment of taxes.
Why is transfer pricing so important?
Transfer pricing refers to the rules and methods for pricing transactions within and between enterprises under common ownership or control.
For example, if your business transacts with a related entity overseas – for example, a loan between your Australian business and a foreign subsidiary – your Australian tax can be affected if the amounts for the transaction don’t comply with the arm’s length principle under the transfer pricing rules.
Transfer pricing is particularly important in Australia because:
- We are an open trading country, with a high level of imports and exports, much of which occurs between related entities;
- We are a country open to foreign investment, with high levels of investment from overseas;
- We have a high reliance on corporate taxes, particularly from large businesses; and,
- We have a relatively high headline corporate tax rate.
These factors provide significant incentive for businesses to seek to aggressively transfer price or simply transfer mis-price. Further, some multinational businesses attempt to shift their profits to low-tax jurisdictions by setting unrealistically low prices for their commercial or financial products and services – between their commercially related entities. It is important to know that businesses with related-party international dealings face the possibility of pricing adjustments and penalties if your transfer pricing is reviewed or audited by the ATO. Hence, the more significant and broader the scope of your business’s international dealings with related parties, the more likely it will attract an ATO review. Further, those at greatest risk of review are businesses with significant dealings that are considered ‘low-tax’ compared to industry standards.
As such, the ATO and Government is acutely focused on ensuring that related party transactions are transfer priced, not transfer mis-priced. This has been a key driver behind ensuring the Australian tax system is at ‘best practice’, with early and pragmatic adoption of international developments in tax law. Most recently, the current Government has implemented measures such as the Multinational Anti Avoidance Law (MAAL), Diverted Profits Tax (DPT), Country by Country (CbC) reporting, anti-hybrid and the most up-to-date transfer pricing rules. On the ground, the Government has invested $1.7 billion into the ATO’s Tax Avoidance Taskforce, to adequately resource the challenge and scrutiny of transactions between related entities.
Transfer Mis-Pricing Traps
The ATO sees the following transfer mis-pricing issues in practice:
- pricing a contractual arrangement in a way that does not reflect the real market value;
- entering into transactions or restructures
against the best interests of the Australian entities, for example:
- entering into a lesser transaction (worse position) with a related party than could be obtained through a third party;
- artificial allocation of risk and reward that would never occur in the real world
- transferring intellectual property to a related party just before it becomes commercially viable at a significant discount to what it would be worth
- pricing a transaction which would never take place with a third party
- failing to take into account the bargaining power that the group would have with a notional third party if it were to enter into that transaction, for example, in the real world Coles pays less per square meter than the local pet store.
It is important to note that the ATO will request transfer pricing documentation and supporting information when profiling or auditing and often find that the glossier the report, the worse the price, as businesses produce convoluted stories to support the decisions they’ve made.
ATO Role in Reducing Transfer Mis-Pricing
The ATO’s role is to provide greater levels of certainty in the tax system. This provides holistic benefits by:
- providing confidence that expected tax outcomes will be achieved;
- provides a level playing field for all businesses; and,
- makes Australia a more attractive investment opportunity for overseas investors.
As a result of the Tax Avoidance Taskforce funding, the ATO can focus undertake whole-of-taxpayer profiling and risk assessments. Profiling helps the ATO build a picture of the taxpayer’s business model and any tax planning motivation and opportunities they may have. This profile and the risks unearthed provide a view of each taxpayer and whether they are paying the right amount of tax.
Understanding the effective tax borne (ETB) of the Australian channel of a business is critical to the ATO’s understanding of the tax profile. The ATO developed the concept of the ETB to address commentary from large corporates who claimed they had an effective tax rate of about 30% in Australia – when the ATO knew that the amount of corporate tax paid on their economic activities was not commensurate with this percentage. The community can’t be expected to understand this level of detail and public’s confusion led to distrust about the amount of tax large corporates were paying.
For this reason, the ETB methodology has become paramount to the issue of transfer pricing. Itidentifies a business group’s worldwide profit from Australian-linked business activities and the Australian and offshore tax paid on that profit. ETB is effective tool which will provide an insight into how you will be profiled and assessed by the ATO, in an effort to establish justified trust. It is also a useful sense check your transfer prices and whether they are plausible. This will flush out transfer mis-pricing structures, where one methodology is chosen for the exporting company, another methodology is used by the importing company, and a low or un-taxed entity is inserted into the middle, to book the residual channel profit.
Through the Practical Compliance Guidelines materials, the ATO have documented their perspective on safe ‘green zone’ arrangements for transfer pricing, as well as detail on what they consider to be risky or ‘red zone’ arrangements. While they don’t provide detailed arm’s length conditions or pricing in any particular transaction, the aim is to help taxpayers understand the tax risks.
Further, the ATO welcomes the opportunity to provide clarity through early engagement, to resolve issues and ‘lock in’ future arrangements that are in line with the guidance – providing certainty to both the ATO and the taxpayer.
Focus areas for the ATO include:
- Related Party Loans: These loans are used by Australian taxpayers seeking to achieve artificial transfer pricing benefits. The ATO has made significant inroads in addressing these arrangements and recovered $80 billion in previously high-risk, related party loans.
- Marketing Hubs: These have been a key focus area for some time but the ATO’s efforts are paying off, with a reduced use of these arrangements. It’s a matter of public record that BHP will now be paying their full Australian tax on their Singapore hub and, their on-going arrangements are now in line with the ATO’s ‘green zone’ PCG.
- Inbound Supply Chains: The ATO observed a race to the bottom, in terms of the profit landed in Australia. Not only was this inappropriately reducing Australian tax but also clogging up our APA processes with ambit claims, adversely affecting taxpayers with genuine prices seeking certainty. The ATO have since intervened and made significant improvements.
So, when it comes to transfer pricing, be wise. The ATO will seek to understand where channel profit is being landed around the world (especially un-taxed profits) as it considers whether the transactions makes commercial sense. If it doesn’t, it will then consider the price of a transaction for the same product or service on the open market and, apply various methodologies to see if the price makes sense. Where the price is bad, the ATO will request changes the transfer price, to achieve greater compliance – particularly where transfer pricing is part your fundamental tax profile.
If you have any questions or need advice and clarity specific to your business, feel free to contact Semmens & Co on 03 8320 0320 for a free consultation.