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The future of transfer pricing: an Australian perspective

Deputy Commissioner Mark Konza, PSM

Opening address to the Tax Institute's 2018 National Transfer Pricing Conference

Sydney, 8 August 2018

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Thank you for the opportunity to talk to you today.

Today, I would like to talk about the future of transfer pricing and the trends that are shaping that future, from an Australian perspective.

Tax compliance by multinational enterprises has been and remains an issue of acute community concern. Australia’s strategy has been to actively work with the international community to improve international tax law and administrative practice, to maintain and extend the domestic laws needed to deliver the improved international rules and to support the Commissioner of Taxation with resources to ensure that these laws are followed.

Globally and locally, we are seeing changes to the transfer pricing landscape that inhibit the ability of those MNEs who want to ‘game the system’. These changes are occurring on a number of fronts, with important elaborations of the meaning of the arm’s length standard being published by the OECD, new transparency requirements, global cooperation amongst regulators, and the enhancement of the broader framework of international tax rules. Collectively, the measures are making it harder for those MNEs who seek to contrive outcomes under the transfer pricing rules that misalign outcomes with value creation. These efforts are critical to restore and maintain community confidence in a fair international tax system.

When the base erosion and profit shifting (BEPS) issue erupted globally, Australia had already begun working to address these concerns. New transfer pricing laws which ensured the totality of the relations between the parties was considered and which explicitly embraced the OECD guidance on transfer pricing had been passed in 2012 and 2013.

The most talked about aspect of subdivision 815-B is found in s.815-130. Colloquially this is known as the ‘reconstruction’ provision, but notably this is not a term found in the law, or the OECD guidelines for that matter. I will return to discuss s.815-130 shortly.

The new law continues to be founded on the arm’s length standard, which remains the critical international consensus, and imposes on taxpayers the obligation to self-assess their transfer prices in accordance with the arm’s length standard. If I was to paraphrase one key aspect of the current view of the international consensus on the arm’s length standard, it would be to say that transfer pricing is correctly viewed as a structural problem as opposed to one merely concerned with pricing. In other words, there has been an evolution of the role of transfer pricing rules from one where the task was merely to price what the related parties had agreed, to one where it may be necessary to evaluate all of the economically significant features of the arrangement to ensure it is one that would be expected to exist between unrelated parties. In the Chevron decision, Allsop CJ says that the argument that just pricing a loan with the given specific features ‘almost dooms to failure the application of Div 13 if its task is to substitute commercial reality based on independence for intra-group reality based on group control.’ Earlier he says, ‘That the hypothesis must be made to work, if it can, is also to be taken from the commercially rational nature of the task – the property, the acquisition, the consideration are to be seen in their relationship to each other by reference to what can be reasonably expected, assuming independent commercial parties.’

Modification of an inherently non arm’s length deal can therefore sometimes be necessary if it is to be priced as an independent.

Footnote1 More formally, this relates to consideration of all of the ‘conditions’ relevant to determining an arm’s length outcome; and these are not limited to the ‘price condition’ relating to what the related parties have agreed.

In administering these laws, there are constant discussions of current cases around both an evolving view as to how 815-B is to be applied (both in terms of the ‘exception’ provisions), and also how the 2017 amendments to the Transfer Pricing Guidelines fit into that evolving view.

There is also the impact of the Chevron decision on how we are approaching the application of the provisions. Obviously Chevron was decided on the old law (Division 13), with obiter only in relation to 815-A. However it is important to note that the Chevron decision lends support to the view that there is an ability to substitute arm’s length conditions under 815-A, and this may be relevant to the application of 815-B.

As noted, consistent with the internationally agreed position, the new law also expressly provides for circumstances where we need to re-characterise or reconstruct the actual relations entered by the taxpayer to accurately identify the relevant transaction to price.

