House of Representatives

Explanatory Memorandum

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

Chapter 4 - Arm's length principle for permanent establishments

Subdivision 815-C

What is the object of Subdivision 815-C?

4.1 The object of Subdivision 815-C is to ensure that the amount brought to tax in Australia by entities operating at or through permanent establishments is not less than it would be if the permanent establishment (PE) were a distinct and separate entity engaged in the same or comparable activities under the same or comparable circumstances, but dealing wholly independently with the entity of which it is a part. [Schedule 2, item 2, section 815-205]

4.2 In recent years the Organisation for Economic Cooperation and Development (OECD) has revised its approach to the attribution of business profits to PEs. The authorised OECD approach now reflects the functionally separate entity approach. The Government has yet to determine whether it will change its tax treaty practice to adopt the functionally separate entity approach and as such Subdivision 815-C reflects the approach to the attribution of profits to PEs that is currently incorporated into Australia's tax treaties (the relevant business activity approach).

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

4.3 Consistent with Subdivision 815-B, Subdivision 815-C 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 815-210(1)]

4.4 This means that to the extent that an entity is liable to a different tax result under Subdivision 815-C because arm's length profits are taken to have been attributed to a PE of the entity, Subdivision 815-C must be applied in working out the entity's Australian tax liability.

4.5 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 the priority rule in Subdivision 815-C applies to provisions of the ITAA 1936 and ITAA 1997 (the Assessment Acts), whereas subsection 4(2) applies to the extent of an inconsistency between the ITAA 1953 and the Assessment Acts.

4.6 Subdivision 815-C 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 815-210(2)]

4.7 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 (the rule in Subdivision 815-B may be relevant in determining the arm's length profits of a PE).

4.8 A specific rule is not required to deal with the interaction between Subdivision 815-C and the thin capitalisation rules because Subdivision 815-B applies in identifying arm's length profits for a PE. In this process the PE is treated, under certain constraints, as an entity. The provisions of Subdivision 815-B, including the thin capitalisation interaction rule, then apply to determine the arm's length conditions for the PE to the extent they are relevant.

4.9 Subdivision 815-C does not apply in respect of a branch that is taken not to be a permanent establishment under Part IIIB of the ITAA 1936. [Schedule 2, item 2, subsection 815-210(3)]

4.10 Part IIIB applies the functionally separate entity approach in respect of the attribution of income and expenditure to the Australian PEs of foreign banks. Consistent with the interaction between Part IIIB and former Division 13 of the ITAA 1936 (Division 13), Subdivision 815-C does not apply to PEs dealt with under Part IIIB.

Working out an entity's tax position

4.11 Subdivision 815-C applies where an entity gets a transfer pricing benefit in an income year from the attribution of profits to a PE of the entity. In such cases, the actual amount of profits are taken not to have been attributed to the PE, and instead the arm's length profits are taken to have been attributed to the PE for the purposes of working out the amount to which the transfer pricing benefit relates. [Schedule 2, item 2, subsection 815-215(1)]

4.12 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. [Schedule 2, item 2, subsection 815-215(2)]

4.13 In contrast to Subdivision 815-B, Subdivision 815-C does not apply in respect of amounts of withholding tax payable. This is because Subdivision 815-C applies in respect of the intra-entity allocation of income and expenses and as such its effect does not have any implications for withholding tax.

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

4.15 Subdivision 815-C ensures that the attribution of profits between a PE and other parts of the entity reflect the contribution made by the operations of those parts of the entity (consistent with the entity's actual income and expenses). After the arm's length profits are attributed to the PE of the entity, whether and how those profits 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.

4.16 As with Subdivision 815-B, Subdivision 815-C does not contain an explicit rule requiring individual amounts to be specified. A rule of this kind is not necessary because under Subdivision 815-C an entity is required to work out its taxable income, loss of a particular sort or tax offsets on the basis that arm's length profits had been attributed to its PE. This process is different from simply making an overall adjustment to these amounts and by definition requires that the entity identify and value the various items that are relevant in determining the aggregated amounts.

Guidance material

4.17 In establishing the effect that Subdivision 815-C has in respect of an entity, the identification of arm's length profits and arm's length conditions (under the assumption that the PE is a distinct and separate entity) must be done in a way that best ensures consistency with certain guidance material. [Schedule 2, item 2, subsection 815-235(1)]

4.18 This guidance material is:

•

the Model Tax Convention on Income and on Capital, and its Commentaries, as adopted by the Council of the OECD and last amended on 22 July 2010, to the extent that document extracts the text of Article 7 and its Commentary as they read before 22 July 2010;

•

the guidance documents specified by Subdivision 815-B which currently include the 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); and

•

any other documents, or part(s) of a document, prescribed by the regulations for the purposes of either Subdivision 815-C or Subdivision 815-B.

