1. introduction to Transfer pricing
22 January 2019
David Bond, Director
Kristy-Lee Malkki, Associate

2. Agenda What is transfer pricing? Transfer pricing legislation APAs
Transfer pricing compliance

3. What is transfer pricing?
Transfer pricing is a global initiative, led by the OECD. It is one part of the OECD’s base erosion and profit shifting action plan to combat multinationals notionally shifting profits to low or no tax jurisdictions. The BEPs action plan ensures that the appropriate amount of profits is brought to tax in Australia based on where the value is actually created.
Transfer pricing specifically looks at the conditions that operate between cross-border related parties, which are entities within the same global consolidated group or under common control. Transfer pricing applies to any kind of transaction. For example, it would apply equally to the sale of goods, use of intangible property, or the provision of services. The rules stipulate that the conditions which operate between related parties should be the same sort of conditions you would expect to operate between independent parties dealing with each other at arm’s length. This is known as the arm’s length principle. On any transfer pricing engagement, we carefully consider the conditions of any international related party dealing to ensure that the business outcomes properly reflect the economic activity in Australia and accord with the arm’s length principle.

4. What is transfer pricing?
International trade
About 60% of international trade occurs between subsidiaries of multinationals.
The pricing of these transactions impacts the tax liabilities of these multinationals in the countries they operate. For example making a lower profit in the country with the higher tax rate.
Tax Authorities’ response
Transfer pricing represents a significant threat to tax revenues, particularly in higher tax countries
Tax authorities around the world are devoting resources to informing their transfer pricing rules
The BEPS project is part of this response. “
Transfer pricing is a global initiative, led by the OECD. It is one part of the OECD’s base erosion and profit shifting action plan to combat multinationals notionally shifting profits to low or no tax jurisdictions. The BEPs action plan ensures that the appropriate amount of profits is brought to tax in Australia based on where the value is actually created.
Transfer pricing specifically looks at the conditions that operate between cross-border related parties, which are entities within the same global consolidated group or under common control. Transfer pricing applies to any kind of transaction. For example, it would apply equally to the sale of goods, use of intangible property, or the provision of services. The rules stipulate that the conditions which operate between related parties should be the same sort of conditions you would expect to operate between independent parties dealing with each other at arm’s length. This is known as the arm’s length principle. On any transfer pricing engagement, we carefully consider the conditions of any international related party dealing to ensure that the business outcomes properly reflect the economic activity in Australia and accord with the arm’s length principle.

5. What is transfer pricing?“
Transfer pricing is a global initiative, led by the OECD. It is one part of the OECD’s base erosion and profit shifting action plan to combat multinationals notionally shifting profits to low or no tax jurisdictions. The BEPs action plan ensures that the appropriate amount of profits is brought to tax in Australia based on where the value is actually created.
Transfer pricing specifically looks at the conditions that operate between cross-border related parties, which are entities within the same global consolidated group or under common control. Transfer pricing applies to any kind of transaction. For example, it would apply equally to the sale of goods, use of intangible property, or the provision of services. The rules stipulate that the conditions which operate between related parties should be the same sort of conditions you would expect to operate between independent parties dealing with each other at arm’s length. This is known as the arm’s length principle. On any transfer pricing engagement, we carefully consider the conditions of any international related party dealing to ensure that the business outcomes properly reflect the economic activity in Australia and accord with the arm’s length principle.

6. transfer pricing legislation
The transfer pricing rules are contained in Division 815 of ITAA 97:
Subdivision 815-A: treaty-equivalent cross-border transfer pricing rules
Subdivision 815-B: arm’s length principle for cross-border conditions between entities
Subdivision 815-C: arm’s length principle for permanent establishments
Subdivision 815-D: special rules for trusts and partnerships
Subdivision 815-E: reporting obligations for significant global entities
Division 815 is the home of the transfer pricing rules. Subdivision 815-A was enacted in 2012 and applies to income years commencing between 1 July 2004 and 30 June 2013.
Subdivisions 815-B to D apply to income years after 1 July We’ll be spending today’s training session talking about subdivision 815-B.

