by Ian Fullerton, Consultant, Ashurst Australia
The Tax Laws Amendment (Cross Border Transfer Pricing) Bill (No 1) 2012has been passed by Parliament without amendment and awaits Royal Assent. The Government has made it clear that the new provisions are a response to the result in FCT v SNF (Australia) Pty Ltd  FCAFC 74 (reported at 2011 WTB 23 ). In order to understand what the amendments are likely to mean for taxpayers in practice, it is instructive to look at the Commissioner’s approach in the SNFcase and then ask how a case involving similar facts might be conducted in future if the Commissioner were to make a determination under s815-10 of the ITAA 1997 rather than under s136AD(3) and (4) of the ITAA 1936.
The following questions raise some of the issues to be considered:
- Would it be open to the Commissioner to argue in a future transfer pricing case that a large difference between results produced by a transactional method of deriving an arm’s length price, such as the comparable uncontrolled price (CUP) method, and a profit-based method, such as the transactional net margin (TNM) method, suggests there are factors specific to the taxpayer’s situation (which may perhaps be thought of as the transfer pricing equivalent of Higgs bosons – the recently discovered last particle predicted to exist by the standard model of matter) that are not taken into account by the transactional method?
- Might such an approach allow the Commissioner to rely on a profit-based method to defend an assessment of a transfer pricing benefit even where the taxpayer is able to use a transactional method, as in the SNFcase, to establish that no such benefit exists?
The SNF case
The basis of the Commissioner’s argument in the SNF case was that s 136AD(3) of ITAA 1936 required the arm’s length consideration to be identified that might reasonably be expected to have been given or agreed to be given under an agreement between the taxpayer and an independent party dealing at arm’s length with the taxpayer (emphasis added). He contended that the CUP method relied upon by the taxpayer to derive arm’s length consideration could not produce the correct result because there were significant differences between the circumstances in which the transactions identified by the taxpayer as “comparables” were undertaken and the circumstances in which purchases were made by the taxpayer — including the taxpayer’s long history of making losses.
The Full Federal Court interpreted the Commissioner’s argument to mean that transactions cannot be comparables for the purposes of determining arm’s length consideration in s136AD(3) unless they involve the taxpayer or persons in exactly the same position as the taxpayer, and rejected that approach, finding that it was “deeply impractical”. In a decision impact statement on the case, the Commissioner states that he did not intend to make, and did not understand himself to have made, such a submission. Rather, his view was that “a proposed arm’s length consideration must ultimately make commercial sense for the actual taxpayer in its actual circumstances”, and in this case there were “fatal deficiencies” in the taxpayer’s CUP evidence.
In the event, the Court found that two of the three sets of transactions identified by the taxpayer as comparables were in fact comparables and the adjustments made by the taxpayer in establishing arm’s length consideration took appropriate account of the five key factors mentioned in the OECD Transfer Pricing Guidelines (the Guidelines): the character of the property acquired, the functional comparability of the transactions, the terms of the contracts, the economic circumstances of the market and the business strategy of the transacting parties. The Court went on to state that the process of establishing arm’s length consideration may produce more than one arm’s length price and (in a case involving a purchase) it is sufficient for the taxpayer to show, as it had done in this case, that it paid less than an arm’s length price (emphasis added by the Court).
It should be noted that the Commissioner did not attempt any calculation showing how specific differences that he argued were relevant (such as the fact that the taxpayer in question had trading losses for many years) should be taken into account, mathematically, in determining an arm’s length price using the CUP method. Had the Commissioner attempted such a calculation, the Court would have been bound to consider whether it was appropriate. The Commissioner preferred to argue that the taxpayer’s CUP analysis was flawed, and so could not be relied upon to establish arm’s length consideration in this case.
The new test
New s815-10 of ITAA 1997 empowers the Commissioner to make a determination “for the purpose of negating a transfer pricing benefit”. Under s815-15, an Australian resident taxpayer “gets a transfer pricing benefit” in an income year if, essentially, an application of the associated enterprises article in a relevant tax treaty would result in an increase in the taxpayer’s taxable income, a reduction of its tax loss or a reduction of the entity’s net capital loss for an income year.