The first situation where this is important is when the taxpayer has contracts covering the related party dealings, but those contracts do not match the actual transaction reflected in the conduct of the parties. In these cases, we need to ignore the documented terms or legal instrument and, instead, consider the substance of the relations between the parties. For instance, we may need to consider the legal form of a financing arrangement, and test whether the substance of the arrangements is consistent with its form. In determining the substance of the financing relations, we will pay close regard to the business strategies of the entities, and their economic circumstances, to see if the legal form makes commercial sense. If the legal form does not accord with the substance of the financing based on the economic circumstances and business strategies, then the legal form must be disregarded in answering the pricing question.

The second situation where we may need to reconsider the actual arrangement is when the taxpayer has entered into something that independent entities would not have done, and it lacks commercial rationality. In this situation, the law ignores both the form and substance of the actual relations, and instead looks to the arrangement that would have been entered into by independent parties. It was envisaged this so-called ‘reconstruction power’ would only be used infrequently and indeed no cases have yet been completed on this basis. However, we do have some cases where we are faced with arrangements that do not appear to make commercial sense, and the result would appear to move value out of Australia that is fairly seen as created here. For example, we may need to consider the substitution of arm’s length arrangements where an Australian entity seeks to transfer significant assets from Australia, or allows the relative value of its Australian assets to erode, in ways that independent entities acting commercially would not. In these cases, we are currently considering the use of this power as part of a firm response to the taxpayer’s behaviour.

Working with the OECD

The ATO is not alone in our firm stance on these contrived behaviours. The international focus on BEPS has allowed for OECD inclusive framework discussions on responses to the BEPS action plan. Australia has been working with the OECD and our international partners to progress this work and is in the vanguard of countries implementing responsive measures.

Having directly linked our law to the OECD guidance, we were naturally keen that the guidance be brought up to date and better align transfer pricing outcomes with value creation. The revised guidance on how you assess or demonstrate compliance with the arm’s length standard was brought into Australian law from July 2016. As the new transfer pricing rules are part of the company tax self-assessment regime, companies and their advisers have an obligation to ensure they meet the new guidelines.

The new guidelines still have the arm’s length principle as their core foundation, however the commentary on the application of the arm’s length principle has been significantly developed by the OECD BEPS reports on Aligning Transfer Pricing Outcomes with Value Creation. I suspect that the full impact of these developments may be underappreciated by some.

Two of the significant developments in the OECD commentary relate to the proper allocation of risk; and the challenges in dealing with hard-to-value intangibles. These questions are often at the heart of many of the most challenging transfer pricing cases that we must consider. The revised commentary may assist in resolving these difficult cases in a way that builds public confidence in the ability of transfer pricing to produce an outcome that fairly reflects value generation, and this public confidence is ultimately vital for the existence of a stable and sustainable business environment.

The OECD guidance on the allocation of risk under the arm’s length principle has been significantly expanded. Risk is inherent in all aspects of business and plays a role in the generation of profits from opportunities, as well as the potential for losses. The new guidance sets out a framework for the proper identification and allocation of risks, and hence the allocation of the positive and negative outcomes that flow from those risks. Following the framework, risk is not simply allocated based on the contractual arrangements that related entities chose to put in place. Rather, it has to be allocated based on a careful analysis of the circumstances of the entities and how they actually operate. Important considerations are to understand which entity manages and controls the relevant risk, and who has the financial capacity to assume the risk.

We have seen cases in the past where companies have argued that the profits from risk control functions undertaken in Australia should be recognised offshore due to a foreign role in setting a policy environment or formalising a decision through a board meeting. Under the new commentary, it will be clearer that the outcomes of that entrepreneurial function are properly allocated to Australia.

We have also seen cases where it is asserted that the manner in which the Australian entity is contractually compensated by a related entity, such as with a fixed target margin, means that relevant entrepreneurial risks and functions cannot be allocated to Australia. Again, the new commentary makes it clear that the form of contractual compensation is no barrier to properly identifying the dealings, and assigning correct economic prices.

