House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Deputy Prime Minister and Treasurer, the Hon Wayne Swan MP)

Chapter 3 - Arm's length principle for conditions between entities

Subdivision 815-B

What is the object of Subdivision 815-B?

3.1 The object of Subdivision 815-B is to ensure that the amount brought to tax in Australia from cross-border conditions that operate between entities reflects the arm's length contribution made by an entity's Australian operations. Any such amounts should reflect the conditions that might be expected to operate between independent entities dealing at arm's length. [Schedule 2, item 2, subsection 815-105(1)]

3.2 Subdivision 815-B seeks to achieve this outcome in a way that facilitates trade and investment through alignment with international standards. The international standard that is widely accepted by Australia's trade and investment partners is the arm's length principle, the application of which is set out in the Organisation for Economic Cooperation and Development (OECD) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations as approved by the Council of the OECD and last amended on 22 July 2010 (OECD Guidelines).

3.3 The Subdivision implements this principle by requiring entities that would otherwise get a tax advantage in Australia from non-arm's length conditions, to calculate their Australian tax position as though the arm's length conditions had instead operated. [Schedule 2, item 2, subsection 815-105(2)]

How does Subdivision 815-B interact with the rest of the Act?

3.4 Subdivision 815-B takes precedence over other provisions of the Income Tax Assessment Act 1936 (ITAA 1936) and the Income Tax Assessment Act 1997 (ITAA 1997) unless a limitation to its operation is explicitly provided within the Subdivision. [Schedule 2, item 2, subsection 815-110(1)]

3.5 This means that to the extent that an entity is liable to a different tax result under Subdivision 815-B relative to other provisions of the tax law because of the operation of arm's length conditions instead of actual conditions, Subdivision 815-B must be applied in working out the entity's Australian tax liability.

3.6 This priority rule does not however overcome the effect of subsection 4(2) of the International Tax Agreements Act 1953 (ITAA 1953) (referred to at paragraphs 2.37 and 2.38 above). This is because Subdivision 815-B takes precedence over provisions in the ITAA 1936 and the ITAA 1997 (the Assessment Acts), whereas subsection 4(2) applies to the extent of inconsistencies between the ITAA 1953 and the Assessment Acts.

3.7 Subdivision 815-B does not limit the application of Division 820 (which is about thin capitalisation) in reducing, or further reducing, an entity's debt deductions. [Schedule 2, item 2, subsection 815-110(2)]

3.8 This rule preserves the role of Division 820 in its application to an entity's amount of debt. In addition to this rule, Subdivision 815-B contains other special rules that apply in working out an entity's transfer pricing adjustment where Division 820 also applies (these rules are described in further detail below at paragraphs 3.143 to 3.149).

3.9 In contrast to former subsection 136AB(2) of the ITAA 1936, Subdivision 815-B does not disregard the effect of sections 70-20, 420-20, 420-30 or 355-400 (which relate to market value amounts). A rule of this kind is not required under Subdivision 815-B because in the event that a market value substitution has already been applied under one of those provisions (or a similar provision), Subdivision 815-B still applies to the extent that an adjustment under Subdivision 815-B is greater than the market value amount.

3.10 Conversely, where the market value amount is greater than the adjustment under Subdivision 815-B, Subdivision 815-B does not apply where the market value amount has already been substituted (because the entity does not have a transfer pricing benefit). Similarly, if Subdivision 815-B were to be applied before the market value amount has been substituted, sections 70-20, 420-20, 420-30 or 355-400 (or a similar provision) would continue to apply to the extent of the difference between Subdivision 815-B and the market value amount. These outcomes are consistent with those that applied under Division 13 of the ITAA 1936 (Division 13), given that Division 13 relied upon the Commissioner of Taxation (Commissioner) issuing a determination and this would only have occurred where the arm's length consideration under former section 136AD of the ITAA 1936 exceeded the market value amount.

Working out an entity's tax position

3.11 Subdivision 815-B applies where an entity gets a transfer pricing benefit in an income year from conditions that operate between the entity and another entity in connection with their commercial or financial relations. In such instances, the actual conditions are taken not to operate and instead, the arm's length conditions are taken to operate for the purposes of working out the amount to which the transfer pricing benefit relates. [Schedule 2, item 2, subsection 815-115(1)]

3.12 These amounts can be the amount of an entity's taxable income, a loss of a particular sort or tax offsets for an income year, as well as withholding tax payable in relation to interest or royalties. [Schedule 2, item 2, subsection 815-115(2)]

3.13 A tax loss, film loss or net capital loss are all identified by subsection 701-1(4) as a loss of a particular sort.

3.14 For simplicity, the process of working out the amount of an entity's taxable income, a loss of a particular sort, tax offsets for an income year, or an amount of withholding tax payable in relation to interest or royalties on the basis of arm's length conditions, is referred to in this Explanatory Memorandum as working out 'an entity's tax outcome under arm's length conditions'.

3.15 After an entity's arm's length conditions are identified, whether and how those conditions would affect the entity's Australian tax result (and any elements in the calculation of its tax result under the relevant sections of the tax law) must be considered.

3.16 In contrast to the transfer pricing rules that were introduced by Subdivision 815-A (in particular, section 815-30), Subdivision 815-B does not contain an explicit rule requiring individual amounts to be specified. A rule of this kind is not necessary because under Subdivision 815-B an entity is required to work out its taxable income, loss of a particular sort, tax offsets or withholding tax payable on the basis that independent conditions operated. This process is different from simply making an overall adjustment to these amounts (as was permitted under Subdivision 815-A) and by definition allows and requires the identification and valuing of items that are relevant in determining the aggregated amounts.

3.17 As such, even if a profit based method is used in applying Subdivision 815-B, taxpayers (and the Commissioner in the case of an amended assessment) must attribute the arm's length conditions to the value of individual components that form part of the tax equation. The determination of an entity's tax position must therefore include all questions (for example the identification of specific amounts of income and expenditure) that would ordinarily be considered in calculating any elements of the entity's tax position.

3.18 One example of this type of consideration would be where the question of source is relevant to an entity's Australian tax position. This could occur where the entity is a foreign resident or where source is relevant in calculating the entity's tax position insofar as it impacts upon other entities (for example, where the entity is a trust or partnership with foreign resident beneficiaries or partners). In such cases, the question of whether the arm's length conditions would have resulted in an amount of Australian sourced income being made by the entity may need to be determined.

Working out withholding tax under Subdivision 815-B

3.19 If a taxpayer receives a transfer pricing benefit in relation to withholding tax, the actual conditions are substituted with the arm's length conditions for the purpose of working out the amount of withholding tax payable in respect of interest or royalties. The effect of substituting the actual amount with the arm's length amount is that the actual amount is treated as never having been paid or received, and that for all purposes of the Act, the arm's length amount was received in accordance with the arm's length conditions.

3.20 In such circumstances, the time the liability to withholding tax under the arm's length conditions arises is determined by those conditions (as opposed to when an adjustment to the actual conditions is made).

3.21 The omission of 'for the income year' from paragraph 815-115(2)(d) requires the working out of withholding tax be based on the receipt of the royalty or interest payment to which the arm's length conditions related. Assuming there had been an actual payment it would generally be reasonable to conclude that the timing of the arm's length payment would have been the same (unless the arm's length conditions changed this timing).

Guidance material

3.22 Applying the arm's length principle is the internationally accepted approach to dealing with transfer pricing issues. The OECD Guidelines, in particular, expand on the application of the arm's length principle and contain authoritative international know-how on the application of transfer pricing rules. The OECD Guidelines are widely used by both member and non-member tax administrations, and were described by the UK Special Commissioners as 'the best evidence of international thinking on transfer pricing'. ^[3]

3.23 In establishing the effect of Subdivision 815-B for an entity, the identification of arm's length conditions must be done in a way that best achieves consistency with prescribed guidance material. The OECD Guidelines are included as guidance material under Subdivision 815-B. [Schedule 2, item 2, subsection 815-135(1) and paragraph 815-135(2)(a)]

3.24 The OECD's Committee on Fiscal Affairs (CFA) is the primary international tax policy forum for Australia and other developed countries. The OECD Guidelines are initially developed by working parties of the CFA, vetted by that Committee, and finally approved or adopted at Council level. Australia is represented at each of these stages and the OECD consults extensively with the international business community as part of this process.