Section 815-20 states that the interpretation of the associated enterprises article must be consistent with the relevant OECD Model Tax Convention and associated Commentaries and the relevant Guidelines. As noted above, the Guidelines give preference to the use of transactional methods where such methods and profit-based methods are equally appropriate. The starting point, therefore, is to determine the relative appropriateness of the various transfer pricing methods. A transactional method will be preferred if it is as appropriate or more appropriate than a profit-based method but not if it is less appropriate than a profit-based method.
The criteria for establishing which method is most appropriate are set out in para 2.2 of Pt I of Chapter II of the Guidelines. The issues to be considered are:
- the respective strengths and weaknesses of the OECD recognised methods (which are discussed elsewhere in the Guidelines);
- the appropriateness of the method considered in view of the nature of the controlled transaction, determined in particular through a functional analysis;
- the availability of reliable information (particularly on uncontrolled comparables) needed to apply the selected method and/or other methods; and
- the degree of comparability between controlled and uncontrolled transactions, including the reliability of comparability adjustments that may be needed to eliminate material differences between them.
Disputes on the relative appropriateness of particular transfer pricing methodologies in cases on facts similar to those in the SNF case, where a determination has been made under s185-10 rather than s136AD, will be decided on the basis of the criteria set out above. A barrage of expert evidence may be anticipated. In weighing the evidence, a Court will have to consider what the following statements in the Guidelines mean, if anything, in the context of litigation:
- No one method is suitable in every possible situation, nor is it necessary to prove that a particular method is not suitable under the circumstances (para 2.2).
- The guidance at paragraph 2.2. . . does not mean that all of the transfer pricing methods should be analysed in depth or tested in each case in arriving at the selection of the most appropriate method (para 2.8).
- In general, the parties should attempt to reach a reasonable accommodation keeping in mind the imprecision of the various methods and the preference for higher degrees of comparability and a more direct and closer relationship to the transaction. It should not be the case that useful information, such as might be drawn from uncontrolled transactions that are not identical to controlled transactions, should be dismissed simply because some rigid standard of comparability is not met (para 2.10).
The Guidelines also contain an important paragraph on the use of more than one method of establishing an arm’s length price (para 2.11). It starts with 2 categorical statements: “The arm’s length principle does not require the application of more than one method for a given transaction (or set of transactions . . ), and in fact undue reliance on such an approach could create a significant burden for taxpayers. Thus, these Guidelines do not require either the tax examiner or the taxpayer to perform analyses under more than one method.” The sole exception to this general rule is stated as follows: “However, for difficult cases, where no one approach is conclusive, a flexible approach would allow the evidence of various methods to be used in conjunction”.
The following provisional conclusions may be drawn:
- If the Commissioner makes a determination under s815-10 on the basis of a particular transfer pricing methodology, the taxpayer can challenge the appropriateness of the Commissioner’s choice of methodology.
- In general, the merits of the approach proposed by each party will have to be argued and decided on the basis of the four factors noted above. The argument suggested in the questions posed at the outset, which might be paraphrased as “the use of a transactional method is inappropriate because it produces a very different result from the TNM method, thereby proving that unquantifiable factors have been excluded from the transactional method”, would seem not to be available to either party.
- Equally, the view stated in the ATO’s Decision Impact Statement on the SNF case, that “a proposed arm’s length consideration must ultimately make commercial sense for the actual taxpayer in its actual circumstances”, and the implicit suggestion that the result of applying a particular methodology has a bearing on the question of whether that methodology is appropriate, finds no support in the Guidelines.
- One might expect that a party arguing for a particular methodology would also argue, in the alternative, that if the other party’s methodology is preferred by the Court, the application of that methodology produces a different result from that contended by the other party.
- If a party can establish that the case is “difficult” and that “no one approach is conclusive”, various methods might be used in conjunction with one another to establish an arm’s length amount.