7. subdivision 815-B – Transfer pricing benefit
“Actual conditions” - different to “arm’s length conditions”
“Cross border test” is satisfied
Replacing “arm’s length conditions” would result in:
higher taxable income;
lower losses; or
lower tax offsets
“Arm’s length conditions” are substituted in calculating taxable income
(self assessment provision)
Subdivision 815-B is most relevant for us. It addresses situations where an entity adopts a non-arm’s length structure, arrangement or dealing, and gets a transfer pricing benefit as a result. It does this through a two step process:
first, identify the arm’s length conditions; and
second, if those conditions are different to the actual conditions which operate, we substitute the actual conditions for the arm’s length conditions.

8. ACTUAL conditions Commercial or financial relations
Broad enquiry about all the relevant or comparable circumstances
Comparable circumstances
Functions performed, assets used, and risks borne by the entities
Characteristics of any property or services transferred
Terms of any relevant contracts between the entities
Economic circumstances
Business strategies of the entities.
To determine what the arm’s length conditions should be, we need to determine the actual commercial and financial relations which exist between the related parties.

9. Reconstruction provisions
Basic Rule
Arm’s length conditions must be based on the commercial or financial relations in connection with which the actual conditions operate, having regard to both the form and substance of the relations
Exceptions
where the substance is inconsistent with form
where independent parties dealing wholly independently with one another:
would not have entered into the commercial or financial relations
but instead would have entered into other commercial of financial relations
where independent entities would not have entered into the commercial or financial relations
The basic rule requires that when determining the arm’s length conditions, they must be based on the actual commercial and financial relations, having regard to the form and substance.
There are two questions that the taxpayer should ask:
"What other option would be available to achieve a commercial outcome?"; and
"Why are those options less favourable to the Australian entity than the transaction that actually took place?"
Proving these assertions without any evidence is really difficult, especially after the transaction has been executed and the ATO are now questioning it. Documentation and evidence is really important to having solid support behind a transfer pricing arrangement.

10. Reconstruction – substance v form
Case study
Foreign IP Owner
100%
R&D services contract
Australian R&D activities
The basic rule requires that when determining the arm’s length conditions, they must be based on the actual commercial and financial relations, having regard to the form and substance.
There are two questions that the taxpayer should ask:
"What other option would be available to achieve a commercial outcome?"; and
"Why are those options less favourable to the Australian entity than the transaction that actually took place?"
Proving these assertions without any evidence is really difficult, especially after the transaction has been executed and the ATO are now questioning it. Documentation and evidence is really important to having solid support behind a transfer pricing arrangement.
Form
Australia provides R&D services with IP owner retaining any IP developed
Substance
Australia is driving the R&D activities & in substance is the economic owner of IP
Reconstruct
Australia is the owner of all IP developed in Australia

11. Reconstruction – Would have entered into different arrangements (1)
Case study
Foreign Manufacturer
100%
Sale of products
Australian distributor
Assumes warranty risk, and receives warranty fee = 1% sales
Market evidence that independent distributors don’t assume warranty risk
The basic rule requires that when determining the arm’s length conditions, they must be based on the actual commercial and financial relations, having regard to the form and substance.
There are two questions that the taxpayer should ask:
"What other option would be available to achieve a commercial outcome?"; and
"Why are those options less favourable to the Australian entity than the transaction that actually took place?"
Proving these assertions without any evidence is really difficult, especially after the transaction has been executed and the ATO are now questioning it. Documentation and evidence is really important to having solid support behind a transfer pricing arrangement.
Actual
Australian distributor assumes warranty risk, and makes losses
Reconstruct
Australian distributor doesn't assume warranty risk, and is reimbursed for all warranty costs

12. Reconstruction – Would have entered into different arrangements (2)
Case study
Parent
100%
$100m loan
Australian gas subsidiary
- AUD loan
- 10 years
The basic rule requires that when determining the arm’s length conditions, they must be based on the actual commercial and financial relations, having regard to the form and substance.
There are two questions that the taxpayer should ask:
"What other option would be available to achieve a commercial outcome?"; and
"Why are those options less favourable to the Australian entity than the transaction that actually took place?"
Proving these assertions without any evidence is really difficult, especially after the transaction has been executed and the ATO are now questioning it. Documentation and evidence is really important to having solid support behind a transfer pricing arrangement.
Actual
Based on loan agreement, income mainly in USD
Reconstruct
USD loan, 5 years