[Schedule 2, item 2, paragraph 815-235(1)(b) and subsection 815-235(2)]

4.19 Requiring consistent interpretation with the OECD Guidelines (where relevant) does not imply that the legislation is adopting the functionally separate entity approach to the attribution of profits to PEs. As stated earlier, the Government has yet to determine whether it will change its current tax treaty practice to adopt the functionally separate entity approach. Subdivision 815-C therefore reflects the approach to the attribution of profits to PEs that is currently incorporated into Australia's tax treaties (the relevant business activity approach).

4.20 Further, Australia's tax treaties are generally based on the OECD's Model Tax Convention. The revised Commentary to Article 7 (which deals with the taxation of business profits, including the allocation of such profits to PEs) of the OECD Model Tax Convention as it read prior to 22 July 2010 contains specific references to the OECD Guidelines, and how they are to be used in the context of attributing profits to the PE of an enterprise. Within the confines of the relevant business activity approach, this is the approach that is adopted by Subdivision 815-C.

4.21 Because arm's length conditions under Subdivision 815-B have some relevance in identifying the arm's length profits of a PE, the documents that are relevant for identifying arm's length conditions under Subdivision 815-B are also relevant under Subdivision 815-C.

4.22 Given the hypothesis that a PE is a separate and distinct entity, arm's length profits must be determined by applying by analogy the principles developed for the application of the arm's length principle between associated enterprises (these are articulated in the OECD Guidelines). This is done by reference to the functions performed, assets used and risks assumed by the enterprise in carrying on business at or through the PE and through the rest of the enterprise.

4.23 Consistent with applying the Guidelines by analogy in attributing profits to PEs, generally the references in the OECD Guidelines to associated enterprises or related parties should be read in the context of Subdivision 815-C to be references to entities and their PEs dealing with each other as distinct and separate entities.

Regulation making power in relation to documents

4.24 Consistent with Subdivision 815-B, regulation making powers are included to allow for modifications to the list of guidance material under Subdivision 815-C. Requiring such modifications to be prescribed by regulation strikes an appropriate balance between ensuring ongoing consistency with developing international arrangements while providing for Parliamentary scrutiny of future developments.

4.25 The regulation making powers include the ability to prescribe additional documents or parts of a document. 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 by the current OECD Guidance material. [Schedule 2, item 2, paragraph 815-235(2)(b)]

4.26 Material prescribed under either Subdivision 815-B or 815-C may also be removed by regulation from the list of guidance material for Subdivision 815-C. This allows material to be removed in the event that it is no longer relevant to determining arm's length profits of a PE. [Schedule 2, item 2, subsection 815-235(3) and (4)]

4.27 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.

4.28 Regulations may also prescribe which documents, or parts of documents, are to be used or removed in specific circumstances. [Schedule 2, item 2, subsection 815-235(5)]

4.29 An example of this may 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 documents 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?

4.30 An entity gets a transfer pricing benefit under Subdivision 815-C in respect of the attribution of profits to a PE of the entity if:

•

the actual profits attributed to the PE differ from the arm's length profits for the PE; and

•

had the arm's length profits, instead of the actual profits, been attributed to the PE, the entity would have received a tax advantage in Australia.

[Schedule 2, item 2, subsection 815-220(1)]

The actual profits differ from the arm's length profits

4.31 In determining whether an entity gets a transfer pricing benefit, the actual profits attributed to the PE of the entity must differ from the arm's length profits. Arm's length profits are discussed in further detail at paragraphs 4.41 to 4.50 below. [Schedule 2, item 2, paragraph 815-220(1)(a)]

The actual profits result in a tax advantage in Australia

4.32 Subdivision 815-C requires an assessment of what an entity's Australian tax position would have been had the arm's length profits been attributed to its PE.

4.33 Assessing what the entity's tax position would have been requires a comparison between the arm's length profits and the actual profits. 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 actual profits attributed to its PE, relative to the arm's length profits being attributed to its PE.

4.34 An entity has a tax advantage if the attribution of arm's length profits to its PE, relative to its actual profits, would mean that one of the following applies:

•

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 ; or

•

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

[Schedule 2, item 2, subsection 815-220(1)]

4.35 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.

