What to expect when the ATO opens a transfer pricing review
Hello, and welcome to the CPA Australia podcast, your weekly source for accounting education, career and leadership discussion.
Hello, and thanks for joining us today. My name is Elinor Kasapidis, and I'm the tax policy advisor here at CPA Australia. This week on the CPA Australia podcast, we will focus on transfer pricing, which is an important tax issue for medium to large businesses with cross border dealings between related parties. We will cover why transfer pricing seems to be a perennial risk for the ATO, how COVID-19 is impacting transfer pricing, what a company can expect when the ATO opens a transfer pricing review, how a taxpayer should respond to a risk review or audit, and if there is a transfer pricing dispute, how should a company resolve it?
Our guests today are Geoff Morris from INTP and George Constantinou from Deayton Tax Consulting. Geoff has had more than 20 years experience analysing, negotiating and resolving transfer pricing disputes. Geoff worked as a senior director with the ATO's economist practise, developing the ATO's economic position on transfer pricing, risk reviews, audit, advanced pricing arrangements and supporting competent authority negotiations. For five years, Geoff was an authorised competent authority for the ATO. Geoff negotiated APAs and treaty agreements to resolve double tax with Australia's treaty partners.
George worked in the ATO for over 30 years, predominantly in a compliance role in a number of different business segments. He was part of a public groups in international teams, specialising in transfer pricing cases from 2002 to 2015, with the last five years as the technical leader.
Transfer pricing is for many something that is mysterious if they've even heard of it at all, but for those who specialise in or are subject to transfer pricing rules, the environment is one of complexity and often uncertainty, with transfer pricing often being a battleground between multinationals and tax administrators. EY's 2019 transfer pricing and international tax survey found 79% of executives described today's international tax environment as uncertain and 80% have experienced challenges to their transfer pricing over the past three years. Certainly in Australia transfer pricing seems to be a perennial risk for the ATO. Geoff, why is that?
Well, Elinor, I'm not surprised by those statistics. The nature of transfer pricing is a difficult one for everyone to deal with as a price is paid for goods and services and the cost of debt changes with the market process of those things. So it's difficult to say at a particular time, that a particular price is arm's length when market circumstances change quickly. And COVID-19, commercial impacts of that are a case in point. Consumers find it hard to spend if they're confined indoors, so sales volumes and revenues experienced by suppliers can easily be impacted. And add to that the revenue at risk or the tax owed and if non-arm's length prices cause lower profits. And that's certainly what the ATO is interested in, lower taxable profits. Those can add up over several years to be a multi-million dollar tax obligation the company didn't expect.
And to deal with these risks, the ATO has set up its top 1000 programme so that the largest companies get periodically reviewed. Smaller companies can and are selected for TP review based on data-driven risk algorithms, which might identify taxpayers that have restructured their local businesses. They might've transferred intangibles like brand names, offshore or local companies might simply be making losses. Then the ATO has developed those algorithms to identify transfer pricing risks.
But add to that, the ATO has been much more active in the last few years in publishing guidance around how taxpayers could deal with transfer pricing compliance. So, in that sense, transfer pricing is becoming much more complex than it has before. And it's fair to say that unless the taxpayer always chooses the most conservative approach in say by adopting one of the ATO's published risk metrics. And one of the recent practical compliance guides published by the ATO says that motor vehicle distributors will be in a high risk zone if it earns less than a 2% EBIT margin, but a life science distributor might be in the green zone if they earn more than 10% EBIT margin. Then transfer pricing represents an ongoing issue, both to keep up with commercial realities and keep up with what the ATO is suggesting is a low risk or high risk space to play in.
And the picture is further complicated by the fact that the tax administration on the other side, whether that's the UK or the IRS or Canada or Japan or an Asian jurisdiction, they'll have their own view about what arm's length is, and sometimes that will be quite a different interpretation from the ATO's. So, getting transferred pricing into the zone where both administrations and the company are satisfied, can be quite a challenge.
