Large businesses and SMEs
When it comes to international dealings and tax, most of the attention falls on large multinational businesses. However, the efficiencies generated from things like international standardisation and digital technology, as well as reductions in trade barriers, has enabled smaller businesses to engage beyond domestic borders.
Today, about a third of small-to-medium enterprises are involved in international transactions, and thus are subject to a number anti-avoidance and integrity tax laws alongside the BHPs and the Apples of the world. These laws include transfer pricing, thin capitalisation, hybrid mismatch rules, debt/equity rules, CbC reporting and so on.
Falling foul of any of these rules can result in significant additional tax, penalties and interest. Accordingly, a whole additional layer of tax risk accompanies cross-border transactions. However, the inherent nature of being in business means managing risks, and tax is just another one of those risks to be managed.
Transfer pricing’s pervasive shadow
The transfer pricing anti-avoidance laws overshadow any business’s expansion to a presence overseas. They address arrangements that inappropriately shift profits out of Australia, usually through prices charged between companies within the same group, but which are resident in different countries.
For example, take a recently concluded dispute between mining giant Rio Tinto and the ATO in relation to Rio’s Singapore marketing hub. Rio Tinto in Australia doesn’t sell its iron ore to Chinese customers. Rather, it sells the iron ore to a commonly controlled company in Singapore as part of an international marketing hub, and the Singapore company on-sells the iron ore to the customer in China. Thus, the overall profit made on the iron ore is split between Rio Tinto Australia and Rio’s Singapore company. Rio Tinto Australia pays 30% company tax, whereas the company tax rate in Singapore is 17%. So, it’s easy to see why laws are required to prevent inappropriate shifting of profit to Singapore’s jurisdiction (or any other country).
Under transfer pricing laws, the ATO has the power to replace the actual price charged for the iron ore in the above Rio example with a deemed arm’s length price for the purpose of recalculating Rio Tinto Australia’s tax liability. The profit margin earned by the intermediate Singapore company reflects its marketing-hub value contribution to the end result of selling the iron ore to the final customer in China. A greater value contribution from the Singapore company means a justifiably lower arm’s length price Rio Tinto Australia could charge for the iron ore. That results in a smaller share of the overall profit taxed in Australia at 30%, and a commensurately larger share taxed in Singapore at 17%. Of course, the reverse holds true – a lower value contribution from Singapore means Rio Tinto Australia ought to charge a higher (arm’s length) price, resulting in a greater share of the overall profit taxed in Australia at 30%.
The ATO was presumably of the view that the value contributed by the Singapore company was less than what Rio Tinto considered it to be. In consequence, the ATO would have been seeking to apply the transfer pricing laws to recalculate Rio Tinto’s Australian tax liability based on substituting the actual price charged to Singapore with a deemed (higher) arm’s length price. We can surmise that neither side thought their position was sufficiently strong to run the risk of litigating. Accordingly, they agreed to settle all their tax disputes, including this one.
For a billion dollars, paid by Rio.
Better off taxed in Australia?
Australia has a relatively high headline company tax rate of 30%. So, while it might seem counter-intuitive, there are occasions where the overall tax impost on a profit will be lower if it is taxed in Australia rather than overseas (even where tax rates overseas are lower). For example, such an occasion may arise where profits will not be retained in a company for reinvestment over the medium-to-long term, and instead will be extracted to Australian shareholders in the short-to-medium term.
In the above scenario, the foreign tax borne on those profits, however low, simply becomes a double-tax impost on top of Australian tax. Having said that, although there might be an incentive in that situation to shift profits to Australia, we must be mindful of equivalent transfer pricing laws in other countries that seek to protect their revenue base just as we do ours.
Supporting prices, interest rates
As with managing most tax risks, the key with transfer pricing is having supporting evidence. In particular, evidence supporting that the price, interest rate, etc charged is what parties dealing at arm’s length would agree to. In many circumstances, that is easier said than done, especially in the absence of a comparable market for the particular goods or services from which an arm’s length price could be inferred.
The following are internationally accepted pricing methodologies to support an arm’s length price:
- Comparable uncontrolled price method
- Resale price method
- Cost plus method
- Profit split method
- Transactional net margin method
The most appropriate method in a particular circumstance ought to be used. The ATO also has a number of rulings and other pronouncements setting out their views on these pricing methodologies, and there are also OECD guidelines.
There are options available for simplified record-keeping to support transfer pricing arrangements, including for businesses with group-wide turnover below $50 million and satisfying other criteria. However, certain types of transactions are excluded from these concessions.
Advance Pricing Arrangements (APA)
Another way of managing the risk to falling foul of the transfer pricing rules is to agree up-front with the ATO regarding the tax treatment of cross-border transactions or arrangements between related parties. APAs provide the comfort that the arrangements will not be challenged, and reduced compliance and record-keeping burdens.
A unilateral APA is concluded between a taxpayer and the ATO, whereas a bilateral APA is made with the ATO and the taxing authority of another country with whom we have a tax treaty. APAs are usually agreed for terms between three and five years.
Tax return disclosures
Engaging in transactions with overseas related parties may require making additional disclosures in tax returns. This arises where you have cross-border transactions with related parties exceeding $2 million in value for an income year or engage in certain types of transactions (irrespective of turnover). Where required, you must complete the International Dealings Schedule (IDS) in your business’s tax return. For example, a $1 million loan on foot with one overseas related party, plus $1.1 million worth of goods and/or services transacted with another overseas related party, will trigger a requirement to complete the IDS that year.
Managing the risks
Businesses are subject to many risks, with tax being just another one of them, and international dealings add an additional layer of tax risks. And just like with any risk, the key is managing them. That might involve obtaining professional advice, documenting support, or when there is sufficient uncertainty or novelty, engaging with the ATO in advance. For many clients, these are ongoing business risks, and we are there helping our clients manage them.