On 10 August 2016, the ATO released a draft practical compliance guideline (PCG) dealing with the use of offshore marketing hubs.
The media release the draft PCG outlines how the ATO proposes to treat transfer pricing issues related to the location and relocation of certain business activities and operating risks into centralised operating models, commonly referred to as “hubs”. This is designed to to help taxpayers:
- assess whether their hub arrangements pose a transfer pricing risk and how they can work with the ATO to mitigate that risk;
- understand when the ATO may take a closer look at their hub arrangements and the documentation and evidence the ATO will expect taxpayers to have prepared and readily available;
- understand their disclosure obligations.
It is essentially sharing the ATO’s own methods of assessing risk and providing the methodology for compulsory reporting of their risk assessment and basis for it.
[ATO – consultation page with link to draft PCG] [LTN 153, 10/7/16]
The draft PCG – extracts
27. The ATO’s hub risk framework is made up of five risk zones: (a) Green zone – low risk; (b) Blue zone – low to moderate risk; (c) Yellow zone – moderate to high risk; (d) Amber zone – high risk; and (e) Red zone – very high risk.
The business models
12. The structures put in place to facilitate centralised operating models may take a wide range of legal forms. For hubs the basic business models involve the ‘greenfields’ establishment or ‘brownfields’ use of a related party entity (or entities), which acts as an agent or principal in relation to the procurement or sale of goods or commodities on behalf of an Australian resident multi-national enterprise (MNE) without substantially altering the goods or commodities. Activities undertaken and risks assumed by the related party hub entity are usually rewarded by way of a fee or discount on the price of the underlying goods or commodities being purchased or sold.
13. It is usually the case that the arrangement is predicated on a commercial premise. For example:
(a) Efficiencies and synergies for the global group through centralisation of activities by, for example, the removal of duplication of the procurement or sales functions in multiple jurisdictions;
(b) An ability to access economies of scale in the procurement of third party services (such as freight) or other production inputs; and
(c) Benefits associated with key staff being located ‘close to market’ – e.g. where aspects of the ‘marketing function’ (broadly defined) are centralised and conducted through an intermediary located in a jurisdiction closer to major markets and customers.
The ATO’s role
16. The 2013 amendments to Australia’s transfer pricing rules place an onus on Australian taxpayers to self-assess their compliance with these rules on the basis that the arrangement represents a set of ‘arm’s length conditions’ and do not result in the Australian taxpayer getting a transfer pricing benefit.
17. In the first instance, Australian taxpayers are required to structure and price their commercial arrangements in a way that enables them to self-assess whether the conditions that operate between entities operate according to a set of ‘arm’s length conditions’. The role of the ATO as the administrator is to test the outcomes of taxpayers’ arrangements to ensure compliance with the transfer pricing rules. Testing the results implied by a taxpayer’s transfer pricing method through the use of a different transfer pricing method, and/or through the examination of different comparable arrangements or entities, is standard administrative practice when conducting transfer pricing analyses.
The ATO’s compliance approach
20. This Guide identifies and describes the features and attributes (scenarios) of hubs that are considered by us as low risk of not complying with the transfer pricing rules. Following this Guide does not limit or waive the operation of the law but acknowledges that should you choose to follow this Guide and align your hub, or your hub already aligns with the specific low risk indicators set out in the Guide and schedules, we will generally not allocate compliance resources to examine the transfer pricing outcomes of your hub.
21. Importantly this Guide does not constitute a ‘safe harbour’ and the information provided in this Guide does not replace, alter or affect in anyway the ATO interpretation of the relevant law as discussed in various taxation rulings. It does not relieve you of your obligation to self-assess your compliance with all relevant taxation laws but is designed to give you confidence that if you follow this Guide we will generally not allocate compliance resources to test the transfer pricing outcomes of your hub.