The new Guidelines also provide for a mechanism to deal with hard-to-value intangibles. Hard-to-value intangibles are either intangibles where there are no reliable comparables, or intangibles where the future cash flows or relevant assumptions are highly uncertain. In these situations, an understanding of the Intellectual Property or IP can require a specialised knowledge of the business environment. Without such knowledge, the tax administrator is faced with an asymmetry of information that generates transfer pricing risk. Given many taxpayers attribute significant value to their special IP, this potentially creates significant transfer pricing risk, and we take this risk very seriously. Under the new Guidelines, information available after the transaction occurs will provide the tax administrator with presumptive evidence of whether the taxpayer appropriately took into account foreseeable developments in pricing the deal.

This presumptive evidence of what happens after a transaction occurs could be an important source of evidence where we are faced with businesses that deal with their key IP in a way that ultimately erodes the value of the Australian operation. It is open to a taxpayer to rebut the presumptive evidence in a number of ways. A taxpayer may be able to demonstrate that the compensation paid for the IP was within 20 per cent of the value determined after the fact based on actual financial outcomes. Alternatively, the taxpayer can provide reliable evidence that the variation was due to the playing out of factors predicted at the time, and the probability of their occurrence was not significantly overestimated or underestimated. It is also possible to rebut the presumptive evidence by providing reliable evidence showing that differences between projections and outcomes were due to unforeseeable developments. Placing the onus back on the taxpayer to provide better evidence, or accept a valuation based on what subsequently happens, provides us with a stronger ability to manage the risk of a misalignment of value and tax outcomes arising from IP.

Our ability to detect and deal with the misalignment of value and tax outcomes has been significantly bolstered by the OECD Country-by-Country reporting requirements, with which you would be familiar. These were introduced with effect from 1 January 2016 for significant global entities. We received the first electronic lodgement of a CbC report in September 2017 and since then we have received 2,116 Local Files, 1,463 Master Files and 42 CbC reports. Australia is one of 69 jurisdictions that have agreed to automatically exchange CbC reports. The first wave of exchange of CbC reports was due by the end of June this year, and we have now achieved a step change in the global transparency of how MNEs choose to operate.

Leading international cooperation

Australia is an active player in the growing international cooperation among tax regulators.

Commissioner Jordan is Vice Chair of the OECD’s Forum of Tax Administration (FTA), and Sponsoring Commissioner of the Joint International Taskforce on Shared Information & Collaboration, or JITSIC as it is better known. JITSIC has 36 member countries, with a focus on sharing intelligence, and working together on areas of common concern, including collaborative casework on MNEs who may be seeking to misalign outcomes with value creation. We believe that by working together, we can produce the best outcomes for Australia and the international tax system.

We also use our International tax networks to work with other administrations on key projects. One topical project at the moment is the design and implementation of new multilateral cooperative initiatives to assess and mitigate risk.

Launched in January 2018, we, alongside seven tax administrations, are participating in the pilot of the OECD’s International Compliance Assurance Programme, or ICAP.

ICAP involves tax administrations undertaking cooperative multilateral risk assessments on MNE groups using their Country-by-Country reports and other relevant information. This will allow the ATO to engage in real-time with MNEs and other tax administrations to reach an early decision about the level of transfer pricing and permanent establishment risk.

We are committed to supporting this initiative with some of the key potential benefits including:

  • Targeted and consistent interpretation and use of CbC reports

  • Better use of resources for tax administrations and MNEs

  • Coordinated and transparent approach to engagement

  • Faster multilateral tax certainty

  • Few disputes entering into Mutual Agreement Procedures.

The ATO is currently working collaboratively with the MNEs and tax administrations participating in ICAP to conduct the ICAP risk assessments and establishing best practice with regards to multilateral risk assessment and the use of CbC reports.

We have begun reviewing the documentation packages for ICAP cases and have attended risk assessment workshops where the MNE walked through their documentation in order to enhance tax administrations' understanding of the MNE’s business, global value chain and related party transactions.