3.25 Most of Australia's major trading and investment partners look to the OECD Guidelines to ensure consistent application of transfer pricing rules. In the event that different standards were used there would be a greater risk that jurisdictions might each tax the same amount under their transfer pricing rules (resulting in double taxation), or not tax an amount at all (leading to double non-taxation).

3.26 The identification of arm's length conditions under Subdivision 815-B must be done in a way that best achieve consistency with the following material:

•

the OECD Guidelines; and

•

any other documents, or part(s) of a document, prescribed by the regulations for this purpose.

[Schedule 2, item 2, subsection 815-135(2)]

3.27 Insofar as it is possible, the OECD Guidance material is to be used in all cases to determine the arm's length conditions. That is, the Guidance material is relevant in applying the Subdivision to dealings between associated entities and equally to dealings between non-associated entities, and in both treaty and non-treaty cases. Although the OECD Guidelines refer to associated enterprises or related parties, it is intended that in the context of Subdivision 815-B such references be read as references to entities not dealing wholly independently with one another.

3.28 This approach to the use of OECD Guidance material is consistent with the intended operation of former Division 13 (which the amendments in this Schedule replace).

3.29 Similarly, some aspects of the OECD Guidelines assume that transfer pricing adjustments will be made by the tax administrations rather than the taxpayer. Because Subdivision 815-B operates on the basis of self-assessment, where appropriate the references in the OECD Guidelines to tax administrations making adjustments, taking actions, or being prevented from taking actions should be read as references to whoever is applying the rules (which may be the taxpayer or the Commissioner).

Regulation making powers in relation to documents

3.30 Regulation making powers are included to allow for modifications to the list of guidance material. Requiring that such modifications be prescribed by regulation strikes an appropriate balance between ensuring ongoing consistency with developing international arrangements while providing for Parliamentary scrutiny of future developments.

3.31 The regulation making powers include the ability to prescribe additional documents or parts of a document. [Schedule 2, item 2, paragraph 815 135(2)(b)]

3.32 These powers ensure sufficient flexibility to prescribe further guidance material that may be published by the OECD or by other organisations that may be relevant for interpretive purposes in the future. Such material might be supplementary in nature or address issues that are not considered in the current OECD Guidance material.

3.33 The OECD Guidelines may also be removed from the list of guidance material by regulation. This allows material to be removed in the event that it is no longer relevant to determining the arm's length conditions of an entity. [Schedule 2, item 2, subsection 815-135(3)]

3.34 It may be appropriate to remove a document where it is subsequently revised in such a way that it is no longer relevant, or if an alternate model or guidance material is adopted in the future. The regulation making power may also remove a part of a document; this power may be used, for example, where Australia reserves its position on part of a document.

3.35 Regulations may also prescribe which documents, or parts of documents, are to be used or removed in specific circumstances. [Schedule 2, item 2, subsection 815-135(4)]

3.36 An example of this would be where a document explains a specific approach that should be adopted in relation to a certain arrangement in a specific industry but would result in an inappropriate outcome for similar arrangements in all other industries. In such cases it may be appropriate to prescribe that document as relevant guidance material, but confine its application to particular arrangements or industries. Alternatively, a regulation that removes a document specified from the guidance provision may prescribe the circumstances in which those documents are to be disregarded.

When does an entity get a transfer pricing benefit?

3.37 The term 'transfer pricing benefit' describes the shortfall amount of Australian tax that an entity has as the result of its non-arm's length dealings with other entities. In the context of a self-assessed position under these rules, this tax advantage is a notional one as it would only be realised in the absence of the entity applying Subdivision 815-B.

3.38 An entity gets a transfer pricing benefit in an income year from conditions that operate between the entity and another entity in connection with their commercial or financial relations if:

•

the actual conditions differ from the arm's length conditions;

•

the actual conditions result in a tax advantage in Australia, relative to the arm's length conditions; and

•

the actual conditions satisfy the cross-border test.

[Schedule 2, item 2, subsection 815-120(1)]

3.39 While the Subdivision only operates where the entity would otherwise have received a tax advantage in Australia, it does not rely on or assume any tax avoidance purpose or motive.

What are 'commercial or financial relations'?

3.40 The term 'commercial or financial relations' describes the totality of arrangements related to the interactions of two entities. The term is particularly relevant in identifying actual and arm's length conditions, and can be seen as the context in which each set of conditions arises.

3.41 It is intended that 'commercial or financial relations' be sufficiently broad so as to take into account any connections or dealings between the entities that relate to or could otherwise affect the commercial or financial activities of one of the entities.

3.42 In this regard, 'commercial or financial relations' could include (but are not limited to) one or more of the following:

•

a single transaction or a series of transactions;

•

a practice, understanding, arrangement, thing to be done or not be done, whether express or implied and whether or not legally enforceable;

•

the options realistically available to each entity;

•

unilateral actions or mutual dealings;

•

a strategy; or

•

overall profit outcomes achieved by the entities.

What are the actual conditions?

3.43 Conditions that operate in connection with the commercial or financial relations of two entities are the things that ultimately affect each of the entities' economic or financial positions. Conditions need not be explicit contractual terms, but can include the price paid for the sale or purchase of goods or services, terms of an agreement that have an economic impact (such as the allocation of an expense), the margin of profits earned by one or both the entities, or a division of profits between the entities.

3.44 The 'actual conditions' are therefore those conditions that did in fact operate in connection with the actual commercial or financial relations of the entities.

3.45 In cases where the multinational enterprise has a relatively straightforward value chain and there is clarity regarding the identification, location and ownership of key profit drivers in that value chain, relevant conditions might include the price at which trading stock items are sold or the fees charged for common services such as transportation or freight.

The actual conditions must differ from the arm's length conditions

3.46 In determining whether an entity gets a transfer pricing benefit, the conditions which operate between the entity and another entity in connection with their commercial or financial relations must differ from the arm's length conditions. [Schedule 2, item 2, paragraph 815-120(1)(a)]

3.47 A difference will exist when arm's length conditions and actual conditions are not the same.

3.48 A difference will also exist where an actual condition exists that is not one of the arm's length conditions, or a condition does not exist in the actual conditions but is one of the arm's length conditions. [Schedule 2, item 2, subsection 815-120(2)]

The actual conditions result in a tax advantage in Australia relative to the arm's length conditions

3.49 Subdivision 815-B requires an assessment of what an entity's Australian tax position would have been had the arm's length conditions operated.

3.50 Assessing what the entity's tax position would have been requires a comparison between the arm's length conditions and the actual conditions. In order to have a transfer pricing benefit, it must be demonstrated that the entity would have received a tax advantage in Australia because of the operation of non-arm's length conditions.

3.51 An entity has a tax advantage of this kind where under arm's length conditions, relative to actual conditions:

•

the amount of the entity's taxable income for the income year would have been greater ;

•

the amount of the entity's loss of a particular sort for the income year would have been less ;

•

the amount of the entity's tax offsets for the income year would have been less ; or

•

the amount of the entity's withholding tax payable in respect of interest or royalties would have been greater .

[Schedule 2, item 2, paragraph 815-120(1)(c)]

3.52 In general terms, an increase in an entity's income or a decrease in an expense under arm's length conditions relative to actual conditions would generally result in that entity having a greater amount of assessable income or a reduction in an allowable deduction in an income year. All things being equal, this would be expected to result in the entity having a greater amount of taxable income or a lesser amount of a tax loss (which is a loss of a particular sort) for the income year.