13. Reconstruction – Would not have entered into the arrangements
Case study
Parent
100%
Transfer of distribution business
Australian subsidiary
The basic rule requires that when determining the arm’s length conditions, they must be based on the actual commercial and financial relations, having regard to the form and substance.
There are two questions that the taxpayer should ask:
"What other option would be available to achieve a commercial outcome?"; and
"Why are those options less favourable to the Australian entity than the transaction that actually took place?"
Proving these assertions without any evidence is really difficult, especially after the transaction has been executed and the ATO are now questioning it. Documentation and evidence is really important to having solid support behind a transfer pricing arrangement.
Actual
Transfer distribution business for lump sum
Reconstruct
Australian subsidiary - treated as continuing owner of distribution business

14. OECD guidelines Arm’s length conditions:
Identify arm’s length conditions so as to best achieve consistency with:
OECD Transfer Pricing Guidelines last amended on 22 July 2010.
OECD Report - Aligning Transfer Pricing Outcomes with Value Creation, Actions Final Reports (BEPS)
Arm’s length conditions are the conditions you would expect to operate between independent entities dealing with each other wholly independently in comparable circumstances:
it considers the economic reality and effect of the transaction or arrangement
it requires an assessment of whether the commercial or financial relations and the conditions, transactions and the allocation of profits make commercial sense for all of the parties to the transaction, judged from the perspective of independent parties dealing wholly independently with each other
An arm’s length party will be willing to pay for an activity only to the extent that the activity confers on it a benefit of economic or commercial value.
To determine arm’s length conditions, we need to choose an appropriate and reliable method, and identify comparable circumstances. Basically, where we can find reliable data to show that comparable transactions exist in the market, it cannot be argued that our related party transaction lacks commercial rationality.

15. arm’s length conditions
Conditions you would expect to operate between independent entities
Dealing with each other wholly independently
In comparable circumstances.
TP rules:
Can apply to transactions between third parties
Use traditional transfer pricing methods to identify “arm’s length conditions.
Arm’s length conditions are the conditions you would expect to operate between independent entities dealing with each other wholly independently in comparable circumstances:
it considers the economic reality and effect of the transaction or arrangement
it requires an assessment of whether the commercial or financial relations and the conditions, transactions and the allocation of profits make commercial sense for all of the parties to the transaction, judged from the perspective of independent parties dealing wholly independently with each other
An arm’s length party will be willing to pay for an activity only to the extent that the activity confers on it a benefit of economic or commercial value.
To determine arm’s length conditions, we need to choose an appropriate and reliable method, and identify comparable circumstances. Basically, where we can find reliable data to show that comparable transactions exist in the market, it cannot be argued that our related party transaction lacks commercial rationality.

16. transfer pricing Methods
Arm’s length methodologies
Traditional transaction methods:
Comparable uncontrolled price (“CUP”) method
Resale price method
Cost plus method
Transactional profit methods:
Profit split method
Transactional net margin method
There are a number of internationally accepted methods that test whether a transaction complies with the arm's length principle. Which method we might use is based on the sort of transaction we are testing.  
The CUP method compares the price charged for property or services in our taxpayer’s transaction to the price charged for property or services in a comparable uncontrolled transaction in comparable circumstances. This is almost always the most reliable method for related party loans because there is an abundance of public information for what independent parties in the market are charging. We would then go through and compare the term, principal amount, subordination, security, etc. and make adjustments to our CUP where necessary. We will be going through related party financing arrangements next week in more detail.
The resale price method is often applied to marketing situations. An [NEED TO FINISH]

17. transfer pricing methods
CUP example
Term and Conditions
Controlled Transaction
Uncontrolled Transaction
Comparability Analysis
Purpose
Working capital
Comparable
Credit rate of the borrower
BBB+
BBB
Adjustment required
Principal Amount
$1 billion
Currency
AUD
USD
Date Issued
1 February 2018
2 March 2018
Sufficiently comparable
Term
4 years
Subordination
Subordinated
Unsubordinated
Security
Unsecured
Interest
LIBOR %
LIBOR %
???
Let’s look at an example. CUP method is an example of the traditional TP methodologies.
Our controlled transaction is our client’s related party transaction, and the uncontrolled transaction could be either a similar loan arrangement which our client has with an unrelated party (i.e. if they borrowed from a bank in similar circumstances), or it could be data we source from, for example, a Bloomberg bond search.
These are usually the terms and conditions we would compare for a financing arrangement to see whether an adjustment is required. If there are too many adjustments required, then it calls in to question whether it is truly a comparable transaction.
This is the same process if you were to compare product sales, for example. Your comparability factors (i.e. terms and conditions) would be the type of product, quality, delivery basis, volume, timing, you could compare at which stage in the product or distribution chain both transactions are etc.

