Taxing times: June 2008

Common sense not common in transfer pricing

It's often claimed that one of the more complex parts of tax law is its transfer pricing provisions. However, the actual statutory provisions are simple (and not particularly detailed).

And, simple provisions are supported by a multitude (in both number and volume) of ATO, but these rulings mean little.

I sometimes feel sorry for taxpayers since there seems to be a conspiracy among many tax practitioners to convince industry that the transfer pricing rules are incredibly complex. As a consequence, one quite often finds gullible finance directors paying exorbitant amounts to consultants to provide subjective advice as to what in the end should be nothing more than common sense.

An example of this was the recent decision of Roche Products Pty Limited v F C of T (Administrative Appeals Tribunal, 2 April 2008). Despite each side being represented by two senior counsel and two junior counsel, instructing solicitors and most probably accounting advisers, the end result was quite simple, and one that should have been expected.

First, let's consider the tax law. The Australian transfer pricing provisions are contained within Division 13 of the Income Tax Assessment Act 1936. Those provisions apply to just 'international agreements'.

They apply where either a non-resident supplied or acquired property under an agreement other than in connection with a business carried on in Australia by the non-resident at or through a permanent establishment of the non-resident of Australia; or where a resident carrying on a business outside Australia supplied or acquired property under an agreement, that is, property supplied or acquired in connection with that business.

All that Division 13 attempts to do is to make certain that the consideration given or received in respect of any such supply is an arm's-length consideration. The Division also allows the ATO to determine whether or not the consideration should have an Australian source.

Additional to the provisions of the Income Tax Assessment Act 1936 are the various tax treaties that Australia has entered into. Those tax treaties also contain provisions designed to allow the ATO to make adjustments where parties do not deal with each other on an arm's-length basis (although this is not the terminology adopted by those treaties).

The decision in the Roche Products case involved Roche Products Pty Limited, an Australian subsidiary of Roche Holdings Limited of Switzerland. Roche Products carried on business in Australia through three divisions: a prescription pharmaceutical division (which marketed products such as Valium, Mogadon, and Rohypnol), a consumer division (which marketed products such as Rennies, Interdens, Aspro and Berocca) and a diagnostics division (which sold diagnostic equipment and preparations to hospitals and medical laboratories). All the products sold by Roche Products originated from Switzerland.

The ATO formed the opinion that Roche Products had paid amounts to an associated Swiss operating company that were more than what it considered arm's-length amounts.

As a consequence, the ATO increased Roche's assessable income. The decision does not say how much; however, the scale of the dispute can be appreciated when it was realised that the Administrative Appeals Tribunal ultimately reduced Roche Products' adjusted assessable income by $58,741,000.

Roche Products objected against the assessments and referred the assessments to the tribunal (despite the huge amount of the assessments Roche Products would have referred the decision to the Administrative Appeals Tribunal rather than the Federal Court because only the tribunal and not the Federal Court can also exercise a discretion exercisable by the ATO – and the determination of an amount pursuant to Division 13 is the exercise of a discretion).

There was no dispute between Roche Products and the ATO that Roche Products was not dealing with its Swiss associate at 'arm's length'.

As a consequence all the tribunal had to determine was the price that should be payable by Roche Products to its associate for the supply of those products acquired by Roche Products. Despite the fact that the current transfer pricing provisions were enacted with effect from 17 May 1982 and despite annual ATO announcements as to transfer pricing 'crackdowns' Justice Downes said 'this was a novel case'.

Decision
A number of witnesses were produced, one would imagine at vast expense, before the tribunal. The different witnesses tried to justify different amounts of consideration that should had been paid by Roche Products. Their testimony simply proved the proposition that experts will never agree, and as a cynic would say, both sides were able to produce experts to support their case.

These witnesses were all based in the US. This prompted Justice Downes to wonder whether these experts were clouded by their US experiences, and whether Australian experts might not have been better. A note for future litigants: it might be to your forensic advantage to use Australian experts, even if it means your advisers have to forgo an overseas trip.

The tribunal felt that the issue was conceptually simple, Justice Downes said:

'The obvious starting point is to look for actual arm's-length transactions, preferably for the same goods in the same market. Where there are no arm's-length sales of the same goods in the same market it may be possible to find very similar goods or a very similar market. Then, the question is whether the goods or markets are sufficiently comparable and whether any, and if so, what adjustments can be accurately made to compensate for any differences.'