ICAP complements our Justified Trust program as well as other initiatives, such as our Advance Pricing Arrangement and advice and guidance programs to provide tax certainty to MNEs.

We held a meeting with participating jurisdictions in July which discussed what was working well and areas for improvement.

The integrity of the transfer pricing landscape is also being supported by the enhancement of the broader framework of international tax rules.

Part of the improved international tax laws were the changes to the definition and interpretation of the permanent establishment rule. However, the Australian government wanted to see a quick resolution of this issue because, quite frankly, transacting with apparently Australian companies and then seeing the invoicing coming from offshore annoyed Australian taxpayers. They smelt a rat. With good reason.

Multinational Anti-Avoidance Law a success

In 2015 the Government passed the Multinational Anti-Avoidance Legislation or the MAAL, as we refer to it, at the same time as CbC reporting, again with application to significant global entities. The MAAL was introduced to counter ‘operate here – bill overseas’ arrangements that avoid the attribution of sales revenue to an Australian taxable presence to avoid Australian or foreign taxes.

The implementation of the MAAL saw us take a new approach and put together a roadmap which invited taxpayers to actively engage with us. This brought taxpayers to the table and allowed us not only to help them move to more economically responsible structures, but helped us to settle old disputes, including transfer pricing matters.

Our work has seen a large number of multinationals, including some of the biggest e-commerce players, changing the way they operate in response to the MAAL. In fact, 44 have restructured to date. These taxpayers no longer characterise themselves as ‘service providers’ and now book their sales revenue in Australia.

Our work also involved ensuring the proposed restructures result in appropriate transfer pricing outcomes, with the majority of restructures moving from a net cost plus return to a sales based return. This change in transfer pricing method is more reflective of the substance of the arrangement and the value adding activities of the local Australian operations.

The implementation has seen a base restoration of nearly $7 billion in assessable income and there has been no need for MAAL assessments to issue so far. The MAAL has been a major victory for the Commissioner and industry members who have argued for cooperative approaches.

Application of Diverted Profits Tax

The broader framework of Australia’s international tax rules has also benefited from the introduction of the Diverted Profits Tax, or DPT. The DPT came into effect on 1 July 2017 and was implemented by the Australian government in response to constant delays in the completion of audits and arguments that our existing General Anti-Avoidance Regime (GAAR) could not be applied where a scheme was part of a global arrangement.

The primary objectives of the DPT provisions are to ensure that significant global entities pay Australian tax that properly reflects the economic substance of their activities in Australia and to prevent them from reducing their Australian tax by diverting their profits offshore through contrived arrangements between related parties.

Importantly, the DPT provisions are not a provision of last resort, and the application of the DPT can be considered concurrently with other provisions during ordinary compliance activity, including the transfer pricing rules.

However, there are a number of differences between the transfer pricing provisions and diverted profits tax provisions that will dictate when the particular provisions may apply.

Firstly, the DPT only applies to a particular segment of the market, that is, SGEs earning more than $25 million revenue in Australia, while the transfer pricing rules can potentially apply to a broader segment of the taxpayer market.

Secondly, the DPT requires a principal purpose of obtaining a tax benefit or both to obtain a tax benefit and reduce foreign tax liabilities. The transfer pricing provisions, on the other hand, do not require such a purpose.

Thirdly, while the sufficient economic substance exception test references concepts within the OECD guidelines, the DPT requires that the profit made as a result of the scheme by each relevant entity reasonably reflects the economic substance of the entity’s activities.

Given that the DPT can only be applied if the principal purpose test and the other conditions are satisfied, it is expected that DPT assessments will be issued in limited circumstances. This is also ensured by a rigorous internal framework with significant levels of sign-off, including sign-off by me, or one of my fellow Deputy Commissioners. While only expected to apply in a small, limited, number of cases, we are currently looking very closely at some arrangements and a small number of taxpayers have also been alerted to the possibility of DPT being considered.

