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The Practical Operation of Australia's Transfer Pricing Provisions: Lessons to be Learned
Roche Products Pty Limited v Commissioner of TaxationThe preliminary and final decisions of the Australian Administrative Appeals Tribunal in the case of Roche Products Pty Limited v Commissioner of Taxation represent the first substantive Australian court or tribunal decisions concerning the practical operation of Australia's transfer pricing tax provisions. Lessons can be taken from these decisions that apply not only to Australia but also to other jurisdictions.
The Tribunal's preliminary decision was given in April 2008 and its final decision in July 2008. Although each party was entitled to appeal the Tribunal's decision to the Federal Court, neither party lodged an appeal, thus acknowledging that the Tribunal's decision was, on balance, acceptable to - or, at least, accepted by - each of the parties.
The Australian Taxation Office View - SummaryIn January 2009 the Australian Taxation Office (ATO) released a Decision Impact Statement in which the ATO sets out their views of the Tribunal's final decision itself and of its effect on the administration of Australia's transfer pricing tax provisions.
The Background to the CaseThe case arose from disputed amended income tax assessments raised by the ATO on Roche Products following an ATO transfer pricing audit of the company. The ATO audit period was in respect of the eleven years ended 31 December 1992 to 31 December 2002 inclusive.
Roche Products is a subsidiary of the multinational pharmaceutical company, Roche Holdings SA of Switzerland. Roche Products purchased many of its products from Roche Holdings and other overseas associated Roche Group companies. Roche Products sold these products in the Australian market.
The subject of the ATO's transfer pricing audit was the prices paid by Roche Products for the products purchased from Roche Holdings and the other associated Roche Group companies for importation into and resale in Australia.
Roche Products' BusinessDuring the years in question, Roche Products' business was separated into three business divisions:
1. The Ethical Pharmaceutical Division which imported and resold prescription drugs - that is, medicines which require, in Australia, a doctor's prescription to authorise sale to the public;
2. the Consumer Division which imported and resold ‘over the counter' medicine - that is, medicines not requiring a doctor's prescription for their sale to the public; and
3. the Diagnostic Division which imported and resold medical diagnostic equipment and products for use with the equipment.
The Expert Evidence The large majority of the ATO's audit adjustment related to the pricing of the Ethical Pharmaceutical Division's products.
In the course of the audit, the ATO obtained expert evidence from Dr Wright of Colorado, USA on the basis of which the ATO issued the amended income tax assessments to Roche Products increasing the company's taxable income by approximately A$130 million.
At the conclusion of the audit, Roche Products obtained expert evidence from Dr Frisch of Washington DC, USA which concluded that all of Roche Products' international dealings were at arm's length and that no pricing adjustments were required.
After the ATO had issued the amended income tax assessments to Roche Products, the ATO then obtained the expert evidence of Dr Becker of Washington DC, USA in which he concluded that the pricing adjustments should be A$89.8 million.
The Tribunal's Opinion of the Expert Evidence - ConclusionThe Tribunal was critical of the evidence of all three experts and eventually followed none of the experts' conclusions.
The Transfer Pricing ProvisionsIn order to understand the Tribunal's criticism, it is first necessary to appreciate that, broadly, Australia's transfer pricing tax provisions permit the ATO to make transfer pricing adjustments where:
- a taxpayer has supplied or acquired property under an international agreement;
- the Commissioner, having regard to any connection between any of the parties to the agreement or to any other relevant circumstances, is satisfied that any of the parties to the agreement were not dealing at arm's length with each other in relation to the transaction; and
- consideration was receivable or payable by the taxpayer in respect of the transaction but the amount of that consideration was respectively less or more than the arm's length consideration in respect of the transaction.
If the ATO decides to make a transfer pricing adjustment, consideration equal to the arm's length consideration in respect of the transaction is deemed for Australian income tax purposes to be the consideration receivable or payable by the taxpayer in respect of that transaction.
Thus, Australia's transfer pricing tax provisions are drafted in a manner suited to a comparable uncontrolled pricing methodology, as they refer to the identification of a particular sale or purchase and then determination of the arm's length price for that transaction.
In contrast, the Associated Enterprises article, article 9, of the Australian Swiss Double Taxation Agreement (DTA), being the relevant tax agreement in this case, authorises for income tax purposes the re-allocation, on an arm's length basis, of profits between associated enterprises where the commercial or financial arrangements between the enterprises differ from those that might be expected to exist between independent enterprises.
Article 9 of the Australian Swiss DTA is a standard form of article based on article 9 of the OECD Model Tax Convention. It is drafted in a manner suited to a profit based pricing methodology as it refers to the re-allocation of profits between enterprises.
The Tribunal's Opinion of the Expert EvidenceThe Tribunal was critical of the following aspects of the experts' reports:
- There was a lack of evidence concerning the source and validity of the data used by the experts.