Geoff, I have a question in relation to the last part of your discussion. The point that you raised about other tax administrations, some taxpayers and practitioners might think that once an audit is finalised by the ATO with an amended assessment, is the next step for them is to appeal and then go through the court process. So when you talk about other tax administrations, what's the process there?
Yeah, certainly if a taxpayer disagrees with the assessment, they can go to court, but their other option is to request mutual agreement procedure through the relevant tax treaty, where they ask both the ATO and the other jurisdiction to come to a common view about what an arm's length outcome or price would be. And in that sense can be helpful because the other tax jurisdiction on the other side might be more sympathetic to a company's view than say the ATO might be.
On top of those challenges, how is COVID-19 impacting transfer pricing? What's been different in 2020 compared to the 2019 year when it was more business as usual?
Even though we haven't experienced anything like COVID-19 before, something has stayed the same and that's the need for documentation and detailed documentation. What has changed? The transaction can change. What makes commercial sense can change. Also, we have to factor in to our transfer pricing analysis is the government support that's been offered here in Australia. We still need to understand the broader commercial context of the business, because that's important. With COVID-19, some businesses have experienced disruption. An example is motor vehicle. It's been difficult obtaining trading stock because of the restrictions on movement, including shipping. But other businesses have done well. There's home office suppliers and home entertainment suppliers have done well. So, if a business is experiencing significant changes in revenues or costs resulting in them being in a loss position, that would attract ATO review.
So any business that has international related party dealings and has a loss or a very low return, would come under the microscope of the ATO. Now in regards to COVID-19, for businesses, the quantifiable effects of COVID-19 are not yet known. Many businesses are in the process now of finalising their 2020 accounts. Once, they're finalised, they can make comparisons with previous years. Now, when they make that comparison, they will have to consider what has changed. Have the contractual arrangements changed between the parties in any way. An example is the Australian taxpayer unfairly carrying more of the load of the impact of COVID-19? Have new strategies being introduced to deal with the impact of COVID-19? The motor vehicle example again, those motor vehicle businesses, are they concentrating on the service function instead of the buying and selling function? Whatever the dollar impact is, documenting the impact is important.
What has been the change to revenue items? What has been changed? What has been the change to expense items above the gross profit line, below the gross profit line? Has the allocation of costs between locally sourced items and those sourced overseas changed? Look at trends, look at amounts as a percentage of total expenses or sales. The businesses have got to ask themselves, what would their profitability be, if not for the impact of the COVID-19 virus? Are the reasons or the arguments given for lower profitability or losses reflected in the actual numbers in the accounts, the management accounts, the financial statements? With transfer pricing, the devil is in the detail. Statements can be made, but they have to be supported by numbers.
I don't think that we've experienced anything like the magnitude of COVID-19 on society and businesses. Examples from a transfer pricing perspective, as to how to deal with something like this, I can think of two examples. That's the global financial crisis of 2008, and the Japanese earthquake tsunami in 2011 and their impact on international related party dealings. With the global financial crisis, credit dried up and a similar situation in people didn't have the money to spend and sales for a lot of businesses decreased significantly and sharply. I was involved in a couple of cases where we were in negotiations with taxpayers in how to quantify the impact of the global financial crisis.
We requested information from the taxpayer. The taxpayer had their view of what the amount of the impact was. We prepared our case and we negotiated with the other jurisdiction in the mutual agreement procedure that Geoff mentioned previously, and we were able to negotiate a settlement. And this resulted in no double tax being paid by the economic or the global entity.
It was a similar situation in regard to the 2011 earthquake and floods. This impacted on some businesses in that they were not able to obtain components or whole units from overseas or from Japan, and they were not available to the Australian businesses. One Australian company doubled their bonuses to their independent selling network in order to keep them afloat. So that was a selling, general and administrative expense, and it was accepted that there was no transfer pricing implications. Therefore, we negotiated a settlement again with the Japanese tax administration, and there was no double tax incurred by the global entity.