3.53 Where a change in an amount of profit or component amounts of profit (for example, certain amounts of revenue or expense) would not have affected an entity's Australian tax position, the entity does not have a tax advantage of the kind referred to above. For example, if an amount of profit that might have been expected to have accrued to an entity would have been non-assessable, non-exempt income of the entity, then the entity would not have a transfer pricing benefit in respect of that amount.

3.54 Where an entity receives a royalty or interest payment in an income year that is subject to withholding tax (for example the entity is a foreign resident company that receives a royalty payment from an Australian resident company), and under arm's length conditions the payment would have been expected to have been greater, the entity would generally not be expected to have a greater amount of taxable income or a lesser amount of a tax loss. This is because income that is subject to withholding tax is generally non-assessable, non-exempt income due to the operation of section 128D of the ITAA 1936. In such circumstances however, the entity would be expected to have had a greater amount of withholding tax payable. As such, the entity would have a transfer pricing benefit in respect of that amount.

Determining whether an entity gets a transfer pricing benefit when there is no taxable income, loss of a particular sort, tax offsets

3.55 An assessment of whether an entity receives a tax advantage of the kind referred to above, as well as the amount of any such benefit, requires consideration of the difference between two amounts: the first being based on the actual conditions that operate between entities, and the second being based on the arm's length conditions that might be expected to operate between entities and which is ascertained in accordance with the arm's length principle.

3.56 In instances where an entity has no taxable income, no loss of a particular sort, or no tax offset in an income year, it is not correct to say that the entity has a nil amount (rather it has no amount at all).

3.57 To ensure that the necessary calculation can still be performed where an entity has no actual taxable income, no losses of a particular sort, or no tax offsets (or would not have had such an amount under arm's length conditions), a rule is included to deem the entity to have a taxable income, loss of a particular sort, or tax offsets equal to an amount of nil (as appropriate) in the income year. This allows the relevant amount to be compared with the nil amount (or amounts). [Schedule 2, item 2, subsection 815-120(5)]

3.58 A similar rule is not required in respect of withholding tax, however, because in cases where an entity has no withholding tax payable, the amount of withholding tax payable can still appropriately be described as nil.

The actual conditions must satisfy the cross-border test

3.59 In order for an entity to get a transfer pricing benefit in an income year, the actual conditions that operate between that entity and another entity must satisfy the cross-border test. [Schedule 2, item 2, paragraph 815-120(1)(b)]

3.60 The cross-border test is consistent with former section 136AC of the ITAA 1936 and ensures that Subdivision 815-B does not apply to purely domestic arrangements.

3.61 The test applies to the conditions that operate between two entities in connection with their commercial or financial relations. Although the test examines the conditions from the perspective of each entity individually, it is satisfied where either entity meets its requirements. [Schedule 2, item 2, section 815-120(3)]

3.62 The cross-border test is satisfied in relation to conditions that operate between entities where the 'overseas requirement' for those conditions is satisfied by either or both of the entities. Different overseas requirements apply in relation to different types of entities. [Schedule 2, item 2, paragraph 815-120(3)(a)]

3.63 Where one of the entities is an Australian resident, a resident trust estate or a partnership in which all of the partners are ultimately Australian residents, the overseas requirement will be met where the conditions operate at or through an overseas permanent establishment of that entity. [Schedule 2, item 2, table item 1 in subsection 815-120(3)]

3.64 Where one of the entities is not an Australian resident, is not a resident trust estate, and is not a partnership in which all of the partners are ultimately Australian residents, the overseas requirement will be met where the conditions do not operate solely at or through an Australian permanent establishment of that entity. [Schedule 2, item 2, table item 2 in subsection 815-120(3)]

Note: for simplicity, any references in the following examples to 'table items' refer to the table items in subsection 815-120(3). Further, an entity that is an Australian resident, a resident trust estate or a partnership in which all of the partners are ultimately Australian residents will be referred to as a 'resident entity'. Similarly, an entity that is not a resident entity will be referred to as a 'foreign resident entity'.

Application of the overseas requirement to conditions that operate between two resident entities

Example 3.7

Aus Co (an Australian resident company) sells goods to Aus Trust (a resident trust estate). The sale and purchase are each conducted solely through the Australian business operations of Aus Co and Aus Trust.

The overseas requirement cannot be met under table item 1 because the conditions do not operate at or through an overseas permanent establishment of either Aus Co or Aus Trust.

Table item 2 is not relevant for either Aus Co or Aus Trust because they are both resident entities.

Example 3.8

Aus Co also sells goods to Aus Part (a partnership in which all of the partners are Australian residents). The sale is conducted through the Australian business operations of Aus Co and the purchase is conducted through an overseas permanent establishment of Aus Part.

The overseas requirement is met under table item 1 because the conditions operate through an overseas permanent establishment of Aus Part.

Example 3.9

Aus Part purchases goods from Aus Trust. The sale and purchase are each conducted through the overseas permanent establishments of Aus Part and Aus Trust.

The overseas requirement is met under table item 1 because the conditions operate through an overseas permanent establishment of Aus Part.

The overseas requirement is also met under table item 1 because the conditions operate through an overseas permanent establishment of Aus Trust.

Application of the overseas requirement to conditions that operate between a resident entity and a foreign resident entity

Example 3.10

Aus Co sells goods to For Co (a foreign resident company). The sale is conducted solely through the Australian business operations of Aus Co and the purchase is conducted solely through an Australian permanent establishment of For Co.

The overseas requirement cannot be met under table item 1 because the conditions do not operate at or through an overseas permanent establishment of Aus Co.

Similarly, the overseas requirement cannot be met under table item 2 because the conditions operate sorely through the Australian permanent establishment of For Co.

Example 3.11

Aus Co sells goods to For Trust (a non-resident trust estate). The sale is conducted solely through the Australian business operations of Aus Co and the purchase is conducted solely through the overseas business operations of For Trust.

The overseas requirement is met under table item 2 because the conditions do not operate solely at or through an Australian permanent establishment of For Trust.

Example 3.12

Aus Co purchases goods from For Part (a partnership with three partners - two of which are Australian residents and one of which is a foreign resident). The purchase is conducted through an overseas permanent establishment of Aust Co and the sale is conducted solely through an Australian permanent establishment of For Part.

The overseas requirement is met under table item 1 because the conditions operate through an overseas permanent establishment of Aus Co.

Example 3.13

Aus Co purchases goods from For Co. The purchase is conducted through an overseas permanent establishment of Aust Co and the sale is conducted solely through the overseas business operations of For Co.

The overseas requirement is met under table item 1 because the conditions operate through an overseas permanent establishment of Aus Co.

The overseas requirement is also met under table item 2 because the conditions do not operate solely at or through an Australian permanent establishment of For Co.

Application of the overseas requirement to conditions that operate between two foreign resident entities

Example 3.14

For Co sells goods to For Trust. The sale and purchase are each conducted solely through the overseas business operations of For Co and For Trust.

The overseas requirement is met under table item 2 because the conditions do not operate solely at or through an Australian permanent establishment For Co.

The overseas requirement is also met under table item 2 because the conditions do not operate solely at or through an Australian permanent establishment of For Trust.

Example 3.15

For Co sells goods to For Part. The sale is conducted through the overseas business operations of For Co and the purchase is conducted solely through an Australian permanent establishment of For Part.

The overseas requirement is met under table item 2 because the conditions do not operate solely at or through an Australian permanent establishment of For Part.

Example 3.16

For Part purchases goods from For Trust. The sale and purchase are each conducted solely through the Australian permanent establishments of For Part and For Trust.

The overseas requirement cannot be met under table item 2 because the conditions operate solely through an Australian permanent establishment of For Part.

Similarly, the overseas requirement cannot be met under table item 2 because the conditions operate solely through an Australian permanent establishment of For Trust.