18. transfer pricing methods
TNMM example
AusCo is a distributor of krill oil, which it purchases from SwedenCo, a related party.
Revenue: 6,500,000
Cost of Goods: 6,100,000 Profit ,000
EBIT: %
Interquartile Range of EBIT Margins for Comparable Companies
Maximum Quartile
12.3%
Upper Interquartile
8.3%
Median
5.7%
Lower Interquartile
3.8%
Minimum Quartile
1.2%
TNMM is one of the transactional TP methods. It measures the net operating profits realised from our controlled transactions (i.e. our client’s transaction). It then compares the profit level to the profit level realised by independent enterprises engaging in comparable transactions.
Our client is in the business of importing and distributing krill oil tablets. Rather than comparing like-for-like products (i.e. volume, price, delivery etc.), we are going to compare profit outcomes to ensure that AusCo’s profit is within the same interquartile range of comparable companies. Ordinarily you would have at least 5 companies to ensure there is sufficient spread of profit outcomes.
You can see from this example that AUsCo’s EBIT margin falls within the interquartile range of EBIT margins of comparable companies.

19. RECAP of subdivision 815-B
Step
Actions
Actual conditions
Legal agreement – e.g. loan agreement
Comparable circumstances – business of taxpayer, industry practice
Reconstruction
(work out all terms except interest rate)
Evidence of arm’s length terms in industry
USD common in oil & gas industry because revenue mainly in USD
Loans generally 3 to 7 years ) may be longer for project finance
Select method
Generally use CUP for financing transactions
Arm’s length conditions
Review group debt funding (often most comparable)
May need to review external comparables (Bloomberg)
May need to make comparability adjustments (e.g.. swap currency, adjust for length of loan, adjust interest frequency
Transfer pricing benefit
Compare arm’s length conditions and actual, conditions
Let’s look at an example. CUP method is an example of the traditional TP methodologies.
Our controlled transaction is our client’s related party transaction, and the uncontrolled transaction could be either a similar loan arrangement which our client has with an unrelated party (i.e. if they borrowed from a bank in similar circumstances), or it could be data we source from, for example, a Bloomberg bond search.
These are usually the terms and conditions we would compare for a financing arrangement to see whether an adjustment is required. If there are too many adjustments required, then it calls in to question whether it is truly a comparable transaction.
This is the same process if you were to compare product sales, for example. Your comparability factors (i.e. terms and conditions) would be the type of product, quality, delivery basis, volume, timing, you could compare at which stage in the product or distribution chain both transactions are etc.

20. advance pricing agreement
A taxpayer can apply to the ATO to join the APA program.
It provides the taxpayer with an opportunity to reach an agreement with the ATO on the future application of the arm's length principle to the taxpayer’s international related party dealings.
All of that can be very complicated, and in some instances is like throwing a dart at a dart board to get the answer. The most appropriate solution to that is to apply to the ATO to join the APA program.
The APA program is a prospective agreement covering generally three to five future tax years. It essentially gives the ATO and the taxpayer future certainty around the taxpayer’s related party transactions. The APA process is almost as detailed as an ATO audit. The ATO reviews the related party transactions and surrounding circumstances and comes to an agreement with the taxpayer about the arm’s length nature of the ‘actual conditions’.
APA’s could be thought of as the transfer pricing equivalent to a PBR. It can actually be a really good tool where there is the potential for future double taxation. Entering into a bilateral APA minimises the potential for double taxation and reduces the need for MAP because it brings the tax authority of the other jurisdiction to the table up front. For those who don’t know, MAP is a process which allows two tax authorities to come to an agreement about the tax treatment of something to avoid double taxation. David had a situation whereby his client was facing double taxation in Australian and Korea with a potential transfer pricing adjustment. The ATO wouldn’t allow the MAP process to be initiated until they had formed a view and issued an amended assessment. Korea wouldn’t allow it to be self assessed – MAP couldn’t be started until their tax authority had taken action, and at this stage, no one had taken action. Had they entered into an APA at the outset, it would have forced all parties to the table to negotiate and agree on the future tax treatment.

