International Tax

Australia has a comprehensive transfer pricing regime aimed at ensuring that transactions between cross-border related parties are conducted at arm's length. The arm's length principle requires that prices for goods and services sold to cross-border entities reflect what independent parties would pay for the same or similar good or service. This requires in-depth qualitative analysis to support the substance and commerciality of the transaction and is usually supported by a transfer pricing report.

If the Commissioner deems the transaction as ‘non-arm’s length’, it has the power to alter the form of the agreement negotiated between entities for the transaction or permit a wholly differently structured transaction to be hypothesised as an alternative to the actual tested transaction. The consequence being, the company’s taxable income is adjusted to bring it into line with the comparable ‘arm’s length’ results, and can result in significant shortfall tax being calculated.

In most cases, transfer pricing disputes boil down to the correct characterisation of the role/risks borne by the taxpayer in the cross-border transaction, and the comparability of the taxpayer to identified independent comparable companies.

The Top 500 Program, which reviews Australia’s largest private groups, specifically singles out transfer pricing as a key concern.

The ATO has also released a suite of Practical Compliance Guidelines (PCGs). In broad terms, these PCGs set the ATO perspective on what it considers are safe “green zone” arrangements in relation to transfer pricing issues as well as risky “red zone” arrangements. These PCGs are designed as risk assessment tools only.

Several cases demonstrate the Commissioner’s growing focus in this area. The landmark case of Chevron Australia Holdings Pty Ltd (CAHPL) v Commissioner of Taxation sought to challenge Australia's transfer pricing rules and the appropriate method for establishing an arm’s length interest rate for a related party loan.

Key takeaways from this case, which should act as a warning for MNEs with cross-border related party transactions, include:

• The taxpayer has the burden of proof of demonstrating that the consideration for the cross-border related party transaction is an arm’s length consideration.
• There are still difficult statutory interpretation questions which arise in transfer pricing disputes.
• Complex matters of evidence arise including issues in ensuring expert opinions are admissible, probative and reliable.
• The timely documenting and substantiating of the commercial reasons for entering into the cross-border related party transaction are critical.  

The case of Commissioner of Taxation v Glencore Investment Pty Ltd [2020] FCAFC 187 confirmed that the first step for the Commissioner is not to first identify what independent parties might reasonably be expected to have agreed in a comparable transaction. Instead, the arm's length hypothetical used to test a cross-border related party transaction should be based on the form of the actual transaction entered into between the entities, with the arm's length consideration substituted for the actual consideration.

Overall, transfer pricing disputes requires a carefully considered strategic approach in order to properly analyse the Commissioner’s reconstruction or counterfactual to the related party transaction.

Australia’s CFC rules are highly complex and can be difficult to navigate.

Under Australia’s CFC regime, non-active income of foreign companies controlled by Australian residents may be attributed to those residents who will be required to include it in their assessable income. The CFC regime distinguishes between foreign companies resident in 'listed countries' (e.g. Canada, France, Germany, Japan, New Zealand, the United Kingdom, and the United States) and in other 'unlisted' countries.

The breadth of the provisions are still being tested some 30 years after their introduction. The High Court judgment of BHP Billiton Limited v Commissioner of Taxation concerned the application of the CFC rules to a foreign marketing entity in the group, which was jointly held by the dual listed companies BHP Billiton Limited (an Australian company) and BHP Billiton Plc (a UK company). The Court agreed with the Commissioner’s position that the dual listed entities were considered “associates” within the CFC rules, and as a result, the income derived by the foreign marketing entity should be included as assessable income in Australia.

Therefore, it is important to work through the complexities both in terms of whether the CFC rules apply, and if so, the tax outcomes that flow if income is attributable to the taxpayer.

Broadly, treaty shopping refers to a contrived arrangement designed to obtain a reduced rate of withholding tax (WHT) under a double-tax agreement.

Taxpayer Alert 2022/2 released on 20 July 2022 announced the ATO’s focus on targeting such arrangements being adopted by taxpayers for the principal or main purpose of treaty shopping on royalty and unfranked dividend payments from Australia to which they would not otherwise be entitled.

What transactions are attracting the ATO’s attention?

1. Structures and restructures involving the interposition of an existing or newly incorporated entity between Australia and the ultimate recipient of royalties or unfranked dividends.
2. Circumstances where an interposed entity may have significant existing operations and employees and the taxpayer contends that commercial benefits and/or synergies flow to the Australian operations or the interposed entity.
3. Royalty or unfranked dividend payments to an interposed entity that are, or would be, subject to reduced withholding tax rates under the relevant double tax agreement, compared with Australian domestic law or the applicable withholding tax rate under the double tax agreement between Australia and the country of residence of the ultimate recipient.

If the ATO determines that the principal or main purpose of implementing the structure is to obtain reduced withholding tax rates under the relevant double tax agreement, that reduced rate will be denied and the taxpayer’s position will revert to the position under Australian domestic tax law. This could occur either under the relevant double tax agreement or through other provisions of domestic tax laws, such as Part IVA (as noted in TD 2010/20).

Therefore, it is crucial that planned or current cross-border structures featuring the risks identified by the Commissioner in the taxpayer alert are addressed, and if needed, brought before the Commissioner in the form of a tax ruling or risk having the treaty benefits relied upon being denied.

Australia has comprehensive hybrid mismatch rules which target instruments or cross-border group structures which take advantage of the different tax treatments under the laws of two or more tax jurisdictions.

This includes imported hybrid mismatches, which requires Australian taxpayers to understand arrangements outside of their domestic business, and prevents taxpayers from making offshore hybrid mismatches that provide an overall tax benefit to a multinational group.

If a mismatch arises, the law operates to neutralise the mismatch in Australia by:

1. Disallowing Australian deductions for a range of otherwise deductible payments if the payments, directly or indirectly, benefit a group entity that is a party to a hybrid mismatch arrangement in an offshore jurisdiction.
2. Limiting the scope of the foreign branch income exemption.
3. Denying imputation benefits on franked distributions made by an Australian entity if all or part of the distribution gives rise to a foreign income tax deduction. In addition, disregarding certain foreign equity distributions received, directly or indirectly, by an Australian entity from being exempt if all or part of the distributions give rise to a foreign income tax deduction.

The ATO has been progressively introducing or amending a range of measures which specifically target entities which meet the definition of 'significant global entities' (SGEs) and/or ‘country-by-country reporting entities’ (CbCREs).

Determining whether an entity meets the definition of SGE can be complicated. Broadly, the SGE definition is met if the entities are part of an actual consolidated accounting group or notional consolidated accounting group (determined by assuming that each member of the group were a listed company and disregarding certain exceptions for preparing consolidated accounts) with global revenue of AUD 1 billion or more.

Key measures include:

• SGEs face double the maximum administrative penalties that can be applicable for entities that enter into tax avoidance and profit shifting schemes. There is also a doubling of penalties for making a false or misleading statement.
• A Diverted Profits Tax (DPT) applies to an SGE at a penalty rate of 40% in circumstances where the amount of Australian tax paid is reduced by diverting profits offshore through contrived related-party arrangements. The DPT is extremely broad (for example, both financing and non-financing arrangements are in scope).
• Significantly increased penalties (from 1 January 2023 as great as AUD 687,500, previously AUD 555,000) that can be applied for failing to lodge a tax return (or other tax-related document) on time.
• Requiring the public reporting of certain tax information on a country-by-country basis, and a statement on their approach to taxation, for disclosure by the ATO.