House of Representatives

Explanatory Memorandum

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

Chapter 2 - Modernisation of the transfer pricing rules

Outline of Chapters 2 to 7

2.1 Schedule 2 inserts Subdivisions 815-B, 815-C and 815-D into the Income Tax Assessment Act 1997 (ITAA 1997) and Subdivision 284-E into Schedule 1 to the Taxation Administration Act 1953 (TAA 1953). These Subdivisions contain amendments that modernise the transfer pricing rules contained in Australia's domestic law. They ensure Australia's transfer pricing rules better align with the internationally consistent transfer pricing approaches set out by the Organisation for Economic Cooperation and Development (OECD).

2.2 The amendments also ensure greater alignment between outcomes achieved for international arrangements involving Australia and another jurisdiction irrespective of whether the other country forms part of Australia's tax treaty network.

2.3 Schedule 2 also makes consequential amendments to:

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the ITAA 1997;

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the Income Tax Assessment Act 1936 (ITAA 1936);

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the Income Tax (Transitional Provisions) Act 1997 (IT(TP) Act 1997); and

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the TAA 1953.

2.4 All legislative references in Chapters 2 to 7 are to the ITAA 1997 unless otherwise stated.

Context of amendments

2.5 The amendments ensure that application of the arm's length principle in Australia's domestic rules is aligned with international transfer pricing standards, especially those of our major investment partners. These standards are currently set out in 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).

2.6 The OECD Guidelines are widely recognised as representing international best practice. Greater consistency with international standards reduces uncertainty and the risk of double taxation, and assists in minimising compliance and administration costs.

2.7 Transfer pricing rules are critical to the integrity of the tax system. Related party trade in Australia was valued at approximately $270 billion in 2009, representing a considerable proportion of Australia's cross-border trade flows (about 50 per cent).

2.8 Multinational trade has grown over the last decade. Further, since 2002 the compositional change in multinational trade in Australia has been striking. For example, whilst trade in tangible items such as stock in trade grew by 67 per cent between 2002 and 2009, trade in highly mobile factors such as services grew by more than 100 per cent and trade in insurance products and interest flows grew by more than 160 per cent over the same period.

2.9 Growth of this nature underscores the need for modern, robust transfer pricing rules capable of dealing with complex arrangements.

2.10 Australia's transfer pricing rules seek to ensure that an appropriate return for the contribution made by an entity's Australian operations is taxable in Australia for the benefit of the community. The appropriate return is determined through the application of the arm's length principle, which aims to ensure that an entity's tax position is consistent with that of an independent entity dealing wholly independently with others.

2.11 The new rules apply the arm's length principle by identifying the conditions that might be expected to operate in comparable circumstances between independent entities dealing wholly independently with one another.

2.12 In addition, where the allocation of an entity's profits to an Australian or overseas permanent establishment is relevant in determining its tax position, the arm's length principle ensures that the allocation is performed on the basis that the permanent establishment was a distinct and separate entity dealing wholly independently with the entity of which it is a part. Under this approach the allocation of profits to the permanent establishment is constrained to the allocation of actual income and expenses of the entity.

Current transfer pricing rules

2.13 Australia's domestic transfer pricing rules are currently set out in Division 13 of the ITAA 1936 (Division 13) and in Subdivision 815-A. Transfer pricing rules are also contained in Australia's bilateral tax treaties. Division 13 is to be repealed and Subdivision 815-A will no longer have effect when Subdivisions 815-B and 815-C are enacted.

2.14 The rules in Division 13 generally focus on determining the arm's length consideration for the supply or acquisition of property and/or services under an international agreement. By contrast, in determining whether outcomes are consistent with the arm's length principle, Australia's tax treaties and the OECD Guidelines also allow for consideration of the totality of arrangements that would have been expected to operate had the entities been dealing with each other on a wholly independent basis. This focus permits the consideration of a broad range of methods in determining arm's length outcomes. Such methods include, but are not limited to, traditional transaction methods.

2.15 Subdivision 815-A, enacted by the Tax Laws Amendment (Cross-Border Transfer Pricing) Act (No. 1) 2012 , applies to ensure that Australia's tax treaty transfer pricing rules operate as intended. The purpose of Subdivision 815-A is to limit taxable profits being shifted or misallocated offshore. Subdivision 815-A also provides direct access to the OECD Guidance material and clarifies how the Subdivision should interact with Division 820 of the ITAA 1997, which deals with thin capitalisation.

Summary of new law

2.16 Subdivisions 815-B, 815-C and 815-D modernise and relocate the transfer pricing provisions into the ITAA 1997 to ensure that consistent rules apply to both tax treaty and non-tax treaty cases. In addition, Subdivision 284-E of Schedule 1 to the TAA 1953 contains rules related to transfer pricing documentation. Consistent with the approaches under Division 13, the new rules in Subdivision 815-B apply the arm's length principle to relevant dealings between both associated and non-associated entities.

2.17 Unlike the current transfer pricing rules in Division 13 and in Subdivision 815-A, which both rely on the Commissioner of Taxation (Commissioner) making a determination, Subdivisions 815-B and 815-C are self-executing in their operation. This better aligns Australia's domestic transfer pricing rules with the design of Australia's overall tax system which generally operates on a self-assessment basis.