Special rule for entities that are dual-residents

3.65 An additional rule is also included in respect of entities that are dual-residents of both Australia and a country with which Australia has an international tax agreement containing a residence article (a residence article is defined as Article 4 of the United Kingdom convention or a comparable provision of another agreement). If as the result of the residence article an entity is treated as a resident of the other country under the agreement, they are deemed not to be an Australian resident for the purposes of meeting the overseas requirement. In addition to applying to the entity to which the overseas requirement directly applies, this rule also applies to a trustee in determining whether a trust estate is a resident trust estate, as well as the partners of a partnership in determining whether all of the partners are Australian residents. [Schedule 2, item 2, subsections 815-120(4) and (6)]

3.66 The dual-resident rule is required because the treaty tie-breaking rules in Australia's international tax agreements only have effect for the purpose of applying the agreement. This rule aligns the application of Subdivision 815-B to that entity with its treatment as a dual-resident under a treaty (which results in Australia being limited to taxing the entity as though it were a foreign resident).

3.67 There is no need for a rule to deem a dual-resident that is treated as an Australian resident under an international tax agreement to be an Australian resident because such entities are already Australian residents. Similarly, the rule does not have any operation in relation to treaties that do not apply to dual-residents (such as the Chile and Turkey agreements), or to non-treaty cases because in such circumstances an entity continues to be taxed in Australia as an Australian resident.

Example 3.17

Aus Co purchases goods from Dual Co. Dual Co is an Australian resident company but is also a resident company of the UK. Under Article 4 of the Australia-UK convention, Dual Co is treated as a UK resident.

For the purposes of the overseas requirement, Dual Co is not an Australian resident and is instead taken to be a resident of the UK only.

Example 3.18

Aus Co purchases goods from Dual Part (a partnership with three partners - two of which are Australian residents and one of which is both an Australian resident and a resident of the UK).

For the purposes of the overseas requirement, the dual-resident partner is not an Australian resident and is instead taken to be a resident of the UK only. This means that in meeting the overseas requirement, Dual Part is taken to be a partnership in which not all of the partners are Australian residents.

Conditions that operate in connection with an area covered by an international tax sharing treaty

3.68 The cross-border test will also be satisfied where the conditions operate in connection with a business an entity carries on in an area covered by an international tax sharing treaty. [Schedule 2, item 2, paragraph 815-120(3)(b)]

3.69 Although some parts of an area covered by an international tax sharing treaty (for example the Timor Sea Treaty) may still be in Australia, Australia's ability to impose tax upon income sourced in those areas (or deal with expenditure in relation to such income) will be affected by the terms of the agreement. As such, the cross-border test is satisfied in relation to conditions that operate in connection with a business carried on by an entity in an area covered by an international tax sharing treaty, irrespective of the residency status of that entity.

Application to parties that are not related

3.70 In satisfying the cross-border test, it is not necessary for the relevant entities to be associated. This approach is consistent with Division 13 and ensures that this Subdivision applies to any conditions that exist between entities that do not operate on an arm's length basis (such as collusive arrangements between unrelated entities).

Conditions that are affected by arrangements entered into by other entities

3.71 Although Subdivision 815-B can only apply to particular actual conditions where the above requirements are satisfied in respect of those conditions, it may be the case that other arrangements or conditions are relevant in determining whether the actual conditions are different from arm's length conditions or result in a tax advantage. These other arrangements need not be covered by Subdivision 815-B.

3.72 Because arm's length conditions are identified by hypothesising what independent entities in comparable circumstances dealing wholly independently would have done in the place of the actual entities, interactions that each of the entities have with other entities may be relevant where they impact upon the actual conditions.

3.73 For example, if two entities were to enter into a loan arrangement under which repayment of the loan was contingent upon one of the entities achieving a certain profit position in an income year, the question under Subdivision 815-B is whether independent entities dealing wholly independently would have agreed to a repayment term of that nature. If the borrower also had arrangements in place with another entity that allowed that other entity to strip profits from the borrower in order to keep it below the specified repayment threshold, those profit shifting arrangements would clearly be a relevant consideration in determining whether the loan arrangement would have been entered into by independent entities. This is the case irrespective of whether the profit stripping arrangement is also covered by Subdivision 815-B.

3.74 It could also be the case that arrangements with other entities appear to justify the existence of actual conditions that result in a tax advantage relative to arm's length conditions. In such circumstances, the relevant question must still be whether independent entities dealing wholly independently would have dealt with one another in the way the actual entities did.

3.75 For example, if a resident entity were to purchase raw materials from a foreign resident at an inflated price, the purchase price would only be at arm's length if independent entities dealing wholly independently in comparable circumstances would have agreed to the purchase price. This is the case irrespective of whether the resident entity sells a product manufactured from those materials to a third entity at an equally inflated price because, having regard to its own economic interests, an independent entity dealing with the seller of the raw materials would still have an incentive to minimise their input costs.

What are the arm's length conditions?

3.76 The arm's length conditions in relation to conditions that operate between an entity and another entity are the conditions that might be expected to operate between entities dealing wholly independently with one another in comparable circumstances. [Schedule 2, item 2, subsection 815-125(1)]

3.77 Arm's length conditions are the conditions that would have operated between independent entities in place of the actual conditions. The identification of arm's length conditions involves hypothesising what independent entities would have done in the place of the actual entities. This process requires the postulation of how independent entities in comparable circumstances would have dealt with one another had they been dealing at arm's length. Cross-border intra-firm trade in services and intangible assets has increased dramatically for Australian entities over recent years. Determining the arm's length conditions in these situations is likely to go beyond looking at the consideration provided in relation to a single condition (such as the price of trading stock) or a discrete element of the overall arrangement.

3.78 Similarly, there have been significant increases over recent years in the volume and complexity of cross-border intra-firm financing transactions involving various forms of debt and hybrid securities. In the more complex cases involving these financing facilities, determining the arm's length conditions could include factors that relate to an entity's relative financial strength, and how the market would perceive the entity's financial strength with explicit consideration given to the fact that the entity is part of a larger multinational group.

3.79 It may also be important to consider issues such as whether independent entities operating in comparable circumstances would have advanced loans with the same or similar characteristics, provided various forms of credit support, sought to refinance at a different market interest rate, issued shares or paid dividends. The consideration of what price and under what conditions those transactions would have occurred between independent parties dealing wholly independently with one another may also be necessary. Similar questions could also be asked regarding royalties or licence payments (such as whether a sale and licence back of a strategic intangible would happen between independent parties), and could also include decisions that may affect an entity's liquidity, such as the time at which an amount should be paid.

3.80 The term 'comparable circumstances' relates to the profile of each of the hypothetical independent entities. By requiring that the independent entities be in 'comparable circumstances' to the actual entities, the nature of the actual entities and the context within which they operate is directly relevant in constructing the profile of the hypothetical entities.

3.81 Although the profile of the independent entities must be comparable to that of the actual entities, arm's length conditions are simply those conditions that might be expected to operate between independent entities dealing wholly independently. The definition of arm's length conditions does not of itself require that the arm's length conditions reflect or conform to actual conditions or the commercial or financial relations of the entities.

Identifying arm's length conditions:

the 'basic rule'

3.82 In order to inform the characterisation of what the independent entities would have done, Subdivision 815-B sets out a 'basic rule' which generally applies in determining arm's length conditions. Under this rule, the identification of arm's length conditions must be based on the form and substance of the commercial or financial relations in connection with which the actual conditions operate. [Schedule 2, item 2, subsection 815-130(1)]

3.83 This rule constrains the way in which the arm's length conditions must be identified. As a result, the form and the substance of the commercial or financial relations that actually existed between the entities (and which gave rise to the actual conditions related to the arm's length conditions that are being identified), must be considered in the identification of the arm's length conditions.

