A shift in focus

In an age of global expansion, the Tax Office is stepping up its efforts to identify SMEs that shift profits to minimise tax.

The rapid expansion of globalisation, together with significant technological advances, means thousands of small-to-medium enterprises (SMEs) are entering international markets for the first time. And when their international deals involve related entities, some SMEs are tempted to artificially set prices in order to underpay tax.

Tax Office staff are increasing efforts to identify SMEs that maximise profits in a lower-taxing country while minimising profits in a higher-taxing country. One avoidance method is to intentionally create break-even returns in a higher-taxing country.

Some 20,00030,000 Australian SMEs (classified by the Tax Office as businesses that have turnover between $2100 million) conduct international transactions with related parties, according to the Tax Office. The tax commissioner is now treating these SMEs as a 'fertile hunting ground', says Pete Calleja, a transfer-pricing partner with PricewaterhouseCoopers.

The Tax Offices 200607 compliance program warns that its stepped-up focus on these SMEs includes their more sophisticated international transactions involving royalty payments, patents, rights and management fees. This attention to intangibles reflects the considerable shift in the Australian economy away from manufacturing.

Particular targets for the Tax Office are SMEs that allegedly use tax-haven schemes as a means to underpay tax on their international deals with related parties. An SMEs dealings through a tax haven act as a red flag to the Tax Office staff that some avoidance is possibly being attempted.

Businesses that dont comply with Australias transfer-pricing laws for international dealings with related entities are sometimes said to be participating in profit shifting. In this context, transfer pricing means the setting of prices between international related parties.

Tax jurisdictions in OECD countries follow an arms-length principle by seeking to have the prices of internationally traded goods and services between related parties set as if charged by independent, unrelated parties.

The Tax Offices more intensive focus of its enforcement activities on SMEs marks a significant policy shift given that most concentration in the past has been on big business.

Paul Riley, CPA Australias representative on the transfer-pricing subcommittee of the national tax liaison group, describes the Tax Offices increasing attention on SMEs as a 'hot issue' for these businesses.

Riley, who is national leader for transfer pricing with Deloitte, says emerging small businesses are concentrating on developing new markets. 'They typically have little time or resources to give to transfer-pricing compliance,' he explains. Riley believes that SMEs usually do not intend to breach transfer-pricing laws.

Pete Calleja of PricewaterhouseCoopers says that one of the difficulties for SMEs in meeting their tax obligations is that transfer pricing is an area of 'subjectivity and uncertainty'.

Transfer pricing has been described by some professionals as a black art. The Tax Office, for instance, employs a team of economists to help it determine acceptable arms-length prices.

Although Australias trade with emerging economies grabs the headlines, transfer-pricing issues perhaps most frequently arise with the mature economies, and involve Australian subsidiaries acting as distributors for their multinational parents.

Indeed, the deputy tax commissioner for small and medium businesses, Mark Konza, says the Tax Office is not specifically focusing on related-party international deals involving emerging economies. However, he says some businesses in emerging economies may lack knowledge of the legal implications of transfer pricing both in their own countries and in Australia.

Konza points out that some overseas-based multinationals drive the international tax policies of their group and dictate terms to their Australian subsidiaries. This can place the Australian subsidiary in a difficult position with both the Tax Office and overseas tax jurisdictions.

Under Australias transfer-pricing laws, businesses of all sizes must be able to justify their prices for related-party international deals, using an acceptable arms-length method of pricing or testing the prices by undertaking a benchmarking study.

And the level of documentation needed to justify their prices expands with the value and the complexity of a business and its international deals. An SME that has tens of millions of dollars in international related-party deals is expected to keep very detailed documents supporting its prices.

Konza says that while the Tax Office has been focused on transfer-pricing issues in large business for 10 years, tax officers have only been looking at SMEs 'in earnest' for the past two years [and then stepping up enforcement activities in 200607]. 'Things take time to build up,' Konza says.

The Tax Offices figures show that just eight of the 146 advanced pricing arrangements (APAs) in place involve SMEs. Under APAs, the Tax Office and a business agree on the methodology to be used to set arms-length prices or results over the next three to five years. Often the APAs are between the business, the Tax Office and a foreign tax jurisdiction. This is considered within the tax profession as a valuable means for a business to gain certainty about its approach to transfer pricing.

Twelve transfer-pricing audits involving SMEs were completed in 200506, with another 13 in progress, according to the preliminary figures for that financial year. Also, the Tax Office is involved in just four transfer-pricing cases before the Administrative Appeals Tribunal or Federal Court none involving SMEs.

Konza says the Tax Office has only the resources to carry out what are known as transfer-pricing reviews and audits of high-risk matters. (His office points out the Tax Offices economist practice has developed a risk-profiling tool to rate the risk to revenue of large businesses and almost all SMEs undertaking international transactions with related parties. This enabled the Tax Office to concentrate on high-risk cases.)

Regarding the lack of litigation, Konza says transfer pricing revolves around issues of economics and commercialism, and less around interpretation of the law. 'It is not commonly litigated,' he explains.