21. advance pricing agreement
All of that can be very complicated, and in some instances is like throwing a dart at a dart board to get the answer. The most appropriate solution to that is to apply to the ATO to join the APA program.
The APA program is a prospective agreement covering generally three to five future tax years. It essentially gives the ATO and the taxpayer future certainty around the taxpayer’s related party transactions. The APA process is almost as detailed as an ATO audit. The ATO reviews the related party transactions and surrounding circumstances and comes to an agreement with the taxpayer about the arm’s length nature of the ‘actual conditions’.
APA’s could be thought of as the transfer pricing equivalent to a PBR. It can actually be a really good tool where there is the potential for future double taxation. Entering into a bilateral APA minimises the potential for double taxation and reduces the need for MAP because it brings the tax authority of the other jurisdiction to the table up front. For those who don’t know, MAP is a process which allows two tax authorities to come to an agreement about the tax treatment of something to avoid double taxation. David had a situation whereby his client was facing double taxation in Australian and Korea with a potential transfer pricing adjustment. The ATO wouldn’t allow the MAP process to be initiated until they had formed a view and issued an amended assessment. Korea wouldn’t allow it to be self assessed – MAP couldn’t be started until their tax authority had taken action, and at this stage, no one had taken action. Had they entered into an APA at the outset, it would have forced all parties to the table to negotiate and agree on the future tax treatment.

22. advance pricing agreements
 ATO’s APA statistics (as at 30 June)
2016
2017
2018
Total active APAs at 30 June
131
114
110
Multilateral APA - 1
Bilateral APA 22 6 12
Unilateral APA 19 10 11
Total APAs completed 41 16 24
Renewals 29 15
New APAs 4 9
All of that can be very complicated, and in some instances is like throwing a dart at a dart board to get the answer. The most appropriate solution to that is to apply to the ATO to join the APA program.
The APA program is a prospective agreement covering generally three to five future tax years. It essentially gives the ATO and the taxpayer future certainty around the taxpayer’s related party transactions. The APA process is almost as detailed as an ATO audit. The ATO reviews the related party transactions and surrounding circumstances and comes to an agreement with the taxpayer about the arm’s length nature of the ‘actual conditions’.
APA’s could be thought of as the transfer pricing equivalent to a PBR. It can actually be a really good tool where there is the potential for future double taxation. Entering into a bilateral APA minimises the potential for double taxation and reduces the need for MAP because it brings the tax authority of the other jurisdiction to the table up front. For those who don’t know, MAP is a process which allows two tax authorities to come to an agreement about the tax treatment of something to avoid double taxation. David had a situation whereby his client was facing double taxation in Australian and Korea with a potential transfer pricing adjustment. The ATO wouldn’t allow the MAP process to be initiated until they had formed a view and issued an amended assessment. Korea wouldn’t allow it to be self assessed – MAP couldn’t be started until their tax authority had taken action, and at this stage, no one had taken action. Had they entered into an APA at the outset, it would have forced all parties to the table to negotiate and agree on the future tax treatment.

23. compliance requirements
Transfer Pricing Documentation
Country-by-Country Reporting
International Dealings Schedule
Reportable Tax Position Schedule

24. Transfer pricing documentation
Subdivision 284-E Tax Administration Act:
Transfer Pricing Documentation (explains how Subdivision 815-B applies to the transaction and meets certain requirements)
In English
Prepared before lodgement of income tax return
Otherwise deemed not to have a RAP and so subject to higher level of penalties
Assist public officer reach view that no transfer pricing benefit and therefore does not need to self assess transfer pricing adjustment
Transfer pricing documentation documents everything we touched on earlier – the arm’s length nature of related party transactions, comparable circumstances, economic analysis, functional analysis regarding the assets, functions and risks of the entities, the basic rule, the exceptions etc.
Its provides protection against penalties in the event the ATO takes a different view as to what the actual conditions should have been, so long as the documentation is prepared contemporaneously with the income tax return.

