Inter-group dealings between multinational companies have become increasingly common, and tax across various jurisdictions has become a critical consideration in structuring transactions.
When two companies that are part of the same group transact, they establish a price which is referred to as the ‘transfer price’.
A core tax risk of transactions involving transfer pricing is the artificial inflation and deflation of prices that do not reflect market values and impact taxable profits in various jurisdictions. This is known as ‘profit shifting.’
The Australian transfer pricing law seeks to prevent companies from obtaining a transfer pricing benefit by setting non-commercial prices in a related party transaction. The transfer pricing laws are set out in subdivisions 815-A to 815-D of the Income Tax Assessment Act 1997 (Cth).
The tax law (both in Australia and around the world) regulates transfer pricing by requiring companies to transact with international group members at ‘arm’s length.’ The OECD explains the arm’s length principle as follows:
“this valuation principle is commonly applied to commercial and financial transactions between related companies. It says that transactions should be valued as if they had been carried out between unrelated parties, each acting in his own best interest.”
By benchmarking against how independent parties would have fairly valued the transaction, transfer pricing rules assist in preventing underpayment of tax.
Australia applies the OECD guidelines to determine an arm’s length price. The following methods are used:
The CUP method compares the price of the related party transaction (controlled transaction) against the price of an independent transaction (uncontrolled transaction) in comparable circumstances.
The CUP method requires the availability of a comparable independent transaction to benchmark against, and companies may be able to use internal or external data to find transactions which occurred in the same or similar circumstances. Factors which affect comparability include:
The resale price method compares the gross profit margin on the end sale of a product to a third party against that in a comparable transaction where involvement of related entities would not artificially manipulate costs. After calculating the difference between the two profit margins, adjustments for costs associated with the product (such as customs duties) are applied to determine the arm’s length price.
The cost plus method is a measure against the market standard mark up on a particular product. This involves determining the costs to produce/supply a good or service and associated mark up. To determine that the pricing is at arm’s length, the mark up is reviewed against mark ups in comparable transactions between unrelated entities.
The profit split method best applies to transactions in which related entities agree to split profits (such as joint ventures), and involves considering how independent parties would have divided the profit from engaging in a comparable transaction. This can be done by analysing the functions performed by the parties and risks which they each individually bear (contribution profit split method), or by working with an established margin as a ‘routine profit’ for each entity and splitting the remainder based on each entity’s contribution (residual profit method).
The transactional net margin method applies similarly to the resale price method and cost plus method. A profit level indicator (which can be selected based on the circumstances of the transaction) is selected and the calculation using the indicator is measured against other comparable transactions undertaken by independent parties. Examples of profit level indicators which could be use are:
Significant penalties may apply for non-compliance with the transfer pricing rules.
As discussed above, the transfer pricing rules require taxpayers to assess whether the conditions of their international arrangements reliably reflect ‘arm’s length conditions’, such that no tax benefit is obtained.
A core reason for failure of transfer pricing positions is inadequate documentation to substantiate the actual transaction undertaken, arm’s length conditions, the pricing methodology adopted and identification and selection of comparable transactions. Records should be kept of each of these requirements, and expert opinions considered to support positions adopted (particularly where comparable circumstances are scarce or there is uncertainty as to how to define what is comparable).
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