- Some of the groups of data used by the experts were too small to be considered statistically reliable.
- The experts' reports did not contain sufficient details of the businesses in the sample groups so that it was not possible to determine which of those business activities were most comparable to those of Roche Products. - The experts lacked local (that is, Australian) experience. They had not applied their expertise within the context of the Australian transfer pricing tax provisions.
- Although the experts' reports purported to apply transactional methods of pricing (for example, the cost plus and the resale price methods), these methods were not applied to particular transactions, with the result that what were actually applied were profit based pricing methods. In the context of the Australian transfer pricing tax provisions, profit based pricing methods are less satisfactory as they do not equate with the terms of the provisions.
Some LessonsAlthough the experts' reports were not prepared for the purposes of transfer pricing documentation, some lessons for the preparation of transfer pricing documentation (as well as for the litigation of transfer pricing tax cases) can be taken from the Tribunal's criticism:
- Care should be taken to ensure that data used in support of transfer prices is appropriately sourced and is valid for the purpose. The data should also be comparable to the transfer prices it supports. The source, validity and comparability of the data should be clearly explained. - Any methodology or reasoning in support of transfer prices should be set in the context of the transfer pricing tax provisions (and, if applicable, revenue authority rulings and regulations) of the country in which the taxpayer is resident. The methodology and reasoning should relate directly to the transfer pricing tax provisions (rulings and regulations), rather than being a more general economic pricing analysis. Even the most highly qualified expert witness' evidence will be of less value if it does not relate to the specific tax provisions, rulings and regulations.
- Whichever pricing method is chosen to support transfer prices, it should be carefully followed to its conclusion. This requires a clear understanding of the differing applications of the different pricing methods. If there is insufficient data to support a particular pricing method, then it is unwise to attempt to apply that particular method.
The Case DecisionIn conclusion, the Tribunal's decision in the case can be summarised as set out below.
It will be noted that despite the Tribunal's observation that profit based pricing methods are less appropriate that a CUP method in terms of Australia's transfer pricing tax provisions, in fact the Tribunal applied a gross margin method for all years. This is indicative of the difficulty of applying the CUP method either in complex transfer pricing situations or in situations where comparable uncontrolled prices are hard to find:
When determining whether acquisitions were made for arm's length prices, as many comparables should be included as possible, particularly so in a case where comparables are hard to find. However, non typical transactions should be excluded. The experts' opinions in this case were of assistance but were not determinative.The gross profit margin for the Ethical Pharmaceutical Division was in fact 37.54%. An arm's length price for prescription pharmaceuticals would have yielded the company a gross profit margin of at least 40%. The 40% margin should be applied to each year rather than the amounts applied in raising the ATO's amended assessments. As the overall operating profit of the Consumer Division was well within the arm's length range, the Tribunal's conclusion was that the acquisition prices for the products were arm's length as well.The company also satisfied the Tribunal that the prices for which it acquired the products sold in its Diagnostic Division were arm's length prices. The poor financial results of this division resulted from operating expenses, not from acquisition prices.Although the ATO's decision to amend the company's assessment was affirmed in relation to the 1997 year, as the time limit within which the ATO could amend the 1997 assessment had expired, the Tribunal's power to amend the assessment for that year had also expired so the Tribunal could not amend the 1997 assessment. The net effect of the decision was to increase Roche Products' taxable income by approximately A$45 million; that is, an increase of taxable income of A$85 million less than the ATO's amended income tax assessments.
The Australian Taxation Office ViewThe ATO's Decision Impact Statement tends to ‘read down' or minimise the effect of the Tribunal's decision. For example, in relation to the actual arm's length outcomes decided upon by the Tribunal, the ATO states that:
"The conclusions reached in relation to the determination of the arm's length consideration were open on the evidence before the Tribunal. The decision is confined to the facts of the case."
Similarly, in relation to administration of Australia's transfer pricing tax provisions, although the ATO agrees with the Tribunal's concerns about profit based pricing methods in the context of the Australian provisions, the ATO states that:
"All things considered, it [the Tribunal's decision] is seen as having limited significance for the administration of transfer pricing laws generally."
A technical point on which the ATO disagrees with the Tribunal is the question of whether Australia's DTA's, in their Associated Enterprises and other articles, provide the ATO with a power to actually assess taxpayers to income tax.
This question was not in issue in the case because the parties agreed that Australia's transfer pricing tax provisions applied, but the Tribunal made the comment that the DTA's:
"...do not go past authorising legislation and do not confer power on the Commissioner to assess. They allocate taxing power between the treaty parties rather than conferring any power to assess on the assessing body."
In contrast, the ATO's view is that "...the business profits or associated enterprises article of a DTA may provide a separate basis for assessing transfer pricing adjustments, independently of Division 13 [Australia's transfer pricing tax provisions]."
Contact the HLB Transfer Pricing Team for more information and assistance.