If a multinational is in an advanced pricing arrangement and they're impacted by COVID-19, I think early engagement with the ATO is wise. If it has impacted on the business, then once the business notifies the ATO, they're being transparent, early engagement, the ATO will conduct periodic reviews and keep abreast of what is happening in the business. And it could save a lot of work later on because they'll let the taxpayer know what sort of information they need to consider the impact of COVID-19.
If a taxpayer received JobKeeper, the ATO has published some guidance on how that impacts on the prices of Australian services being sold overseas. Australia, or the ATO has published a taxpayer alert around non-arm's length arrangements around the transfer of intangibles and the value from intangibles offshore. The ATO has updated legislation to include BEPS action items, eight to 10 in the OECD guidelines and including chapter nine of the current OECD guidelines on business restructures. So if businesses have been restructuring during the time of COVID, then they may well need to take a careful look at how that chapter nine might impact what they've done. So this transfer pricing area hasn't been quiet by any means.
When the ATO opens a transfer pricing review, what can a company expect?
When the ATO starts a risk review or transfer pricing risk review, that generally means that they have a concern and they start off with a risk review before an audit, but not always. That depends on the taxpayer's history and their behaviour in previous interactions with the ATO. But it means that they have a concern. Internally, the ATO will collect all the information that they have on the taxpayer, and that could be from their tax returns, their international dealing schedule, reportable tax positions, any request for private rulings.
They'll also obtain information publicly available, from the media, statutory requirements, any stock exchange reporting, any industry publications. They obtain as much information as they can before they contact the taxpayer. The ATO will obtain information from the taxpayer, and this could be their transfer pricing documentation, their organisational structure, more detail on how the business operates, what their activities are in Australia, engagement with overseas related parties.
Now information requests, the taxpayer has to make sure that they know what is being requested, because I've been involved in a number of cases where there's been confusion about terms and what certain documents are known as. So it's good to be clear with the ATO on what they're actually requesting, because you don't want to waste time misunderstanding their requests. It's also important to know why the ATO is requesting certain information, because it gives you a better understanding of what their approach is, and also stops them from asking for a blanket request for a number of documents that may not even be relevant to any issues that they're looking at.
They'll meet with the taxpayer, they'll get a better understanding of the business and what impacts upon the business. When a taxpayer responds to the information request, it gives the opportunity to put forward what has impacted on the business, what may be reasons for not falling into the ATO parameters as to what would be medium or low risk. In the initial information sharing sessions between the taxpayer and the ATO, the ATO should understand where you stand, and this is an opportunity for dialogue, okay? So an ATO economist may be present at these interviews. If they're not present at these initial meetings, I'm sure that they're working behind the scenes or internally, and they're involved in researching the taxpayer as well, and seeing if there's any inconsistencies with any of the information that's been provided.
The ATO, at the end of the review, will analyse all the information available and decide whether to proceed to audit. Now, I'll give you an example of a review that I was involved in. An overseas company purchased an Australian business, and for the first few years of their trading in Australia they were making large losses, okay? We collected information. We had an inkling as to what the reason may be, but when we went out and saw the taxpayers is they were consolidating some of the businesses that they purchased, meaning that they had to pay a number of large redundancies over a few years. So that was a non transfer pricing issue, and there was no further action taken there.
Where a case jumps from a review to an audit, that means that the ATO is not satisfied with the taxpayer arguments or analysis and means that they have to dig a bit deeper. So more information or more detailed information is required and requested. And a big difference between a review and an audit is that key staff of the business in Australia are interviewed. And the purpose of these interviews is to understand how the business operates. The purpose of these interviews is for the ATO to more understand the business and what functions it performs, the assets it uses, and the risks it is exposed to. The ATO will prepare some arguments as to why they think that there's a transfer pricing issue. They will counter some of the taxpayer's arguments, but because transfer pricing is not an exact science, the eventual outcome, there is some scope for there to be negotiation.
The commercial realism point is important. The company's transfer pricing should make sense in terms of how transactions between the parties will be carried out. It should make sense in terms of commercial outcomes and consistent with industry practise, where there are similar transactions.