- The elements of the Guidelines exhorting the parties to arrive at practical, mutually satisfactory results, and emphasising that the application of the Guidelines is not meant to be unduly burdensome, would seem to have no direct implications for litigation, other than in relation to matters such as penalties, interest and costs.
Same factual issue; different balance of factors
Finally, let us assume that the facts in a future case are substantially the same as those in the SNF case; the Commissioner makes a determination under s815-10, having applied a TNM method in arriving at the adjustments to the taxpayer’s losses and (potentially) taxable income; and the taxpayer contests the determination, relying on the CUP method and claiming that it did not get a transfer pricing benefit. Applying the conclusions set out above, the issues to be decided would seem to be these:
- Which method of determining whether a transfer pricing benefit has been obtained is most appropriate?
A taxpayer relying on the CUP method would need to demonstrate not only that the CUP method is appropriate in itself (because of the availability of comparables and the reliability of any adjustments required, and so on), but also that the TNM method chosen by the Commissioner is less appropriate or equally appropriate (in which case the CUP method, being a transactional method, would be preferred). In contrast, the taxpayer in the SNF case merely had to show that the CUP method could be used to derive arm’s length consideration.
- If the taxpayer succeeds in showing that the CUP method should be used, it is likely then to need to respond to the Commissioner’s argument, in the alternative, that the application of the CUP method produces a different result from that contended by the Commissioner.
In formulating his alternative argument, the Commissioner may suggest the existence of “Higgs bosons” that in his view cause the CUP method to produce the arm’s length consideration on which he based his transfer pricing adjustments. The taxpayer will have to disprove the existence of those factors or show that they do not have the effect for which the Commissioner contended. In the SNF case, the Commissioner did not put forward an alternative CUP analysis. Instead, he relied on the argument that an arm’s length price could not be derived using the CUP method. It seems unlikely that such an approach would generally be adopted in s815-10 cases.
- If the taxpayer fails to establish that a transactional method (such as CUP) is at least as appropriate as a profit-based method (such as the TNM method), it will probably wish to argue in the alternative that there are “Higgs bosons” that are not taken account of in the Commissioner’s TNM calculations.
. In the SNF case, the taxpayer did not have to challenge the Commissioner’s calculations; it merely had to show that its own approach represented an acceptable application of a generally accepted method of deriving arm’s length consideration.
- A final possibility is that one of the parties proposes the use of more than one method in combination,
and persuades the Court that this is a “difficult case” in which such an approach is appropriate. In that event, the parties are likely to put forward different views on the result of applying a mixed approach.
The challenge for a taxpayer seeking to displace a determination under s136AD(3) was interpreted in a very straightforward way by the Court in the SNF case. The issue was simply whether the taxpayer had shown, using an accepted transfer pricing methodology, that it paid no more than an arm’s length price, ie a price within a range of possible arm’s length prices. In contrast, a taxpayer challenging a determination under s815-10 will initially face a relative test as to the appropriateness of its method of deriving an arm’s length price (which it may well win on facts similar to those in the SNF case) followed by other challenges relating partly to the existence and influence of the transfer pricing equivalent of Higgs bosons.
As noted above, a difference between the results produced by two different methodologies is not one of the factors that can be taken into account under the Guidelines in determining which methodology is the more appropriate. But given that in pure theory all methodologies should produce the same result, a comparison of methodologies at the commencement of proceedings, revealing very different financial results, may suggest that either or both parties have work to do in identifying and quantifying the effect of the transfer pricing equivalent of Higgs bosons to which those differences might be attributable. By that means, no matter which methodology is selected as the most appropriate in determining the dispute, the influence of the other may be felt more strongly than it was in the SNF case.
It seems, therefore, that taxpayers should take some of the statements in the Guidelines with a pinch of salt. Even though the Guidelines state that it is not necessary “to prove that a particular method is not suitable under the circumstances” (para 2.2), it will be necessary to prove, in the event of a dispute, that the method relied upon is the appropriate method. It may also be necessary to show that the application of the chosen methodology takes account of all relevant factors that another methodology may indirectly suggest are present and influential, though difficult to detect.