Justice Downes stated that this approach was a common one for valuers, particularly real estate valuers, and approved in a multitude of cases following a 1907 decision of the High Court.

The problem in the case in question, was that of establishing comparable sales. This was because of the nature of the pharmaceutical market. The evidence showed that here there were no comparable sales. Accordingly, Justice Downes had to select another method for determining comparable sales. He selected a gross profit method. He felt that the pharmaceutical division had not made a sufficient gross profit, he said that the gross profit should have been 40 per cent.

An application of this method still allowed the ATO to reduce the deductions claimed by Roche Products, but not to the extent claimed by the ATO. Justice Downes felt that no adjustments were required for the other two divisions; this was despite their poor results. Justice Downes said that these poor results 'flowed from operating expenses and acquisition process'. That is, there is a distinction between a taxpayer's profitability and what they should have acquired product for.

It's all a matter of timing
Retirement village investments used to be attractive tax shelter investments. This was because on 30 June 1994 the ATO issued a binding taxation ruling (TR 94/24), which stated that those who invested in retirement village schemes were entitled to an outright deduction for costs incurred by the scheme in acquiring land and developing the village. The ruling was technically suspect and was withdrawn on 19 April 2000.

However, that ruling was insufficient for many investors. They not only wanted a tax deduction for their share of acquisition and development costs, but they expected that deduction as soon as possible even though they might not have to pay those costs for some years. There were some cases where payment could not be quantified.

The decision in Malouf v F C of T (Federal Court, 22 April 2008) involved a taxpayer who had sought such upfront tax deductions.

The taxpayer was a partner in a partnership that through a second partnership wanted to take advantage of TR 94/24.

A company related to the partnerships agreed to build, develop, and commercially exploit a retirement village.

On 25 June 1999 the company entered into a contract for sale of land to the second partnership. Part of the purchase price for the land was then paid by deposit. It's amazing how often contracts are entered into just before the end of a financial year. The balance of the purchase price was not payable by the second partnership until 14 days after the 'stage 1 completion date' and that date was after the financial year ended on 30 June 1999.

The ATO allowed the second partnership (and by extension Malouf) to deduct the deposit (or Malouf's case part thereof) in the 1999 year. However it refused to allow the partnership (or Malouf) to deduct the balance of the purchase price (or in Malouf's case part
thereof) in that year.

The ATO argued that there were a number of reasons why it should not allow a deduction for the balance of the purchase price. However, it first argued that payment of the balance of the purchase price was conditional upon the development approval process (and thus as at 25 June 1999 all that second partnership had was a mere contingency to make the further payment).

The Federal Court (Justice Allsop) rejected that argument. Effectively it said that the agreement was not conditional on the building work taking place, rather the obligation of the vendor to make a payment after the 'stage 1 completion date' went to the timing of payment and not to the obligation to make a payment. That condition did not mean that a liability to make a payment had not been incurred.

By way of associated argument, the ATO said even if the obligation to pay the balance of the purchase price was incurred in the 1999 year, the deduction was not allowable in that year because no outgoing was referable to that year.

The court noted (referring to the decision in Coles Myer Limited v F C of T, High Court of Australia, 29 April 1993) that a deduction is referable to the year in which the advantage gained by a loss or outgoing is enjoyed and is only deductible in the year to which it is referable. This means that the loss or outgoing might not be deductible in the year in which the loss or outgoing was incurred.

However, the court said: 'The advantage secured and enjoyed was the binding of the vendor [that is the company] to an unconditional contract ; creating contractual rights capable of protection by a court of equity conformable with their extent. This occurred in the 1999 year of income.'

The lesson in this case is simple: deductions are allowed even when timing of the payment is conditional. But the wording of the contract must be such that it gives rise to an obligation to make a payment, even though that timing is conditional. It is essential that taxpayers commit themselves to making a payment.

The harder question is how a taxpayer becomes entitled to a tax deduction when it is not known at the time that the taxpayer binds him or herself to make a payment or what the quantum of that payment might have to be.

This is the case when people enter into cost-plus contracts. At the time of entering into a contract they will not know what the quantum of the total payments to be made under the contract will be.

As a consequence, it will not be possible to say that they have committed themselves to a particular payment, at the time they entered into the contract. One approach might be to enter into a contract that definitively binds people to make a payment but that will be reduced if based on a cost-plus analysis. Those people ultimately pay less than what they first committed themselves for.

Robert Richards CPA is a solicitor specialising in tax matters.

Reference: June 2008, volume 78:05, p. 64 - 67

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