3.84 The 'form' of commercial or financial relations describes the prima facie features or legal characteristics of the dealings between entities. In contrast, the 'substance' of the commercial or financial relations describes the economic reality or essence of those dealings. The substance of commercial or financial relations is determined by examining all relevant facts and circumstances, including the economic and commercial context of any arrangements entered into, its object and effect from a practical and business point of view, the conduct of the entities and the functions performed, assets used and risks assumed by them.

The arm's length condition is the most appropriate and reliable condition

3.85 The identification of the arm's length conditions involves hypothesising what independent entities would have done in comparable circumstances to the actual entities. As such, a number of alternative conditions may be hypothesised as potentially operating between independent entities.

3.86 In order to quantify a transfer pricing benefit and make the consequent adjustment, Subdivision 815-B requires the selection of the most appropriate and reliable condition as the arm's length condition.

3.87 For example, where the identification of an arm's length condition requires the consideration of a range of values (as opposed to a single value), the most appropriate and reliable point within that range will determine the arm's length condition. Where a number of points within the range are equally appropriate and reliable, any of those points may be selected.

Entities dealing wholly independently with one another

3.88 Whether entities (associated or not) deal with each other in accordance with the arm's length principle is essentially a question of fact. The relevant question for the purposes of Subdivision 815-B is whether the conditions which operate between the entities would make commercial sense if the entities were dealing wholly independently with one another.

3.89 When considering whether parties have dealt with one another independently, the question is whether they have acted as independent parties would in comparable circumstances, so that the outcome of the dealings is a matter of real bargaining: Trustee for the Estate of the late AW Furse No. 5 Will Trust v Federal Commissioner of Taxation (1990) 21 ATR 1123 at 1132.

3.90 The relationship between the parties is relevant but not determinative. Thus, parties that are related to each other may deal independently with one another and parties that are not related to each other might not deal independently with one another: Barnsdall v Federal Commissioner of Taxation (1988) 81 ALR 173; Furse 21 ATR 1123 at 1132; RAL and Ors and Federal Commissioner of Taxation (2002) 50 ATR 1076 [at 45-51].

3.91 Examples of where parties that are unrelated to each other are not dealing independently with one another include where:

•

one of the parties submits to the will or direction of the other, perhaps to promote the interests of the other: Granby v Federal Commissioner of Taxation 129 ALR 503 at 507;

•

one party is indifferent to an outcome sought by the other party on a particular aspect of their dealings: Collis v Federal Commissioner of Taxation (1996) 33 ATR 438 at 443; or

•

the parties collude, or act in concert, to achieve an ulterior purpose or result: Granby 129 ALR 503 at 507.

Identifying arm's length conditions:

exceptions to the 'basic rule'

3.92 There are three exceptions to the 'basic rule' for identifying arm's length conditions. Where these exceptions apply, actual commercial or financial relations in connection with which the actual conditions operate are disregarded for the purposes of identifying arm's length conditions. Specific rules for each exception then provide the alternative means of identifying arm's length conditions. As with the basic rule, the exceptions continue to constrain the way in which the arm's length conditions must be identified.

3.93 In determining whether the exceptions apply, as well as identifying the arm's length conditions under one of the exceptions, rules related to the comparability of circumstances remain relevant. [Schedule 2, item 2, subsections 815 130(5)]

3.94 The exceptions to the basic rule are intended to be consistent with the 'exceptional circumstances' discussed in the OECD Guidelines in the context of non-recognition and alternative characterisation of certain arrangements or transactions (for example under Chapters I and IX of the OECD Guidelines). Given that the OECD Guidelines are prescribed as relevant guidance material under the guidance provision in Subdivision 815-B, the identification of arm's length conditions under one of the exceptions must be done that best achieves consistency with any aspects of the Guidelines that are relevant.

3.95 The first exception is based on the approach taken under the OECD Guidelines in relation to economic substance (see for example paragraphs 1.65, 9.169 and 9.183 of the OECD Guidelines). In this regard paragraph 9.183 of the OECD Guidelines states:

'Under the first circumstance of paragraph 1.65, where the economic substance of a transaction differs from its form, the tax administration may disregard the parties' characterisation of the transaction and re-characterise it in accordance with its substance.'

3.96 The second and third exceptions are based on the approach taken under the OECD Guidelines in relation to the non-recognition and alternative characterisation of certain arrangements (see for example paragraphs 1.65, 1.66, 9.61, 9.175, 9.169 and 9.185 of the OECD Guidelines). In this regard, paragraph 1.66 of the OECD Guidelines states:

'Article 9 would thus allow an adjustment of conditions to reflect those which the parties would have attained had the transaction been structured in accordance with the economic and commercial reality of parties dealing at arm's length.'

The form of the commercial or financial relations differs from the substance

3.97 In cases where the form and substance of the actual commercial or financial relations of the entities differ, the form is disregarded to the extent of the inconsistency with the substance. [Schedule 2, item 2, subsection 815-130(2)]

3.98 The arm's length principle is fundamentally concerned with ensuring that entities are appropriately rewarded for their economic contributions. Although in many cases, the substance of the commercial or financial relations will be identical to the legal form, where this is not the case the identification of arm's length conditions must be based on the substance of the entities' commercial or financial relations. Although the effect of this rule is that certain aspects of the commercial or financial relations are disregarded, the identification of arm's length conditions still relates to actual commercial or financial relations that exist between the entities.

Independent entities would have entered into different commercial or financial relations

3.99 In cases where independent entities dealing wholly independently with one another in comparable circumstances would not have entered into the actual commercial or financial relations, the identification of arm's length conditions is based on the commercial or financial relations that independent entities would have instead entered into. [Schedule 2, item 2, subsection 815-130(3)]

3.100 This exception only applies where, having regard to their own economic interests, independent entities dealing wholly independently would not have entered into the actual commercial or financial relations, but would have instead entered into alternative commercial or financial relations that differ in substance from the actual commercial or financial relations.

3.101 As each element of this test must be positively satisfied, it is not of itself sufficient to propose that independent entities might have dealt with one another in an alternative manner. Moreover, the mere fact that actual independent entities have not been observed to have dealt with one another in a particular way (or that information on such independent dealings is not available) will not necessarily mean that independent entities would not have entered into the commercial or financial relations that the entities actually did. The relevant question is instead whether independent entities behaving in a commercially rational manner and acting in their own best commercial and economic interests would have dealt with one another in the same way, given the options that are realistically available to them. Without detracting from the relevance of actually observed dealings, nothing prevents each aspect of the test from being established hypothetically.

3.102 The requirement that independent entities 'would' have done something different to the actual entities imposes a higher standard of proof than simply demonstrating that independent entities 'might' or 'might be expected to' have entered into alternative commercial or financial relations.

3.103 This standard is intended to reduce the number of possible alternatives that can be hypothesised under the exception. In the event that more than one alternative set of commercial or financial relations would have been entered into by independent entities (for example, because the overall effect of each alternative is similar enough that independent entities would be indifferent about which one operated), the substituted commercial or financial arrangements under this exception should comport as closely as possible with the facts and economic substance of what actually occurred. This approach is consistent with both the OECD Guidelines (see for example paragraph 9.187 of the OECD Guidelines) and the requirement in the exception that in the course of identifying arm's length conditions, the independent entities must be in comparable circumstances to the actual entities.

Independent entities would not have entered into any commercial or financial relations

3.104 In cases where independent entities dealing wholly independently with one another in comparable circumstances would not have entered into any commercial or financial relations, the identification of arm's length conditions is based on the assumption that no commercial or financial relations existed. [Schedule 2, item 2, subsection 815-130(4)]

3.105 This exception will only apply where independent entities dealing wholly independently would not have entered into the actual commercial or financial relations, or any other commercial or financial relations whatsoever. The effect of this exclusion is that the actual commercial or financial relations are disregarded for the purposes of identifying arm's length conditions. In such cases, the actual conditions connected with the commercial or financial relations are likely to be disregarded, and the arm's length condition is that nothing would have occurred.

