Under the Australian tax laws, the onus is on the taxpayer to establish that the consideration applicable to international related party transactions is at arm's length. In any disputes, the Commissioner of Taxation has the distinct advantage of being able to impose a self-determined arm's length consideration where he forms the view that the consideration applied was not arm's length. The taxpayer then has the unenviable task of challenging the commissioner and, in order to be successful, establishing that another consideration correctly reflects the arm's length position. Adequately documenting a transfer pricing methodology therefore plays a pivotal and proactive role in a taxpayer's audit defence strategy.
The commissioner makes no secret of the fact that the adequacy of a taxpayer's transfer pricing documentation guides his assessment of the perceived risk to the revenue. With the commissioner focusing special attention on transfer pricing in his 2007/08 compliance programme, a taxpayer who sets an arm's length transfer price and meets the Commissioner's documentation requirements will significantly reduce the risk of a comprehensive audit. The commissioner has set out his views on the documentation required in his public taxation ruling
TR 98/11 Income tax: documentation and practical issues associated with setting and reviewing transfer pricing in international dealings (TR 98/11).
Documenting the transfer pricing approach
In addition to the statutory requirement for taxpayers carrying on a business to retain records that record and explain all transactions relevant for tax purposes, the Commissioner has outlined his views regarding transfer pricing documentation requirements in TR 98/11. These views are based on a four step approach. The following summary touches on the key points for taxpayers to address.
Step 1: Accurately characterise the international dealings between the associated enterprises in the context of the taxpayer's business and document that characterisation
The commissioner focuses on two issues in the first step: identifying the scope, type, value and timing of international dealings with associated enterprises and preparing a preliminary functional analysis that identifies the most economically important functions, assets and risks.
The commissioner advises taxpayers to retain the documentation collated and used to prepare the preliminary functional analysis. In addition, TR 98/11 states that taxpayers should retain any documentation that relates to ongoing changes in the taxpayer's international related party dealings, either in the context of the taxpayer's business or the broader economic environment.
Step 2: Select the most appropriate transfer pricing methodology or methodologies and document the choice
While emphasising that every circumstance is unique and therefore needs to be analysed on its own facts, the commissioner accepts the use of five transfer pricing methodologies in appropriate circumstances: comparable uncontrolled price, resale price, cost plus, profit split, and transactional net margin. The commissioner's public taxation ruling TR 97/20 Income tax: arm's length transfer pricing methodologies for international dealings (TR 97/20) outlines the circumstances when a particular methodology would, in the commissioner's opinion, be suitable for establishing arm's length consideration. In TR 97/20, the commissioner also outlines other transfer pricing methodologies that he generally does not accept will establish arm's length consideration.
In documenting step 2, a taxpayer should establish why a particular methodology was selected. For audit defence purposes, selecting a transfer pricing methodology based on the reasoning provided in the commissioner's public taxation rulings, or on the OECD's Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations is likely to provide a sound level of assurance. Documenting this choice with reference to the relevant paragraphs of the relevant authority (either the 1995 OECD Report or public taxation rulings) will provide stronger evidence that a taxpayer has kept contemporaneous documentation of its decision under step 2.
In TR 98/11, the commissioner also tentatively suggests that a taxpayer should be able to explain its reasons for choosing not to use the other methodologies. A taxpayer should consider, having regard to the nature and quantum of the affected related party dealings, whether such additional documentation is necessary.
Step 3: Apply the most appropriate method, determine the arm's length outcome and document the process
Step 3 requires a taxpayer to broaden or refine the preliminary functional analysis, prepare a comparability analysis and then take steps to improve the reliability of the comparables obtained. The critical documentation needs to demonstrate which comparables are considered reliable (and why) and how adjustments to the consideration (if any) are to be calculated. Specific documentation requirements vary depending on the transfer pricing method chosen and are separately listed in Chapter 7 of TR 98/11. The commissioner states that particular business strategies require special justification and supporting documentation. These business strategies include sustained losses, market penetration, marginal costing, global pricing and set-off arrangements.
