Transfer prices are most often used when companies sell goods or services to divisions or subsidiaries in other international jurisdictions. This type of transfer pricing is common and a large part of international commerce is actually done within companies as opposed to between unrelated companies.
Australia’s transfer pricing rules seek to avoid the underpayment of tax in Australia by having businesses price related party international dealings according to what is expected from independent parties in the same situation. Pricing for international dealings between related parties should reflect the right return for the activities carried out in Australia, the Australian assets used (whether sold, lent or licensed), and the risks assumed in carrying out these activities.
Pricing not in accordance with Australia’s transfer pricing rules is often referred to as ‘international profit shifting’. Some multinational businesses attempt to shift their profits to low-tax jurisdictions by setting unrealistic prices for their actual commercial or financial dealings with their related parties.
Businesses with related party international dealings may have their transfer pricing reviewed or audited by the Australian Taxation Office (ATO), with the possibility of pricing adjustments and penalties. The more significant and broader the scope of a business’s international dealings with related parties, the more likely the ATO is to review those dealings. Business is at the greatest risk of ATO review if it:
- has significant levels of international dealings with related parties;
- tax payments are low compared to industry standards;
- has recently undertaken business restructures that materially affect its related party international dealings;
Businesses should carefully consider the terms and conditions of any international dealings with related parties to ensure their business outcomes properly reflect the economic activity in Australia. Australia’s double tax agreements and domestic law require pricing of goods and services and allocation of income and expenses between related parties to accord with the arm’s length principle.
The arm’s length principle uses the behaviour of independent parties as a guide or benchmark to determine the pricing of goods and services and how income and expenses are allocated in international dealings between related parties. It involves comparing what a business has done and what an independent party would have done in the same or similar circumstances. This principle is supported by all OECD countries.
As many factors may influence prices or margins, business need to closely examine the dealings they are comparing and the circumstances of the parties involved. This comparison with arm’s length activity means it is difficult to achieve absolute precision and certainty. For dealings to be comparable, none of the differences between the situations should be material. Otherwise, reasonable adjustments should be made to eliminate the effect of any such differences. The materiality of any differences depends on examining the facts and circumstances of each case and recognising there is likely to be some uncertainty in the judgments that have to be made.
In assessing compliance with the arm’s length principle, business should exercise commercial judgment about the nature and extent of documentation appropriate to their particular circumstances. Businesses should have proper internal procedures and documents to demonstrate the methods used to determine their arm’s length prices. Failure to present such documents, means risking a transfer pricing adjustment and penalties as a consequence of any audit.
Transfer Pricing Documentation
Transfer pricing is closely monitored within a company’s financial reporting and requires strict documentation that is included in financial reporting documents for auditors and regulators. This documentation is closely scrutinized. These prices are closely checked for accuracy to ensure that profits are booked appropriately within arms-length pricing methods and associated taxes are paid accordingly.
International dealings schedule (IDS)
If your business is engaged in international dealings with related parties, and has more than $2 million of related party dealings, you are required to complete an IDS and lodge it with your income tax return for that year. The IDS imposes obligations to disclose information about related party international dealings, including:
- the nature and amount of certain categories of transactions;
- details of dealings of a financial nature
- receipts or payments of non-monetary consideration
- details of restructuring events
- details of arm’s length methodologies used
- the level of documentation held to support the selection and application of the most appropriate arm’s length methodologies
- details of disposals or acquisitions of any interest in a capital asset
The IDS allows business taxpayers to notify the ATO if they are eligible and choosing to adopt any of the simplified transfer pricing record keeping options. The ATO use the information provided to help identify businesses that may pose a transfer pricing risk. If you fail to complete an IDS where required, you may incur penalties or be prosecuted.
Advance pricing arrangements (APA)
APAs provide the opportunity for your business to reach an agreement with the ATO on the future application of the arm’s length principle to your dealings with international related parties. It is a mechanism for managing and mitigating business transfer pricing risk by providing you with greater certainty on a prospective basis. Entering into an APA fosters a constructive working relationship built on mutual trust established through early engagement and full and frank disclosure throughout the creation of the APA. Entering into an APA reduces the potential for double taxation on your covered cross border dealings.
The operation of the APA may depend on you complying with particular requirements, and certain critical assumptions being met. Once the APA is finalised, the ATO will be administratively bound by the terms of the APA and will not impose any additional income tax to that payable based on the pricing worked out under the APA on the covered cross border dealings.
The APA generally covers a period of three to five years and may be reviewed if trading circumstances materially change. APAs are also subject to an annual reporting requirement.
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