3.106 Any arm's length conditions that are identified under this exception are still subject to the general transfer pricing benefit requirements set out under section 815-120, meaning that this exception does not apply if disregarding the commercial or financial relations would result in the entity obtaining an Australian tax advantage (for example, an actual payment to the entity could not be disregarded under this exception). As such, application of this exclusion is limited to disregarding positive actions of an entity that give rise to a transfer pricing benefit. One example of this would be where the actual commercial or financial relations result in an expense being borne by an entity that would simply not have been borne by an independent entity in comparable circumstances. In such instances, the non-recognition of the expense would result in the entity not being able to claim a deduction.

Selecting the method or combination of methods to determine the arm's length conditions

3.107 Transfer pricing methods seek to determine what the arm's length conditions would be if the parties involved were dealing wholly independently with one another. An entity required to identify arm's length conditions under Subdivision 815-B must use the method or methods that produces the most appropriate and reliable assessment of the conditions having regard to:

•

the respective strengths and weaknesses of the possible transfer pricing methods;

•

the circumstances, including the functions performed, the assets used and the risks borne by the entities;

•

the availability of reliable information required to apply a particular method; and

•

the degree of comparability between the actual circumstances and the comparable circumstances, including the reliability of any adjustments to eliminate the effect of material differences between those circumstances.

[Schedule 2, item 2, subsection 815-125(2)]

3.108 The method must be capable of practicable application and produce an arm's length outcome that is a reasonable estimate of what would have been expected if the dealings had been undertaken between independent entities dealing wholly independently with one another.

Which methods are relevant?

3.109 The OECD Guidelines provide a framework for the application of the arm's length principle.

3.110 Pursuant to the guidance rules in Subdivision 815-B, entities must have regard to the OECD Guidelines in identifying arm's length conditions.

3.111 Although the various methods currently outlined in the OECD Guidelines are explained in the following paragraphs, these methods are not the only methods that may be used. Consistent with the OECD Guidelines, where an alternative method (or combination of methods) gives a more appropriate arm's length outcome, that alternate method (or combination of methods) may be used.

Comparable uncontrolled price method

3.112 The comparable uncontrolled price (CUP) method compares the price actually charged for property or services that have been transferred with the price that would be charged for materially the same property or services by the same supplier in a comparable dealing with an independent party or by a comparable independent entity dealing wholly independently with another entity in comparable circumstances.

Cost plus method

3.113 The cost plus method provides an estimate of an independent margin by adding an appropriate cost plus mark-up to the supplier's costs. The profit mark-up is determined by reference to the cost-plus mark-up earned by the same supplier in comparable dealings with independent parties or by independent entities dealing wholly independently with each other in comparable circumstances.

Resale price method

3.114 The resale price method estimates an independent price for property or services by taking the price at which the product is sold to or by independent entities and reducing it by an independent resale price margin. The margin would be determined by reference to the resale price margins earned by the same supplier in comparable dealings with independent parties or by independent entities dealing wholly independently with each other in comparable circumstances.

Transactional Net Margin Method

3.115 The transactional net margin method (TNMM) compares the net profit margin that the taxpayer has achieved with that which independent parties dealing wholly independently in relation to a comparable transaction or dealings would have achieved.

3.116 Comparisons at the net profit level can be made on a single transaction or in relation to an aggregation of dealings between the taxpayer and one or more other entities.

3.117 The TNMM examines the net profit margin relative to an appropriate base (for example, costs, sales, assets) that a taxpayer realises from an activity or transaction.

Profit split method

3.118 The profit split method identifies the combined profit of two or more enterprises and then splits those profits between the enterprises on an economically valid basis that approximates the division of profits that independent entities would have expected to realise had the arrangements existed between parties dealing wholly independently.

3.119 The profit split method may be appropriate where different activities undertaken by the entities make unique and valuable contributions. In these cases, it may not be practical or feasible to assess arm's length outcomes with reference to a specific comparable.

Equally appropriate methods

3.120 Consistent with the OECD Guidelines, where it is considered that more than one method can be applied in an equally reliable manner, the more direct method should be preferred. For example, where a transaction based method and a profit based method are equally reliable (taking into account the factors provided for in subsection 815-125(2)), the transaction based method should be preferred.

Comparability of circumstances

3.121 One of the factors in selecting and applying a method is the degree of comparability between the actual circumstances and any circumstances being compared.

What is meant by the term 'comparable'?

3.122 For circumstances to be comparable, none of the differences (if any) between the situations being compared should be capable of materially affecting a condition that is relevant to the method. [Schedule 2, item 2, paragraph 815-125(4)(a)]

3.123 Where differences exist, a situation may be considered comparable if reasonably accurate adjustments can be made to eliminate the effects of the difference on a condition that is relevant to the method. [Schedule 2, item 2, paragraph 815-125(4)(b)]

Example 3.19 : Comparability adjustments

Most of Aus Co's dealings are with wholly independent enterprises. Aus Co does however undertake limited dealings with a non-arm's length party that operates in the same market, undertakes comparable commercial roles, does not undertake a commercial strategy, is of comparable market importance and takes possession of comparable amounts of production inputs as the independent enterprises with which Aus Co deals. However, the dealings between Aus Co and the non-arm's length party are on different freight terms to those with other independent enterprises. The non-arm's length dealing, while not being completely comparable, is capable of being adjusted for freight terms such that the circumstances are comparable, to achieve comparability between the conditions of the commercial or financial relations of the independent and non-arm's length arrangements.

3.124 Where reliable comparability adjustments cannot be made, this may indicate that another method should be used, which relies on different points of comparison.

3.125 In determining the degree of comparability, including any adjustments that may be necessary, consideration must be given to the range of options that would be realistically available to an independent enterprise in comparable circumstances. That is, consideration needs to be given to what an independent enterprise would consider in terms of the options available to it and whether the options would significantly affect the value of an arrangement.

What factors must be taken into account in determining comparability?

3.126 In identifying comparable circumstances, regard must be had to all relevant factors including but not limited to the following:

•

the functions performed, assets used and risks borne by the entities;

•

the characteristics of any property or services transferred;

•

the terms of any relevant contracts between the entities;

•

the economic circumstances; and

•

the business strategies of the entities.

[Schedule 2, item 2, subsection 815-125(3)]

How do the OECD Guidelines describe these factors?

3.127 Below is a selected discussion of the factors as presented by the OECD Guidance material. However, the entire text of the OECD Guidance material should be taken into account when determining whether the circumstances are of a sufficient level of comparability.

Functional analysis

3.128 In general, the level of compensation that passes between entities should reflect the functions that each entity performs (taking into account assets used and risks assumed). Therefore in determining whether certain arrangements or entities are comparable, a functional analysis is required. Such a comparison must seek to identify and compare the commercially significant activities and responsibilities undertaken, assets used and risks assumed by the parties.

3.129 The types of functions that may be relevant include those relating to design, manufacture, assembly, research and development, servicing, purchasing, distribution, marketing, advertising, transportation, financing and management. It is important to consider the assets used or intended to be used and the condition and value of those assets. Assets might include, but would not be limited to, plant and equipment, valuable intellectual property, and financial assets.

3.130 The risks assumed by different parties are an important feature of a functional analysis. Generally, in an open market, the assumption of increased risk would also be compensated by an increase in the expected return.

3.131 The types of risks that might be considered would include but not be limited to market risks such as fluctuations in input costs and output prices, risks associated with investment in and use of property, plant and equipment, risks of the success or failure of investment in research and development; financial risks, credit risks and so forth.

3.132 The functions carried out (taking into account the assets used and risks assumed) determine to some extent the allocation of risks between the parties. In considering this allocation it is important that the risks allocated on a contractual basis match the economic substance of the arrangements. In this regard, the parties' conduct should generally be taken as the best evidence concerning the true allocation of risk. Furthermore, in considering the economic substance of a purported risk allocation, it generally makes sense for parties to be allocated a greater share of those risks over which they have relatively more control - arm's length parties would generally not be willing to assume risks over which another party has significantly more control.