Konzas office says the decision to proceed to litigation over a transfer-pricing matter 'rests with the taxpayer', and that the commercial risk of litigation means it is not favoured by SMEs.

According to the Tax Office, an analysis by its economist practice indicates the compliance of businesses with international related-party dealings is similar to other taxpayers. (The greatest influence in this studys results would have, of course, been large business because of the significant dollars involved.)

Sydney tax lawyer Robert Richards CPA is somewhat cynical about the small amount of transfer-pricing litigation. Richards says that Australias 25-year-old provisions on transfer pricing and accompanying tax rulings are largely untested in the courts.

This is despite the many hundreds of thousands of dollars some taxpayers have spent trying to comply with them. 'I suspect that many taxpayers, or their advisers, treat the voluminous Tax Office rulings as law when they are nothing of the kind,' says Richards, who thinks SMEs should not be overawed by the Tax Offices latest stance on transfer-pricing compliance.

Deloittes Riley suspects the Tax Office 'may be changing tack' on APAs, and moving away from them. He says the Tax Office has been promoting APAs since the late 1990s as the means for businesses to gain greater security about their transfer pricing. But now the Tax Office had become more selective about accepting APAs, and the annual rate of new arrangements was actually declining. 'The ATO says to businesses, Come forward and get certainty with an advance pricing arrangement, Riley says. 'But they seem to be backing off them in practice. If the ATO has changed its mind, taxpayers have the right to know.

'The Tax Office has provided guidance on its criteria used to accept or reject an APA. However, it seems the commissioner is applying discretion outside the well-trodden criteria and has created uncertainty.'

Riley suspects the Tax Office is concentrating more on a cost-benefit analysis from its own perspective when deciding whether to enter an APA rather than considering it from a taxpayers perspective. He suspects Tax Office staff have concluded their resources can be better used on enforcement rather than on APAs. Says Riley: 'With just 146 APAs in force [overwhelmingly involving large businesses], the agreements are not providing a lot of comfort to a lot of people.'

PricewaterhouseCoopers Calleja agrees with Rileys concerns that the APA program appears to be shrinking and says the Tax Office is 'actively discouraging' potential applications. 'The commissioners increased interest in SMEs has prompted many of them to seek certainty through APAs,' says Calleja, adding that the commissioner should be bolstering the APA program rather than pulling back.

The Tax Offices Konza gives a different impression, saying that the Tax Office encouraged APAs but that not many SMEs came forward to seek them.

One time when APAs are encouraged is after a business is subject to a transfer-pricing audit. 'When a taxpayer is audited, auditors are encouraged to make sure their future compliance is straightened out,' Konza says. 'We encourage APAs.'

APAs are a 'very effective means of resolving transfer-pricing issues', according to Konza, and the Tax Office is not 'pulling back [from them] in any way'. Further, Konza says there have not been any cases where the Tax Office had declined to proceed with an APA.

The Tax Office has been promoting a simplified compliance approach for SMEs provided they meet certain criteria, including not being part of a multinational group listed on any stock exchange. In short, the simplified process allows eligible businesses to prepare less documentation and comparative information to support their pricing.

However, some practitioners say the simplified process does not address the more substantive issue about which business bears the risk of, say, expanding into a new market. However, these practitioners say the Tax Office is trying to make a genuine effort to assist smaller businesses with simplified compliance. But then this runs into difficulties because of the complexity and grey areas of transfer pricing. The simplification option for small businesses is not well understood.

PricewaterhouseCoopers Calleja says: 'Many SMEs believe that the effort required and output expected by the ATO to support related-party dealings are still too close to the effort expected of large business that often have much larger transactions and resources.

'This is really tougher for some small-to-medium businesses that are simply trying to make a dollar, and lack the resources for meeting the burdensome transfer-pricing requirements.'

Konza says the simplified approach is about the amount of documentation required. 'Smaller businesses have to make sure transactions are realistic,' he insists.

Deloittes Riley points out that one of the reasons businesses have to be careful when setting prices for international, related-party transactions is that the tax commissioner can go back indefinitely to recover taxes following transfer-pricing adjustments. 'We know of cases where there have been tax adjustments back to the early 1990s,' Riley says. Apart from difficulties with keeping records, a business might have conflicts with customs authorities following a change in the transfer price of imported goods.

Businesses involved in international, related-party transactions need to consider their transfer-pricing arrangements both in Australia and overseas. 'Its a real balancing act,' says Riley. 'You have to worry about both sides.'

Red flags

The Tax Office may decide to have a closer look at the international, related-party transactions of an SME for a range of reasons, including if the business:

has significant international transactions yet consistently reports low profits. And such a business may seem, in the Tax Offices view, unlikely to report much of a profit in the future
conducts transactions through tax havens, particularly through tax-haven schemes. The Tax Office may be suspicious if, say, royalty payments are paid to a tax-haven company
cannot show that sufficient analysis has been carried out to establish that prices between international related parties were set as if charged by independent, unrelated parties

A shift in focus

Further reading