25. Country-by-country reporting (SGE only)
Country by country reports:
Country-by-Country Report
(Spreadsheet with data for each group entity)
Master File
(Word document describing global business)
Australian Local File (IDS on steroids)
Part A
Part B
Short Form Local File
Due 12 months after year end
Country-by-Country reporting is lodged with the ATO 12 months after the end of the relevant financial year. So for entity with a financial year end of 30 June 2018, the CbCR is due 30 June 2019
It applies to significant global entities with a global consolidated income of more than $1 billion. This is calculated on the year preceding the relevant financial year. So to determine whether our client needs to lodge CbCR on 30 June 2019 for the year ended 30 June 2018, we look at the global consolidated revenue for 30 June 2017 for the 2018 year.
CbCR is comprised of three lodgements:
CbC report (tax is rarely free from confusion and transfer pricing isn’t the exception – country-by-country reporting refer to the whole reporting regime, and the country-by-country report is one part of that regime). CbC report is prepared at a parent entity level so we don’t prepare many of these. Most Perth clients are inbound rather than outbound, however we may have a few more outbound clients in Sydney which we could prepare these for. The CbC report is comprised of global financial information and information regarding all of the entities in the global group. Australia has an automatic exchange relationship with 55 countries so where an automatic exchange relationship exists, it does not need to be lodged with the ATO, but rather the ATO will access it directly from the parent entity’s relevant tax authority.
Master File which is also prepared at the parent entity level. It contains information relating to the organisational structure, description of the business, any intangibles, the group’s financial activities and the group’s financial and tax position.
Local File is comprised of three parts – Part A discloses things like the Australian resident, the foreign resident counter party, the type and quantum of the related party transaction, any FX movements on the transactions. Part B discloses whether there are any written intercompany agreements in relation to each transaction, whether there is an advance pricing agreement in place with the ATO

26. international dealing schedule
Lodged with the ATO as a schedule to the income tax return
Applies to all Australian entities with related party transactions in excess of $2 million or with branch operations
Informs the ATO of:
the aggregated income and expense amount of each type of related party transaction;
total value of the related party loans held and issued;
amounts recorded as claimed and returned for branch operations; and
the aggregated value of transactions with entities in specified countries.
International dealings schedules are lodged with the ATO at the time the income tax return is lodged.
An IDS is required for any entities with related party transactions in excess of $2m or where the entity has branch operations.
It informs the ATO of the aggregated income and expense amount of each type of related party transaction, the total value of the related party loans held and issued, the amounts recorded as claimed and returned for branch operations and the aggregate value of transactions with entities in specified countries, which are your low or no tax jurisdictions.
If taxpayers are also subject to CbCR, they have the option to complete Part A of the CbCR in lieu of the IDS.

27. Reportable tax position schedule
Lodged with the ATO as a schedule to the income tax return
Applies only to companies in public or international economic groups with a turnover greater than $250 million, which the ATO have notified in writing
The RTP schedule requires taxpayers to disclose their most contestable and material tax positions:
Category A: a position that is about as likely to be correct as incorrect, or less likely to be correct than incorrect
Category B: a position in respect of something disclosed in the taxpayer's financial statements or a related party's financial statements which is uncertain
Category C: a reportable arrangement
Reportable tax position schedules are also lodged with the ATO at the time the income tax return is lodged.
It applies only to companies in public or international economic groups with a turnover greater than $250 million, which the ATO have notified in writing.
Specific to transfer pricing, “contestable and material tax positions” include those transactions which are not covered by transfer pricing compliant documentation, a transaction which falls within the high risk zone of published ATO guidance (such as the related party financing or marketing hub PCGs which we will go through on Thursday), or if the amount received or paid falls outside the interquartile range and the difference results in a material transfer pricing benefit. There are various tests for each of the categories.

28. What IS the ATO worried ABOUT?
Large and complex transactions with few comparables available
The global economic value creation chain and hubs
Profitable functions that are performed outside Australia in low tax jurisdictions, such as Singapore
Dealings in intangibles
Business restructures
Project finance in Australia
Financial instruments, derivatives and hybrids
Debt pricing and guarantee fees
Large industries such as LNG

29. Contact us David Bond Kristy-Lee Malkki Director, PerthT
Kristy-Lee Malkki
Associate, Perth T