Characteristics of the property or services

3.133 Any differences in the specific characteristics of the property or services that are relevant to the arrangements in place between the relevant entities and those that are potentially comparable need to be carefully considered. Such differences would often account, at least in part, for differences in value.

3.134 In general, the requirement for comparability of property or services is the strictest when using the comparable uncontrolled price method, as any material difference in the characteristics of property or services can have an effect on the price and would require an appropriate adjustment to be considered. By contrast, the remaining methods, which look at gross profit margins, mark-up on costs or other profit-based indicators, are generally less sensitive to such differences.

3.135 In considering the specific characteristics of the property or services transferred, it is important to consider such things as the physical features of the property, its quality and reliability, and the availability and volume of supply.

Contractual terms

3.136 Contractual terms often shed light expressly or implicitly on the nature of arrangements. There may be written documentation in place of, or in addition to contractual documents that add to the overall picture of how responsibilities, risks and benefits are to be divided between parties.

3.137 Where no written documents exist, the contractual relationship between parties must be deduced from their conduct and the economic principles that generally govern relationships between independent parties.

3.138 When parties are dealing wholly independently their separate interests will usually motivate them to hold the other to the contractual terms unless it is in their mutual interests to modify them. When parties are not dealing wholly independently the same incentives may not be present and it is important to establish whether the economic substance of arrangements matches the contractual terms.

Economic circumstances

3.139 Prices and other financial indicators may vary across different markets even where relevant transfers are for the same property or services. Therefore comparability requires that the relevant markets are comparable, if indeed they are not in the same market. In identifying the relevant market or markets regard should be had, amongst other things, to:

•

geographic location;

•

the size of the markets;

•

the extent of competition in the markets and the relative competitive positions of the buyers and sellers;

•

the availability of substitute goods and services;

•

the levels of supply and demand;

•

consumer purchasing power;

•

the nature and extent of government regulation;

•

costs of production;

•

transport costs;

•

the level of the market; and

•

the date and time of transactions.

Business strategy

3.140 Business strategies must also be examined in determining comparability for transfer pricing purposes. The business strategies employed by an entity may materially impact on the conditions that operate in the commercial or financial relations between entities. The business strategies adopted may influence the degree of innovation and new product development, risk diversification and aversion; and would take into account the enterprise's assessment of future changes in the commercial environment.

3.141 Business strategies could also include market penetration schemes. An enterprise seeking to penetrate a market to increase market share might temporarily charge a price for its product or services that is lower than the price charged by otherwise comparable products in the same market. Furthermore, an enterprise seeking to enter a new market or expand (or defend) its market share might temporarily incur higher costs (for example, due to start-up costs or increased marketing efforts).

3.142 Generally a market penetration scheme results in lower profits as it is being prosecuted, with an expectation of higher profits in the future. When evaluating purported business strategies, factors such as the actual conduct of the parties, the nature of the relationships between them, and whether there is a plausible expectation that the strategies will succeed (within a period of time that would be acceptable in an arm's length arrangement) are likely to be relevant.

How does the arm's length principle apply when the thin capitalisation rules also apply to an entity for the relevant period?

3.143 Where Division 820 applies to an entity for an income year and the entity has worked out elements of its tax position under arm's length conditions that relate to its debt deductions, a special rule modifies the way in which Subdivision 815-B applies to the entity. [Schedule 2, item 2, subsection 815-140(1)]

3.144 The rule preserves the role of Division 820 in respect of its application to an entity's amount of debt. If under the arm's length conditions, working out an entity's debt deductions involves applying a rate to a debt interest, the rule requires the rate to be worked out as if the arm's length conditions had operated. However, this rate is applied to the debt interest the entity actually issued instead of the debt interest that would have been issued had the arm's length conditions operated (in the event that there is a difference between the interests). [Schedule 2, item 2, subsection 815-140(2)]

3.145 The rule maintains the administrative approach under Taxation Ruling TR 2010/7, which was confirmed in Subdivision 815-A.

3.146 To the extent that an entity's debt deductions are worked out by applying a rate to a debt interest (such as by applying a rate of interest to a loan amount, or applying a rate to the amount of debt covered by a guarantee) the identification of arm's length conditions in respect of those debt deductions is modified so that only the rate may be adjusted. As such, Subdivision 815-B allows the rate to be adjusted to an arm's length rate, but that rate must be applied to the debt interest actually issued (and still on issue from time to time). This ensures that Subdivision 815-B does not prevent the operation of the thin capitalisation rules.

3.147 Debt deductions (as defined in section 820-40) include any costs directly incurred in obtaining or maintaining a debt interest, for example interest or amounts in the nature of interest, guarantee fees, line fees and discounts on commercial paper.

3.148 The interaction of this Subdivision with Division 820 operates as follows:

•

First, to the extent relevant, the arm's length rate applying to a debt interest is determined in accordance with the normal rules contained in section 815-115. In doing so, it is necessary to consider the conditions operating between the relevant entity and other entities in relation to the commercial or financial relations that exist between them. The arm's length rate may need to be determined by having regard to the conditions which could be expected to operate between entities dealing wholly independently with each other. For example, in some exceptional cases (as provided by the relevant OECD guidance material), it may be appropriate to determine the arm's length rate having regard to the amount of debt the entity is likely to have had, had the conditions operating between it and its associate(s) been consistent with what they would have been if the entities had been independent of each other. Alternatively, it may be possible to determine an arm's length rate, directly or indirectly, by some other means without having to determine an arm's length amount of debt. Whether an entity's amount of debt meets the safe harbours provided for the purposes of Division 820 is not relevant for this first step.

•

Secondly, the arm's length rate for a particular debt interest is applied to the actual amount of debt for that debt interest. The entity's remaining debt deduction after the arm's length rate of interest has been applied then becomes the relevant debt deduction for the purposes of Division 820.

•

Finally, and after the consideration of any other relevant parts of the ITAA 1936 and ITAA 1997, Division 820 may reduce an entity's otherwise allowable debt deductions if the entity's adjusted average debt exceeds its maximum allowable debt.

3.149 Similar to Subdivision 815-A, the following examples illustrate the interaction of Subdivision 815-B and Division 820. They are intended to illustrate the respective fields of operation of Subdivision 815-B and the thin capitalisation rules and are not intended to suggest that a particular method for pricing debt must be applied to the circumstances of a particular case. Nor are the examples intended to preclude the use of other methods that produce an arm's length outcome.

Example 3.20 : Thin capitalisation adjustment and transfer pricing adjustment

Aus Co is an Australian resident subsidiary company of For Co, a resident of the UK. Aus Co is an 'inward investment vehicle (general)' for the purposes of Subdivision 820-C.

For an income year, Aus Co has:

•

a 'safe harbour debt amount', determined in accordance with section 820-195 of $375 million; and

•

'adjusted average debt' determined in accordance with subsection 820-185(3) of $400 million, of which $200 million is borrowed from For Co at an interest rate of 15 per cent, and $200 million from an independent lender at an interest rate of 10 per cent.

Aus Co's only debt deductions are for the interest incurred at a rate of 15 per cent on its $200 million related party debt, and 10 per cent on its $200 million debt from the independent lender, meaning that it has $50 million of debt deductions for the income year.

Aus Co needs to consider whether they would receive a transfer pricing benefit as a result of actual conditions that it would not receive if arm's length conditions instead operated. In doing so, Aus Co has regard to the arm's length rate in relation to the debt interest (that is, the arm's length interest rate), applied to the actual amount of the related party debt.