Step 4: Ensure documentation is complete and implement support processes. Install review process to ensure adjustment for material changes
The purpose of the fourth step is to ensure that a chosen transfer pricing methodology continues to be reliable or can otherwise be adjusted to produce a reliable arm's length price. The commissioner states that a taxpayer should monitor its international dealings and their economic context to identify material changes and collect data relevant to evaluating the impact of these changes on the arm's length price. The review process should be conducted periodically, that is, with a frequency commensurate with the risk to revenue posed by the related party dealings, and the results of the review should be documented.
Proportionality
The commissioner accepts that the documentation collected for transfer pricing purposes should be proportionate to the extent of a taxpayer's international related party dealings. However, the commissioner also states that adequate documentation of international related party dealings will usually require preparing some form of documentation beyond that otherwise generated in the ordinary course of business. A taxpayer should consider documenting its transfer pricing methodology to address each of the commissioner's criteria in his public taxation ruling. In this manner, all of the key issues can be canvassed but the extent of the responses can be limited so as to be proportionate to the extent of a taxpayer's international related party dealings.
Reliance on a public ruling
In Australia, public taxation rulings are generally binding on the commissioner, but not the taxpayer. The result is that a taxpayer can generally rely on a public taxation ruling that provides a favourable effect. The ruling is binding in the sense that the commissioner's assessment and the amount of tax payable must be what they would have been if the interpretation of the law stated in the public ruling applied.
Penalty tax
Where the commissioner takes the view that the consideration between two or more parties to an international agreement was not at arm's length, the Commissioner has the power to deem arm's length consideration. In addition, the commissioner can impose a penalty, generally in the range of 25% - 75% of the tax shortfall amount, that is, the difference in the tax liability determined by the commissioner and the tax liability self-assessed by the taxpayer. The specific penalty percentage imposed varies on whether the commissioner determines that the tax shortfall amount was caused by a failure to take reasonable care, recklessness or intentional disregard and can be increased or decreased (generally by 20%) where there are aggravating or mitigating factors.
Paul Welch is a tax partner and Fletch Heinemann is a tax associate at Baker & McKenzie's Sydney office. The authors acknowledge the contribution of Daniel Gregory in preparing this report
From DLA Piper in Australia
Australia has general record keeping and related documentation requirements set out in section 262A of the Income Tax Assessment Act, 1936 which prescribes that a person carrying on a business must keep records that record and explain all transactions and other acts engaged in by the person that are relevant for any purpose of this Act. A similar requirement is set out in section 121 20 of the Income Tax Assessment Act, 1997 (Australia has two principal Income Tax Acts) which sets out requirements for capital gain or capital loss purposes.
These records must be in English or readily accessible and convertible into English and are generally required to be retained for five years after the preparation of those records or the transactions to which those records relate, whichever is the later.
As there is no statute of limitations (no time limit on Division 13 assessments) for transfer pricing matters, arguably records should be retained indefinitely to properly protect taxpayers.
While there are no specific statutory record keeping or documentation requirements for transfer pricing matters, the ATO has issued various transfer pricing related rulings as well as rulings on general record keeping requirements and these should be referred to as a starting point for all transfer pricing matters. As public rulings are regarded as 'relevant authorities' for tax penalty, tax offences and for matters in determining a reasonably arguable position, tactically/strategically these rulings are of great importance although the legitimacy of the ATO's documentation rules (as outlined in these public rulings) can be questioned because of the limited statutory documentation requirements in both the 1936 and 1997 Tax Acts our domestic transfer pricing provision, Division 13, is included in the 1936 Tax Act. There has been little or no judicial precedent that has tested the Australian TP documentation rules.
Accordingly it is recommended where possible that appropriate documentation be created and maintained on transfer pricing matters; particularly with respect to functions, assets and risks analysis, testing and selection of transfer pricing methods and the outcomes of transfer pricing and other economic analysis.
The primary ATO ruling dealing with transfer pricing documentation is TR98/11, contemporaneous documentation, but several other rulings including those dealing with APA's, arm's length pricing methodologies and related matters are highly relevant to transfer pricing documentation requirements.
• Other rulings of relevance in dealing with general income tax record keeping requirements include TR96/7 and TR2005/9.
• It should be highlighted that taxpayers who fail to keep appropriate records could become liable to administrative penalties pursuant to section 262A of the 1936 Tax Act or to prosecution for an offence under section 8L of the Taxation Administration Act, 1953.