While there are important differences between the application of the DPT and the transfer pricing rules, given some of the similarities and the amount of work involved in preparing an APA, our engagement strategy sets out that: for new APAs, covered transactions will generally be considered low risk from a DPT perspective for the period of the APA. In addition to this, you can also request that a DPT clause is inserted into the APA which constitutes written assurance that we will not seek to issue a DPT assessment in relation to the covered transactions for the income years covered by the APA. This is of course subject to the usual conditions, including that critical assumptions are not breached, and the absence of certain omissions and false or misleading statements.

Additionally, if you wish to gain certainty with respect to the DPT, the expectation is that you will engage with us. This can be done by contacting the DPT specialist team, applying for a private ruling, or by seeking entry to the APA program. More information about gaining certainty over the DPT is available in our draft PCG, which will be released in final form shortly.

Thin capitalisation regime

Australia also pays very close attention to the integrity of its thin capitalisation regime. Recently announced budget measures will remove the ability to revalue some assets for thin capitalisation purposes only. Entities will now have to rely on their financial statements for values in the safe harbour calculation. The measure may result in some taxpayers shifting to the Arm’s Length Debt Test, which requires rigorous analysis and is an area where we are reviewing the guidance regarding our expectations. The ALDT has been an increasingly popular election for thin cap purposes in recent years, so we are looking to provide further guidance to assist in providing certainty to taxpayers.

To best enable the administration of the enhanced international tax framework, in 2016 the Government established within the ATO the Tax Avoidance Taskforce.

The purpose of the Tax Avoidance Taskforce is to increase the ATO’s efforts in the scrutiny of the tax affairs of multinational enterprises, large public and private groups and wealthy individuals operating in Australia.

Taskforce funding has allowed the ATO to reinstate lost capacity in our multinational division and expand it to be able to deal with the new laws.

A ‘risk cluster’ approach has allowed us to concentrate our risk analysis, mitigation and treatment options to effectively deal with the risk.

The advent of the MAAL enabled us to see tremendous success in addressing the e-commerce risk. Our efforts in this area have seen us issue over $1 billion in assessments, collect tax of over $800 million and achieve future revenue effects of more than $590 million.

Thanks to this success, we can shift our focus onto other risks such as transfer pricing in the pharmaceutical industry. We currently have nine audits under way and we hope to achieve a similar success rate there. It is important, however, to note that we also have nine Advanced Pricing Arrangement applications under way in that industry. Again, cooperative channels remain open to any company who wants to go that way.

We will also be continuing to look at the energy and resources sector – specifically exploration expenditure, hubs (particularly marketing hubs) and related party financing such as debt funding, the use of derivatives to avoid interest withholding tax and cross currency interest rate swaps. With Australia projected to become the world’s biggest exporter of liquefied natural gas by 2019, the oil and gas industry is a particular focus for us. With big developments and long term contracts being a feature of the LNG industry, it is important we get the pricing right from the start.

Cooperative engagement

The ATO remains committed to providing cooperative channels by which taxpayers can engage with us. A key mechanism for cooperative engagement is the APA program, which remains an important part of the Australian transfer pricing landscape. The ATO currently has 116 APA applications in progress and 105 that are in place. The program continues to be strongly supported by both industry and the ATO and is seen as an effective way to provide certainty and achieve good compliance outcomes.

As part of our recent refinement of our approach to APAs, we have moved away from the conventional mindset of assessing a transaction in isolation. Instead, we seek a holistic understanding of the economic group behind the transaction and the underlying value chain, rather than focusing purely on the pricing of isolated transactions.

Where holistically done, APAs also have a valuable role to play in supporting the introduction of new legislation such as the DPT. In order to provide certainty to MNEs seeking to do the right thing, we can include an assurance in an APA that the DPT will not be applied to the covered arrangements.

Mutual Agreement Procedures

Our Mutual Agreement Procedures, or MAPs, will also be a focus in 2018 since Australia signed the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (‘MLI’) in June 2017.