Assume that the loan from the independent lender is sufficiently similar to the loan from For Co. Also assume that the circumstances in which each amount of debt funding was provided do not present material differences that would affect the rate applicable to the debt interest or Aus Co's ability to obtain $400 million in debt funding (that is, the independent loan is directly comparable to the related party loan). As a result, using a comparable uncontrolled price is the most appropriate method for determining the arm's length rate. In these circumstances it is commercially realistic for Aus Co to determine that the arm's length interest rate is 10 per cent. In this case, Aus Co gets a transfer pricing benefit of $10 million (being the difference between an arm's length rate of 10 per cent applied to the debt interest arising from the loan from For Co ($200 million) and the actual interest rate of 15 per cent on the debt interest).

Further, to the extent that Aus Co has 'excess debt', Division 820 applies to deny Aus Co's otherwise allowable debt deductions.

Example 3.21 : Transfer pricing adjustment and no thin capitalisation adjustment

Assume the facts and circumstances are the same as in Example 3.14, except that Aus Co has $300 million of debt ($150 million from For Co and $150 million from an independent lender) and $100 million of equity, producing a safe harbour debt amount for Division 820 purposes of $300 million. The interest rate on Aus Co's debt to For Co is 15 per cent, so that, before applying Subdivision 815-B and Division 820, Aus Co has total debt deductions of $37.5 million.

As was the case in Example 3.14, Aus Co determines that an arm's length interest rate of 10 per cent is to be applied to the debt interest from For Co. As such, Aus Co gets a transfer pricing benefit of $7.5 million (being the difference between the arm's length rate of 10 per cent applied to the debt interest from For Co ($150 million) and the actual interest rate of 15 per cent on the debt interest).

Example 3.22 : Transfer pricing adjustment and no thin capitalisation adjustment

Assume the facts and circumstances are the same as in Example 3.15, except that the entire $300 million of debt is borrowed from For Co at an interest rate of 15 per cent. Aus Co's debt deductions for the interest incurred on its $300 million debt total $45 million for the income year.

Unlike the previous examples, there is no internal comparable uncontrolled price that provides an arm's length rate. As such, Aus Co determines the arm's length rate of interest for the loan having regard to available data of market reference rates and the credit standing that the capital markets would be likely to give Aus Co. Aus Co determines that its credit standing would allow it to borrow $250 million from independent lenders. Having regard to the information available, the closest commercially realistic arm's length scenario at which a loan might reasonably be expected to exist between independent parties dealing wholly independently with one another is a loan of $250 million at 10 per cent.

In this case the amount of the transfer pricing benefit is determined by reference to an amount less than the actual amount of the debt interest (being an arm's length amount). The fact that Aus Co's debt amount is less than its safe harbour debt amount for Division 820 purposes is not relevant to determining the amount of the transfer pricing benefit. Alternatively structured arrangements do not need to be considered in this case.

Aus Co's transfer pricing benefit is $15 million (as required under subsection 815-135(2)). This is worked out by applying the 10 per cent arm's length interest rate to Aus Co's actual debt amount ($300 million), and comparing this to Aus Co's actual debt deductions of $45 million.

Consequential Adjustments

3.150 The application of Subdivision 815-B to determine the tax position of an entity could potentially impact the tax result of another entity, or of the same entity, in the same or a different income year. Accordingly, the Commissioner may make a consequential adjustment to ensure that taxpayers are subject to an appropriate amount of tax in Australia.

3.151 The Commissioner may make a determination in relation to a disadvantaged entity if:

•

an entity is required by section 815-115 to work out its tax outcome under arm's length conditions;

•

the disadvantaged entity would have had a more favourable tax result if the arm's length conditions had operated: that is, the disadvantaged entity would have been expected to have a smaller taxable income, a greater loss of a particular sort, a greater tax offset, or a smaller amount of withholding tax payable in respect of interest or royalties had the arm's length conditions operated; and

•

the Commissioner considers that it is fair and reasonable that the consequential adjustment should be made.

[Schedule 2, item 2, subsection 815-145(1)]

3.152 The disadvantaged entity may be the entity to which Subdivision 815-B applied, or another entity.

3.153 In determining whether the application of Subdivision 815-B has resulted in an entity being disadvantaged, the Commissioner must consider whether a similar calculation to that which is performed under section 815-115 is required. That is, the disadvantaged entity must be able to show that it would have had a smaller taxable income, a greater loss of a particular sort, greater tax offsets or a smaller amount of withholding tax payable. This involves a comparison between the actual amounts and the arm's length amounts.

How are consequential adjustments be made?

3.154 Where the Commissioner considers that it is fair and reasonable to make an adjustment to the tax position of the disadvantaged entity, the Commissioner may make a determination in order to:

•

decrease the entity's taxable income for an income year;

•

increase the entity's loss of a particular sort for an income year;

•

increase the entity's tax offsets for an income year; or

•

decrease the entity's withholding tax payable in respect of interest or royalties.

[Schedule 2, item 2, subsection 815-145(2)]

3.155 The Commissioner may also take actions necessary to give effect to the determination made under this section. For example, the Commissioner may remit the relevant tax paid by an entity subject to a specific determination under this section, notwithstanding the absence of a specific provision in the law to that effect. [Schedule 2, item 2, subsection 815-145(3)]

3.156 The Commissioner must provide a copy of the determination to the disadvantaged entity. However a failure to provide a copy of the determination does not affect the validity of the determination. [Schedule 2, item 2, subsections 815-145(4) and (5)]

3.157 Determinations relating to different income years may be included in the same document. The Commissioner may include all or any determinations in relation to a particular entity, including different kinds of determinations, within the same document. [Schedule 2, item 2, subsection 815-145(6)]

3.158 An entity may make a request to the Commissioner to make a determination in relation to a consequential adjustment. The Commissioner must decide whether to grant the request, and give the entity notice of his decision. If the entity is dissatisfied with the decision, the entity may object against that decision in the manner that is set out in Part IVC of the Taxation Administration Act 1953 . [Schedule 2, item 2, subsections 815-145(7) and (8)]

Example 3.23 : Consequential adjustment to interest withholding tax paid

Aus Co is an Australian resident company that has paid interest on a loan to a foreign resident related party. In accordance with the arm's length principle, Aus Co determines that the interest is excessive and, in order to apply the arm's length assumption, works out that it has received a transfer pricing benefit under section 815-120. Aus Co has therefore applied paragraph 815-115(2)(a), and increased its taxable income by reducing its allowable deductions.

The interest payment to the foreign resident associated entity was subject to interest withholding tax. Aus Co applies to the Commissioner under subsection 815-145(7) to make a consequential adjustment. The Commissioner determines that it is fair and reasonable to make a consequential adjustment in respect of the interest paid to the foreign company in excess of the arm's length amount that was subject to withholding tax.

To give effect to the determination the Commissioner refunds the relevant amount of interest withholding tax to the foreign resident associated entity.

Time limit for amending assessments

3.159 Under Division 13 and Subdivision 815-A, the Commissioner had an unlimited period in which to make or amend an assessment in relation to a transfer pricing adjustment.

3.160 Under Subdivision 815-B, the Commissioner is subject to a time limit for amending assessments. A transfer pricing adjustment to the tax position of an entity as a result of the application of Subdivision 815-B must be made within seven years of the day on which the Commissioner gives notice of the assessment to the entity. [Schedule 2, item 2, subsection 815-150(2)]

3.161 This time limit does not apply to the Commissioner's ability to ascertain additional amounts of withholding tax payable under Subdivision 815-B. This is because, pursuant to subsection 128C(6) of the ITAA 1936, any ascertainment of withholding tax does not constitute an assessment. A time limit in respect of adjustments to withholding tax under Subdivision 815-B is not included because no such time limit exists generally in respect of withholding tax.

3.162 There is no time limit for the Commissioner to make a consequential amendment under section 815-145. This is consistent with the unlimited time period that was available for making consequential adjustments under Division 13. [Schedule 2, item 2, subsection 815-150(2)]