Calculating a transfer pricing benefit when there is no taxable income, loss of a particular sort, or tax offsets

4.36 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 attribution of profits to the entity's PE, and the second being the attribution of arm's length profits to the entity's PE.

4.37 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).

4.38 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 an attribution of arm's length profits to its PE), 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 815-220(2)]

Why is there no cross-border test in Subdivision 815-C?

4.39 Although Subdivision 815-C does not contain an express cross-border test, the rules only have application where the allocation of an amount to a PE has an impact upon an entity's tax position. Such an impact will only occur in respect of dealings through a PE that have a cross-border element.

4.40 For example, the attribution of amounts to an Australian PE of an Australian resident does not affect the resident's tax position, whereas the attribution of amounts to a foreign PE of such an entity has implications for their access to the foreign branch income exemption or the business profits articles of a relevant treaty. Conversely, the attribution of amounts to a foreign PE of a foreign resident does not affect the foreign resident's Australian tax position, whereas attribution to an Australian PE does (either because of the sourcing rules in Australia's tax treaties or the equivalent deeming provision under subsection 815-225(3)).

What are the arm's length profits?

4.41 The arm's length profits of a PE are worked out by allocating the actual expenditure and income of an entity between itself and its PE so that the profits attributed to the PE equal the profits that the PE might be expected to make if:

•

the PE was a distinct and separate entity;

•

that separate entity was engaged in the same or comparable activities under the same or comparable conditions; and

•

the conditions that operated between that separate entity and the entity of which it is a PE were the arm's length conditions.

[Schedule 2, item 2, subsections 815-225(1) and (2)]

4.42 Because the PE is taken to be an entity that deals with the entity of which it is actually a part, the approach under Subdivision 815-B to determining arm's length conditions is directly relevant in ascertaining the arm's length profits for the PE. As such, any factors relevant to determining arm's length conditions under Subdivision 815-B may be directly relevant to determining the arm's length profits under Subdivision 815-C. Similarly, the comparability factors and the issues to have regard to under Subdivision 815-B in selecting the most appropriate method may be relevant to applying the arm's length principle under Subdivision 815-C.

4.43 Comparable activities and circumstances should therefore be identified having regard to all relevant factors, including the factors mentioned in subsection 815-125(3). This is achieved by determining the arm's length conditions based on the assumption that the entity is a distinct and separate entity and engaged in the same or comparable activities in the same or comparable circumstances.

4.44 In determining whether an entity has attributed the arm's length profits to its PE, the economically relevant and material characteristics of the situations being compared must be sufficiently comparable. To be comparable, none of the differences (if any) between the situations being compared should be capable of materially affecting the arm's length profits.

4.45 Consistent with the approach adopted in Australia's domestic law and in Australia's tax treaties, the arm's length profits must however be identified subject to the constraint that the allocation is determined within the confines of the actual income and expense position (as they apply for Australian tax purposes) of the entity of which the PE is a part.

4.46 For the purposes of determining the arm's length profits, the actual expenditure of an entity includes losses or outgoings. Similarly, the actual income of an entity includes any amounts that would be assessable income of the entity. [Schedule 2, item 2, subsection 815-225(3)]

Source rules for arm's length profits

4.47 Subdivision 815-C includes a deeming rule in relation to the arm's length profits of an entity's Australian PE. The effect of this rule is that the arm's length profits for that PE are taken to be attributable to Australian sources. [Schedule 2, item 2, subsection 815-230(1)]

4.48 This deeming rule is consistent with the special source rules contained in Australia's tax treaties and has the effect of ensuring that any arm's length profits of an Australian PE are taken to be Australian sourced. Whether or not amounts are Australian sourced is relevant for foreign residents as they are taxed on their Australian sourced income. Similarly, questions of source are relevant for foreign resident beneficiaries of Australian resident trust estates and foreign resident partners of partnerships.

4.49 A similar deeming rule is also included in respect of the arm's length profits of a PE located in an area covered by an international tax sharing treaty. This rule deems any arm's length profits of such PEs to be sourced in the area in which the PE is located. [Schedule 2, item 2, subsection 815-230(2)]

4.50 This rule ensures that the arm's length profits (which can include income and expenditure) of the PE are taken to be sourced in the area covered by the relevant international tax sharing treaty. Although such areas may be within Australia, the rule is relevant for all entities irrespective of residence because Australia's ability to impose tax upon income sourced in an area covered by an international tax sharing treaty (or deal with expenditure in relation to such income), is affected by the terms of such agreements.

Time limits for amending assessments

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

4.52 Subdivision 815-C introduces 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-C 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, section 815-240]