The bill to amend the International Tax Agreements Act 1953 to give legislative effect to the MLI was presented in Parliament and read twice in the House of Representatives on 28 March 2018. It has yet to be debated in the Senate.

Currently, based upon other jurisdictions’ provisional positions, the MLI is expected to modify 31 of Australia’s 44 bilateral tax treaties. These countries can choose to adopt mandatory binding arbitration under the MLI and Australia has provisionally chosen to do so for all of its CTAs.

The date of entry into effect for each of Australia’s Covered Tax Agreements (CTAs) will be dependent on Australia’s and matching jurisdictions' actions, specifically when the MLI has been ratified for their domestic purposes and relevant notifications lodged with the OECD. Subject to these processes, the earliest the MLI can take effect in Australia in respect of:

  • Withholding taxes is for: income derived on or after 1 January 2019;

  • All other taxes: for income years commencing on or after 1 July 2019; and

  • Dispute resolution, after the MLI enters into force for each of the parties.

Based on Australia’s and other jurisdictions' provisional reservations, it is expected that the MLI will introduce mandatory binding arbitration in respect of 13 of our bilateral treaties. These jurisdictions are: Belgium, Canada, Fiji, Finland, France, Ireland, Italy, Malta, Netherlands, New Zealand, Singapore, Spain and the United Kingdom.

This may change as countries notify the OECD of their final positions under the MLI.

Therefore, it is likely that arbitration will be introduced into the negotiation process for aged MAP cases, including aged transfer pricing MAP cases. The inclusion and timing of the availability of arbitration for aged MAP cases will depend on the final reservations made by other jurisdictions and the terms of the separate mandatory arbitration agreement required to be made between Competent Authorities.

Arbitration is currently available under Australia’s treaties with Germany, New Zealand and Switzerland.

Where arbitration applies to a treaty, any issues arising from a Mutual Agreement Procedure (‘MAP’) case which have not been resolved after two years may be submitted for mandatory binding arbitration by the taxpayer (three years in the case of France).

An arbitration panel is usually made up of three panel members. Each jurisdiction will select one panel member, who will in turn select a chairperson for the panel from a pre-agreed list.

Australia has selected final offer or ‘baseball’ arbitration as our preferred method for arbitration. Only one treaty partner (‘Malta’) has opted for a different method – independent opinion.

Final offer arbitration allows each jurisdiction to submit their proposed resolution of the issue in dispute along with a position paper. The panel then selects one of the proposed resolutions as the resolution for the case. No reason is provided and the decision has no precedential value. While this method may encourage countries to engage earlier and to be more measured in their proposals, a ‘winner takes all approach’ can be a gamble.

The arbitration decision is binding on tax administrations, except in situations where the courts overturn a decision on the basis of procedural unfairness. Taxpayers can choose to not accept an arbitration decision or pursue other legal remedies but this terminates the entire MAP process and prevents further consideration by the competent authorities.

As at 1 July 2019, Australia had 36 MAP cases on hand. Based on current reservations of jurisdictions, arbitration may be available for 10 of these MAP cases if not resolved by the date mandatory arbitration comes into effect.


The Australian government and the ATO are committed to ensuring that multinational enterprises pay the correct amount of tax under the law. As I hope I have demonstrated, even within a period of rapid change, the ATO has continued to balance a strategy of cooperation with all those seeking to comply with the law and a resolute response to those seeking to not comply.

The transfer pricing landscape has had seismic shifts. Collectively, their direction heads towards a transparent alignment of tax outcomes with value creation. For those MNEs who may previously have sought to game the system, there is increasing pressure to get on board and use real substance and real commercial drivers in making their pricing decisions. It is up to those MNEs and their advisers to get with those who have been doing the right thing all along and to get real.

Thank you.

Footnote 1

Chevron Australia Holdings Ptl Ltd v Commissioner of Taxation [2017] FCAFC 62 @ Para 55

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