Subdivision 815-B: Arm's length rule for entities

2.18 Subdivision 815-B modernises Australia's transfer pricing rules in respect of dealings between separate legal entities. The Subdivision requires certain amounts (taxable income, a loss of a particular sort, tax offsets and withholding tax payable) to be worked out by applying the internationally accepted arm's length principle.

2.19 The authoritative statement of the arm's length principle is set out in Paragraph 1 of Article 9 (the associated enterprises article) of the OECD Model Tax Convention on Income and on Capital and the OECD Guidelines. Paragraph 1 states:

'[Where] conditions are made or imposed between the two [associated] enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.'

2.20 Each of Australia's tax treaties includes an associated enterprises article based on Article 9 of the OECD Model Tax Convention. Although the application of Article 9 is restricted to associated enterprises, Subdivision 815-B also applies to unrelated entities.

2.21 Consistent with the current transfer pricing rules, Subdivision 815-B does not rely on or assume a tax avoidance motive.

2.22 Broadly, the arm's length principle is introduced into Australia's domestic law by requiring actual conditions that operate between entities in their commercial or financial relations and which result in a transfer pricing benefit for an entity, to be replaced with the arm's length conditions.

2.23 The arm's length conditions for the commercial or financial relations are those conditions that might be expected to operate between entities dealing wholly independently with one another in comparable circumstances. As such, Subdivision 815-B applies the arm's length principle consistent with the associated enterprises articles of Australia's tax treaties.

2.24 Determining the arm's length conditions involves an analysis of the functions performed, the assets used or contributed, and the risks assumed or managed by the entities. From this analysis, the most appropriate and reliable transfer pricing method, or combination of methods, must be selected. Applying the most appropriate and reliable transfer pricing method or methods determines the arm's length conditions that are applicable to the relevant entity.

2.25 In applying the arm's length principle, the actual conditions arising from the commercial or financial relations between entities must be compared to the arm's length conditions that might reasonably be expected to have operated between independent entities in comparable circumstances.

2.26 The identification of arm's length conditions must be done in a way that best achieves consistency with the OECD Guidelines, as well as any documents that are prescribed by regulation.

2.27 Consistent with Division 13 and Subdivision 815-A, Subdivision 815-B allows for consequential adjustments.

Subdivision 815-C: Arm's length rule for permanent establishments

2.28 Subdivision 815-C modernises Australia's transfer pricing rules in respect of the attribution of profits between a permanent establishment and the entity of which it is a part. Consistent with Australia's current treaty practice, the relevant business activity approach (also known as the single entity approach) must be followed in applying Subdivision 815-C.

2.29 Broadly, the allocation of profits between a permanent establishment and the entity of which it is a part is determined by analysing the functions performed, the assets used or contributed, and the risks assumed or managed by the various parts of the business. From this analysis, the most appropriate and reliable transfer pricing method or combination of methods should be chosen, having regard to the circumstances of the commercial or financial relations - bearing in mind the limitation in the attribution process to the actual expenditure and income of the entity.

2.30 Within this framework, applying the most appropriate and reliable transfer pricing method or methods determines the arm's length profits that are attributable to the permanent establishment of an entity.

2.31 The arm's length principle is interpreted so as to best achieve consistency with the OECD Model Tax Convention and Commentaries, as well as the internationally accepted OECD Guidance material.

Subdivision 815-D: Special rules for trusts and partnerships

2.32 Subdivision 815-D sets out special rules about the way Subdivisions 815-B and 815-C apply to trusts and partnerships. The rules ensure that the transfer pricing rules apply in relation to the net income of a trust or partnership in the same way they apply to the taxable income of a company. The Subdivisions also apply to the partnership loss of a partnership in the same way they apply to the tax loss of a company.

Amendments to the TAA 1953: Record keeping and penalties

2.33 Subdivision 284-E of Schedule 1 to the TAA 1953 sets out the type of documentation that an entity may prepare and keep in self-assessing its tax position under Subdivision 815-B or 815-C. This documentation is referred to as transfer pricing documentation. In order to satisfy the requirements of Subdivision 284-E, transfer pricing documentation must be prepared before the lodgement of the relevant tax return.

2.34 While the Subdivision does not mandate the preparation or keeping of documentation, failing to do so prevents an entity from establishing a reasonably arguable position. Establishing a reasonably arguable position is one avenue through which an entity can lower administrative penalties. However, nothing in these amendments prevents the Commissioner from exercising a general discretion to remit administrative penalties where appropriate (as currently available under the law).

2.35 Other amendments to the TAA 1953 ensure that administrative penalties can apply to tax liabilities that arise from the Commissioner adjusting a taxpayer's position under Subdivision 815-B or 815-C.

2.36 If however the additional tax liability is equal to or less than the relevant de minimis thresholds, no administrative penalty applies.

How do Subdivisions 815-B and 815-C interact with Australia's tax treaties more generally?

2.37 Subdivisions 815-B and 815-C are generally aligned with the associated enterprise and business profits articles in Australia's tax treaties (generally Articles 7 and 9). Subsection 4(2) of the International Tax Agreements Act 1953 (ITAA 1953) continues to apply in the event of an inconsistency between Australia's tax treaties and the domestic transfer pricing rules.

2.38 While Subdivision 815-B and 815-C apply where an entity gets a transfer pricing benefit in Australia, nothing in either Subdivision prevents Australia's tax treaties from applying in circumstances where a tax treaty results in a different adjustment relative to a taxpayer's position under the domestic law provisions.

Comparison of key features of new law and current law