The hub risk assessment framework
25. The general principles of the risk framework are set out in the body of this Guide. Specific risk indicators for particular types of hubs are included in the schedules attached to this Guide. You will need to read and apply the general principles together with the specific risk indicators relevant to your type of hub. The schedules also include risk framework diagrams that will assist you in applying the principles to your particular type of hub.
How to work out the risk rating for your hub
30. To determine the risk rating for your hub, you will need to test your arrangements using the methodology set out in the schedule relevant to your type of hub and compare the outcomes against the ATO risk benchmarks provided in that schedule.
31. It is important to note that although the schedules set out methodologies to test the pricing outcomes of your hub, the use of these methods does not imply that the ATO is advocating the use of that particular method as a preferred price-setting transfer pricing method. Rather, it is used as a way for the Commissioner to cross-check the reliability of other methods and the reasonableness of the outcomes of your price-setting method.
Outside of the green zone – Additional risk indicators
34. If you work out that your hub’s potential risk is outside the green zone there is no presumption that your hub arrangement is priced incorrectly. What it means is that we consider your hub is at risk of getting a transfer pricing benefit. Therefore, we will generally conduct some form of compliance activity to further test the pricing outcomes. To be confident about your pricing outcomes and to mitigate the potential for compliance activity we encourage you to contact the ATO to discuss your arrangement.
Determining your base rating
Calculating the net tax impact
37. The net tax impact provides an indication of the potential tax at risk. The indicator is based on the consequence criteria used for rating income tax compliance by large market taxpayers.
Adjusting the base rating
Transfer pricing analysis and supporting documentation
43. Whilst there is no legal obligation for you to have transfer pricing documentation, if you do not meet the transfer pricing documentation requirements in Subdivision 284-E of Schedule 1 to the Taxation Administration Act 1953 (‘TAA’) and the Commissioner makes a transfer pricing adjustment, you will not be able to argue that you have a reasonably arguable position for the purposes of administrative penalties.6
44. The Commissioner views subdivision 284-E as an incentive for taxpayers to make a serious and genuine effort to correctly self-assess their tax positions under the transfer pricing rules and for that effort to be evidenced by documenting the transfer pricing treatment before filing their income tax returns for a given year.
52. The behavioural indicators are as follows, you:
(a) Voluntarily and co-operatively engage with the ATO; and
(b) Disclose all material facts in a timely manner; and
(c) Provide primary supporting evidence (e.g. documents evidencing the level of entrepreneurial risk).
53. It is critical to this risk assessment that you voluntarily disclose your arrangement to the ATO rather than wait for us to identify your hub and commence compliance activity.
Reporting your risk assessment
56. You may be required to disclose whether you have assessed the risk rating of your hub. If you are a large market taxpayer you will be asked via the Reportable Tax Position (‘RTP’) Schedule whether you have tested your pricing outcomes in accordance with the principles in this Guide. It is not a requirement for you to self-assess your risk rating, however, if you are unable to or choose not to you will also need to disclose this on the RTP Schedule.
What you can expect if you are in the green zone
58. If you are in the green zone, we will treat your arrangement as being at lower risk of not complying with Australia’s transfer pricing provisions. This means that:
(a) we will generally not apply compliance resources to the arrangement (other than to confirm certain facts and to check your eligibility) – minimising your compliance costs and providing practical certainty for your arrangement;
(b) you will be eligible to access the simplified record-keeping option – minimising your record keeping costs; and
(c) you will have access to the APA program (subject to meeting the eligibility criteria for the program in PSLA 2015/4) – providing additional certainty in relation to the transfer pricing outcomes of your arrangement.
Limited compliance activity
60. The Commissioner will generally only apply resources to hubs in the green zone to:
(a) verify your eligibility (i.e. factually confirm that the pricing outcomes are less than the relevant low risk benchmark);
(b) confirm that you have performed all calculations in accordance with our guidance (for example cost calculations); and
(c) confirm that the hub has economic substance.