And I'd like to jump in there by just ad libbing a point, I think. George, your commercial realism point is important, and it reminds me that a good transfer pricing defence has three elements to it. Firstly, the transfer pricing has to provide commercially realistic outcomes, but the arrangement itself should also be commercially realistic or at least that's what the ATO will be looking for. Secondly, the technical TP analysis, the analysis of functions, assets, risks, and other factors of comparability, the choice and application of method, and the benchmarks and the comparable selected, all needs to be pretty solid. And the legal analysis that supports the use of the technical analysis and supports or confirms, about how to approach the transfer pricing question, is an important one. So I think your commercial realism point stands as one of those three parts to a good transfer pricing defence.
We're going to take a short break. And once we are back, I will ask Geoff for his insights on how taxpayers should respond to a risk review or audit.
We hope you're enjoying this episode so far. To access all of CPA Australia's COVID-19 related resources, including articles, videos, checklists and advice, go to cpaaustralia.com.au/covid19. And now back to the episode.
Welcome back listeners. We have heard about the transfer pricing environment in Australia, and now we will consider how a taxpayer should respond to a risk review or audit. Geoff, what are your insights and experiences?
Thanks Elinor. Every situation and every taxpayer is different, but I think from my experience, the golden rules are preparation and engagement with the ATO. Preparation includes good TP documentation. Difficult to prove your transfer pricing is arm's length, unless you have contemporaneous analysis, going through those functions, assets and risks that we spoke about and that George mentioned, going through the selection of method and the selection of comparables, decisions around making adjustments to the comparables and so on, and demonstrating that the underlying arrangement is commercially sound. All needs to be set out in the documentation. And the ATO will often look at questions like where is the risk allocated in the value chain? Where is the risk of product volume changes allocated in the value chain? Is it allocated to the local distributor or is some part of that volume risk allocated to the offshore parent or manufacturer?
And the ATO, as George was saying, want to know that the facts on the ground confirm the functional profile in the documentation. And companies, at the time that they do prepare their documentation will need to consider their risk appetite and work with their parents because obviously their parent will decide what their transfer pricing budget will be for documentation. And they'll need to decide whether they rely on ATO risks guidance material, like the compliance guides around inbound distributors that we've mentioned before, or whether they want to replace reliance on the local TP technical analysis.
The second golden rule is engagement with the ATO, which, coming from an economist like me, it's not probably something you hear often people talk about, but it is important from my experience as a competent authority, dealing with taxpayers and dealing with other tax jurisdictions. The perspectives that people bring to these issues, might be quite unique or it might be quite out of step with what taxpayers' experience are in other parts of the world. But the engagement will bring an understanding of what the ATO risk hypothesis might be. And engagement when the company is providing information in response to RFIs from the ATO, is an opportunity to put the narrative, to show how the facts on the ground confirm that the transfer pricing used, has been appropriate. So understanding the risk hypothesis can help the business provide information to the ATO, to debunk the perspectives of the ATO is working from.
ATO case times for transfer pricing reviews and audits can stretch from six months to several years, so the relationship is going to be a long one. This means the review is going to take up a lot of time and resources, from the company and from their advisors, from the local tax manager, from the parent's tax manager, and knowing what the ATO is thinking over that journey will help manage the risks and help negotiate a reasonable outcome. And the goal here is to try and end the review at the earliest stage possible.
For as long as an audit goes on, the more likely it is that the ATO will propose an adjustment and with it, a tax bill. In my experience, most audits do end in adjustments, though some audits have ATO positions that aren't necessarily very well founded. Once you receive a position paper or a statement of audit position, the risk becomes crystallised and it becomes something urgent to deal with.
Whilst it's not always possible, it might be appropriate to get the sense from the ATO as to whether there's the possibility of an advanced pricing arrangement, or even explore the possibility of invoking mutual agreement relief provisions of the relevant tax treaty. And that could bring another advocate, that is the other tax jurisdiction, another advocate for the taxpayer's view to the table. It might also be possible to hear the ATO view or the views of the ATO economist, as a way to better understand what changes to a future transfer pricing policy might look like, and without a prior year adjustment.
