26 June 2020
As a part of its initiative to support the economy and businesses during COVID-19, the Australian Taxation Office (ATO) has issued guidance on various aspects including JobKeeper payments, instant asset write-offs, thin capitalisation, permanent establishment, and central management and control.
On 19 June 2020, the ATO issued guidance on the analysis of changes to transfer pricing policies due to COVID-19 and documentation the ATO recommends taxpayers prepare to support these changes.
Transfer pricing documentation to include impact of COVID-19
The ATO has acknowledged the effects of COVID-19 on the economy are yet to be fully seen and each business could be impacted differently. However, to determine the impact of COVID-19, the ATO will assess taxpayers’ circumstances before and after the pandemic. This will include:
- Function, asset and risk profile of the taxpayer before and after COVID-19;
- Actual economic impact of COVID-19 on the industry and the Australian operations;
- Contractual arrangements between the taxpayer and its related parties, and any amendments of material terms and conditions or termination of obligations;
- Evidence of the impact of COVID-19 on the specific product and service offerings of the taxpayer and how this has affected the financial results; and
- Evidence of changes in business strategies as a result of COVID-19.
The ATO has emphasised the need to contemporaneously gather evidence to support any changes to, or impacts on, the business as a result of COVID-19.
Supporting arm’s length nature of transfer pricing outcomes
Most benchmarking analyses undertaken to support transfer pricing positions rely on identification of comparable companies to determine the arm’s length price. The ATO has recognised that such reliance may be misplaced, especially in the short term, as the impact of COVID-19 may not be adequately reflected in the comparable results.
The ATO will seek to analyse financial outcomes based on variance between pre-COVID-19 budget and actual results. This may include:
- Detailed profit and loss analysis showing changes in revenue and expenses, with an explanation for variances resulting from COVID-19, including a variance analysis of budgeted (pre-COVID-19) versus actual results;
- Details of profitability adjusted to expected outcome if COVID-19 had not occurred. (This should consider all factors that have an impact on the profit and include any evidence);
- Rationale and evidence for any increased allocation of costs or a reduction of sales (and subsequent changes in operating margins) to the Australian taxpayer, taking into consideration its functional profile; and
- Evidence of any government assistance provided or affecting the Australian operations.
Impact of COVID-19 on PCG 2019/1 on Inbound Distributors
The Practical Compliance Guidance PCG 2019/1 issued by the ATO included ‘profit markers’ to be used as a risk assessment tool to assess inbound distribution arrangements. These profit markers were based on benchmarking analyses undertaken by the ATO. The ATO has clarified that it will not review the profit markers included in PCG 2019/1 due to the effect of COVID-19, unless there is material movement in the information used to develop the risk assessment framework.
Amongst others, this is likely to impact taxpayers who are required to mandatorily apply the risk assessment framework as a part of the Reportable Tax Position Schedule included in their tax return.
It is likely that more taxpayers may fall in higher risk zones of PCG 2019/1 due to reduced profit resulting from COVID-19, potentially leading to increased review by the ATO. We recommend taxpayers update their transfer pricing documentation, having regard to the guidance provided by the ATO outlined above, to support their related party transactions and risk rating under PCG 2019/1.
Advance Pricing Arrangements during COVID-19
To reduce the risk of audit, taxpayers may have entered into Advance Pricing Arrangements (APA) with the ATO and upfront agree upon the transfer price of related party transactions. It is likely that due to COVID-19, some taxpayers may not be able to meet the conditions agreed upon in the APA.
Taxpayers are encouraged to engage with the ATO in the event they are likely to breach critical assumptions of their APAs. The ATO may consider renegotiating the APA over the time period of the impact or suspending or modifying the APA for a period.
In the case of taxpayers who are currently in the APA process, the ATO will continue to apply standard APA processes and analyses where the economic performance of the taxpayer is not significantly impacted by COVID-19. In the event the taxpayer is significantly affected by COVID-19, then the ATO will continue the process provided there is evidence to support the greater level of certainty on the impact of COVID-19 on the operations of the taxpayer.
In other cases, the ATO may discuss with the taxpayer and place the application on hold or end the APA process. Bilateral APAs will need to be considered in consultation with the corresponding jurisdictions.
Tax planning schemes to be reviewed by the ATO
The ATO has recognised that by making changes to their related party arrangements, taxpayers may consider reducing their assessable income, increase deduction of expenses, avoid withholding tax, increase contractually assumed risks, or allocate global losses.
The ATO has notified it will review such changes to assess if:
- Independent parties dealing in comparable circumstances would have agreed to the changes to existing related party arrangements or terms and conditions of new related party arrangements.
- There is a mismatch between the substance of the actual dealings or relations, and changes made to related party arrangements.
- The purpose of the changes to the arrangements was to obtain an Australian tax benefit or a diverted profits tax benefit relevant to considering the application of Part IVA of the Income Tax Assessment Act 1936 or other anti-avoidance rules.
- The changes to the related party arrangements and the commercial justification developed in anticipation of a potential review by the ATO, originated with a tax adviser.
While the ATO has provided much needed guidance on how it will seek to assess cross border arrangements of taxpayers impacted by COVID-19, it is noted that the guidance does not reduce the compliance requirements of taxpayers.
In fact, the guidance provided by the ATO is broadly consistent with transfer pricing principles contained in the OECD Guidelines, which include analysis of changes to business operations based on the circumstances existing before and after such changes.
The guidance reinforces the fact that taxpayers should prepare contemporaneous transfer pricing documentation complying with the Australian regulations, including reconstruction provisions, while supporting the arm’s length nature of their related party transactions.
If you need any advice relating to transfer pricing, please submit this form or get in touch directly with these members of our Tax Advisory team:
Keerthiga Sharma, Manager, Tax Advisory (Sydney)
Anthony Patrk, Partner, Tax Advisory (Sydney)
John Baillie, Senior Partner, Tax Advisory (Melbourne)
Trevor Pascall, Senior Partner, Tax Advisory (Brisbane)
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