Simplified record keeping
62. If you are in the green zone, documenting your transfer pricing in a way that meets all of the requirements of Subdivision 284-E may impose an administrative burden on you that is disproportionate to your risk of not complying with the transfer pricing rules. We will therefore allow a simplified transfer pricing record keeping option consistent with the concepts set out in ‘Simplifying transfer pricing record keeping’.* Therefore, if your hub is rated as being in the green zone you can opt to minimise your transfer pricing record-keeping and compliance costs in relation to your hub. (* See: https://www.ato.gov.au/Business/International-tax-for-business/In-detail/Transfer-pricing/Simplifying-transfer-pricing-record-keeping/ ).
APA program if within the green zone
65. An APA (Advance Pricing Arrangement) is ‘an arrangement that determines, in advance of controlled transactions, an appropriate set of criteria (e.g. method, comparables and appropriate adjustment thereto, critical assumptions as to future events) for the determination of the transfer pricing of those transactions over a fixed period of time.’ The Commissioner’s practice and procedures in relation to APAs, including criteria to enter the APA program is set out in Practice Statement PS LA 2015/4.
Transitioning existing arrangements to the green zone
97. If you have an existing arrangement and you intend to adjust your pricing to move within the green zone going forward, the Commissioner is willing to work with you to resolve the ‘back years’ in a co-operative and practical manner.
98. In recognition that this is the first time that the Commissioner has publicly released guidance in relation to hubs and to encourage willing and co-operative compliance going forward, the Commissioner, for a limited time, is willing to remit penalties and interest if certain pre-conditions are met. Specifically, the Commissioner undertakes that if you make a voluntary disclosure17 in relation to the back years and adjust your pricing to come within the green zone, the Commissioner will exercise his discretion to remit:
(a) penalties arising under Division 284 of Schedule 1 of the TAA (shortfall penalties) to nil; and
(b) shortfall interest charges arising under Division 280 of Schedule 1 of the TAA to base rate.
Current compliance hot spots
Use of third party commission rates
109. The ATO’s concern has been the absence of supporting information – in particular, information that addresses the OECD ‘factors determining comparability’ – to establish the market indicators relied upon by taxpayers as representing reliable CUP information.
Testing transfer prices – using alternative PLIs
111. In certain scenarios, the ATO has found that the results implied by a taxpayer’s transfer pricing method vary significantly depending on which PLI is applied. This has arisen in the following circumstances:
(a) The taxpayer’s chosen transfer pricing method relies on the application of a sales commission, derived from arrangements or entities considered to be comparable by the taxpayer;
(b) This is then applied to the value of the intermediary’s third party sales (in the case of a sales agent or distributor), or third party purchases (in the case of a procurement business) to derive the ‘arm’s length’ remuneration for the intermediary;
(c) When other PLIs are examined as part of the analysis, while a sales-based commission appears reconcilable with broadly comparable arrangements or entities, cost-based PLIs are not able to be reconciled with market-based outcomes (for example it produces profitability exceeding top Australian Stock Exchange performers). In these scenarios, the tested entities’ operating costs, when measured as a proportion of revenue, are significantly lower than observed in comparable entities with an implication that the level of profitability in the hub entity is disproportionately higher (in the context of the cost base) than that observed in broadly comparable entities.
The low risk benchmark
126. Your offshore marketing hub will be assessed as being in the green zone if it satisfies the low risk benchmark. The low risk benchmark is made up of two indicators:
(a) The ‘cost plus’ indicator – Based on the cost plus methodology, this is ‘the primary test’ (see below); and
(b) The ‘commercial realism’ indicator – This secondary test is applied to offshore marketing hubs that satisfy the primary test to cross-check that the profit outcomes of the hub are commercially realistic.
127. You must satisfy both tests in order to be in the green zone.
Primary test – the cost plus indicator
130. The cost plus indicator, is:
Hub profit is less than or equal to 100% mark-up of hub costs
Secondary test – the ‘commercial realism test‘
134. To risk assess your offshore marking hub arrangement using the commercial realism indicator you will need to:
(a) [to be developed]