This item requires estimations of the percentages of the total dollar value of the related-party international dealings for which you have written documentation to support:
- the characterisation of the international dealings in the context of your business, as described in step 1 of Taxation Ruling TR 98/11 - Income tax: documentation and practical issues associated with setting and reviewing transfer pricing in international dealings
- the selection of the most appropriate arm's length pricing methods for those dealings, as described in step 2 of Taxation Ruling TR 98/11, and
- the application of the most appropriate arm's length pricing methods to those dealings, as described in step 3 of Taxation Ruling TR 98/11.
The total related-party dealings to be included in this calculation are those dealings identified in items 2a to 2d. Do not include related-party dealings identified in items 2e or 2f.
The concept of 'the most appropriate method' is discussed in Taxation Ruling TR 97/20 - Income tax: arm's length transfer pricing methodologies for international dealings, at paragraphs 3.5 to 3.9.
Contemporaneous documentation
Documentation is contemporaneous if:
- it is existing or brought into existence either
- at the time you are developing or implementing any arrangement that might raise transfer pricing issues, or
- when you are reviewing these arrangements prior to or at the time of the preparation of tax returns, and
- the documentation records information relevant to transfer pricing decisions.
The documentation may be in the form of books, records, studies, budgets, plans and projections, analyses, conclusions and other material that record the information. It may be in electronic or written form.
The initial analysis of your international dealings against the arm's length principle will have been carried out and documented at the time of engaging in the dealings. To review those international dealings before you prepare your tax returns is prudent business practice.
Where you have not used arm's length consideration in the ordinary course of your related-party international dealings, review prices before preparing the tax return, and make any adjustments for taxation purposes. Keep all your documentation in relation to this.
Adequacy of documentation
The ATO does not expect taxpayers to prepare or obtain documents beyond the minimum needed to make a reasonable assessment of whether they have complied with the arm's length principle in setting prices or consideration.
However, the documentation that is created in the ordinary course of the taxpayer's business and used by it to establish the prices for its international related-party dealings - for example, invoices and orders - will not generally be regarded as contemporaneous documentation in relation to the arm's length nature of the dealings. This is because the documents do not produce any evidence or provide any basis for comparison for determining whether prices are established at arm's length.
It is not possible to provide a general checklist of documentation that would be adequate or desirable. The ATO realises that it is necessary to strike an acceptable balance between the need to keep compliance costs to a minimum and the legitimate concern of the ATO in ensuring the proper amount of Australian tax is paid.
The amount and type of documentation that should be created or obtained over and above that created in the ordinary course of business will depend on the facts and circumstances of each case.
The issue is a practical one having regard to what a prudent business person would do in the same circumstances, and taxpayers need to exercise commercial judgment in assessing their own compliance with the arm's length principle.
Arm's length pricing methods
The arm's length principle is the statutory test for pricing related-party international dealings. The principle is incorporated into the associated enterprise articles in each of Australia's double tax agreements.
No particular method to establish the arm's length pricing, or order in which methods should be applied, is prescribed in the double tax agreements or related legislation, and taxpayers have the greatest scope to use methods appropriate to their circumstances.
Taxation Ruling TR 97/20 sets out:
- the methods acceptable to the ATO
- when these methods are considered acceptable
- our views on the concepts involved, and the issues that arise, in applying the methods.
We strongly recommend that all taxpayers with international related-party dealings read this ruling.
Further information is in Taxation Ruling TR 94/14 - Income tax: application of Division 13 of Part III (international profit shifting) - some basic concepts underlying the operation of Division 13 and some circumstances in which section 136AD will be applied, paragraphs 86 and 343, and also in the OECD's report Transfer pricing guidelines for multinational enterprises and tax administrations - 1995.
A brief overview of some methods is at item 5 column A. However, for detailed information about the different methods, see the references above.
Permanent establishments
Where the international dealings are conducted between a permanent establishment and its head office, or between related permanent establishments, the prices adopted for those dealings, for tax purposes, should be determined under the arm's length principle where the prices form the basis for the allocation of profits of the taxpayer in and out of Australia.
Capital dealings
Where the dealings between related parties are capital in nature, the methods discussed at item 5 column A may not be appropriate.
Some alternative suggestions are given at item 6b, and these may be appropriate under certain circumstances. However, no specific methods are recommended.
For the purpose of answering items 4a and 4b, include capital dealings where written documentation is held to support the choice of method for the processes involved in steps 1, 2 and 3 of Taxation Ruling TR 98/11, and a bona fide belief is held that the resulting transfer pricing is arm's length.
Choice of method to determine arm's length pricing
The characterisation of the dealings and the selection and application of the appropriate method are three steps in a four-step process for establishing arm's length transfer prices between associated enterprises. The fourth step is to provide processes for review and adjustment, if necessary, to the chosen method.
The four steps, briefly, are:
- understanding the cross-border dealings in the context of the taxpayer's business - that is, characterisation of the dealings
- selecting the most appropriate method or methods
- applying that method
- establishing review and adjustment processes.
The first two steps may be complex processes and you may need to refer to specific details provided in Taxation Ruling TR 98/11.
The ATO considers that the prudent taxpayer will document:
- the processes of characterisation and selection
- the reasons for the final choice of method
- the reasons why other methods were considered and rejected.
As mentioned earlier, the ATO requires that adequate documentation be kept. However, the complexity of the dealings will indicate the extent to which analysis and supporting documentation is required.
Application of pricing methods
The application of the chosen method will usually require two separate processes:
- an assessment of comparability
- the collection of supplementary data.
The first process will include:
- searching for comparable transactions or enterprises
- identifying sources of information used in the search
- adopting transactions or enterprises as being comparable
- rejecting other transactions or enterprises as not being comparable
- providing reasons and amounts where an independent transaction has been adjusted to make it comparable with the dealings under examination
- applying the pricing method, and any checking method - such as sampling - to ensure the validity of the chosen method and resultant arm's length price.
The second process will include:
- collecting data on profit projections
- creating or acquiring records to supplement the analysis of comparability and function
- collecting data to calculate financial performance ratios, as part of applying the chosen pricing methods.
You must prepare and retain relevant documentation about these processes.