And if I can add a third golden rule, and that is to continue to explore other options like court or the mutual agreement procedure under the tax treaty. Putting a transfer pricing case into MAP can bring another jurisdiction into the dispute, as I mentioned. This can be especially useful when the other jurisdiction has a deep transfer pricing experience with a company's parent.
So Elinor in finalising, in final words, transfer pricing can be long, arduous dispute. Better not to get into dispute, but if you're there, get some good transfer pricing advice.
That's some really good advice around preparation and the audit stage and resolving the issues. However, if there is a transfer pricing dispute, how should a company resolve it? Geoff, what are your experiences?
Yeah, that's a good question, and I've mentioned a few ways. Not to have one in the first place is probably difficult to avoid sometimes. And most companies will have resources to use Big 4 advisers and top tier lawyers, to help them work through the issues and draw on global experience. But not all taxpayers can afford Big 4 advisers, and we need to draw on expertise from a wider range of sources. But from my experience, in 20 years of transfer pricing and working through competent authority disputes with other jurisdictions, even Big 4 advisers and large companies can get to a point where there's difficult decisions to be made around how to settle a case.
Unfortunately, there's no silver bullet to resolving a dispute. From our experience, resolving disputes can come from doing several things. Continue to put the company view from your own perspective about why the transfer pricing outcomes are commercially realistic. Don't forget the TP technical analysis and the legal analysis should help there as well. Speak the ATO's language, which means showing them, using their own materials, where their arguments are weak. And in my experience, sometimes the parties are at cross purposes and not talking about the same thing. So trying to speak the ATO language can draw them out and where they need to concede a point.
One does need to respond to the ATO's technical analysis and their economists' viewpoints. So engaging with them on that technical analysis is still relevant. Providing the ATO good reasons why they should withdraw a position, is more than just that transfer pricing, technical, legal rebuttal. And I made this point before, and I can't make it often enough perhaps, that demonstrating that the pricing makes commercial sense to your businesses is really important.
Where your adviser doesn't have the specialist knowledge to deal with transfer pricing disputes, seek out that specialist support. Sometimes an independent transfer pricing expert can be useful, especially if they have some ATO insight into how the ATO resolves disputes. And that might be to help work out a negotiation strategy or work with a legal team. And developing a negotiation strategy includes where it's sensible, to concede a point, if it actually ends the dispute. So sometimes the ATO might be happy with adjusting their comparability set if the taxpayer would agree to, say some point in the range of that new comp set as a way to resolve the dispute. And certainly consider the prospects of an APA, to provide certainty over a longer period. That gives companies, I think, some savings in compliance costs further down the track.
Unfortunately, not all disputes end with the ATO withdrawing their position, and very few do. So it's important to consider your further options, like independent review, court processes or MAP and APAs, which, undoubtedly could be a subject of a podcast all on their own.
Yeah, I think we've mentioned that preparation and documentation is really important. So it helps if the taxpayer position is consistent, meaning that their functional analysis is consistent with what key personnel state in their interviews, that their arguments as to the impacts on profitability are consistent and reflected in the management accounts and financial statements. Yeah, just want to reiterate the point that preparation and good detailed contemporaneous documentation is important.
Thank you very much, Geoff and George for your insights today.
Thanks Elinor, for your time.
Thank you, Elinor. It's been a pleasure.
Be sure to visit our show notes on the CPA Australia podcast webpage for links and more information on this week's episode. Thanks for listening.
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About this episode
Transfer pricing is an important tax issue for medium to large businesses with cross-border dealings between related parties.
In this podcast episode, join our experts as they discuss why transfer pricing seems to be a perennial risk for the ATO, and the impact of the COVID-19 pandemic.
You’ll also learn what a company can expect when the ATO opens a transfer pricing review, how to respond to a risk review or audit, and if there is a transfer pricing dispute, how you should resolve it.
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