There is a quiet revolution going on in transfer pricing. It is almost 30 years since the transfer pricing provisions, which require firms engaging in international dealings to do so at ‘arm's length', were inserted into domestic tax law. Since then, the Tax Office has generally interpreted these provisions using hypothetical profit-based modeling to arrive at an appropriate arm's length price. 

However, recent decisions in the Full Federal Court and the Administrative Appeals Tribunal have thrown into question traditional transfer pricing methodology

The starting point is Division 13 of the 1936 Income Tax Act, which sets out the legislation enabling the Tax Office to adjust the price that taxpayers pay related parties for goods and services they purchase from overseas associates. It also enables the Tax Office to adjust the price that taxpayers receive from related parties when they purchase Australian goods or services. While these 10 or so pages of legislation appear simple, they have rarely been tested in the courts. 

Since 1991, the Tax Office has issued over 15 Taxation Rulings that address these provisions, amounting to over 700 pages of guidance. In addition, the OECD publishes its own guidance on how to interpret transfer pricing provisions. The 2010 revision alone contains over 370 pages on the arm's length principle.

Wading through this literature can be hugely complicated, not to say time consuming, and so in the early 1990s the Tax Office moved to enable taxpayers to conclude Advance Pricing Agreements (APAs). An APA is an agreement between a taxpayer and the Tax Office on an appropriate transfer pricing methodology before the related party transaction actually goes ahead. It enables risk averse taxpayers to get Tax Office sign off on a particular methodology for similar transactions over a 3-5 year period.  

Since 2004, the Tax Office has completed over 220 (APAs) with taxpayers. Our understanding is that more than 65% of APAs concluded during this time involve transfer prices being calculated using the transactional net margin method (‘TNMM'). However, recent court decisions indicate that this may not be the most appropriate method in cases where a robust ‘comparable' is obtainable.

The SNF decision

The SNF case (FCT v SNF (Australia) Pty Ltd [2011] FCAFC 74), handed down in June 2011, is the first time the Federal Court has heard a matter involving transfer pricing. The case involved SNF Australia, a wholly-owned subsidiary of a French company that distributes chemical products (polyacrylamides) in Australia. SNF Australia's business model involved purchasing the chemicals from its French parent company and its associates and distributing them locally to customers in Australia.

SNF Australia found itself subject to an audit by the Tax Office. It appears that the audit was triggered by SNF Australia having to explain a period of sustained tax losses. At the conclusion of the audit, the Tax Office determined, using the TNMM, that SNF Australia's net profit margins were not sufficiently profitable compared to similar Australian businesses involved in similar arm's length transactions. The Tax Office concluded that the losses were the result of the parent company overcharging for some of the chemicals distributed in Australia. Subsequently, the Tax Office raised transfer pricing assessments of approximately $13 million.

In essence, the Tax Office argued that when a business is faced with persistent losses, it would not have continued to purchase products from an arm's length supplier at a price that led to the perpetuation of these losses.

However, the court held that the most direct way to determine whether an arm's length price had been exceeded was to examine comparable transactions. In doing this, the court put forward the primacy of comparable transactions and an examination of the transaction itself, rather than consideration of the overall profitability of the Australian entity.  It also accepted that the losses were the result of other commercial factors rather than just the prices paid to the head company for the chemicals.

In attempting to limit potential comparables, the Tax Office argued that a comparable was only truly comparable in identical circumstances. However, when the taxpayer's independent expert examined over 50,000 invoices and 7,000 spreadsheet records, they were able to identify that global customers of the parent company were paying prices that were on average less than the price paid by SNF Australia.

Ultimately the court accepted the taxpayer's argument that there was no need for identical comparables and that "differences which were material should be taken into account through a process of adjustment". 

The Roche case

In an earlier case, Roche Products Pty Ltd v Commissioner of Taxation [2008] AATA 639, the Tax Office also claimed that the taxpayer was paying more than an arm's length price for pharmaceutical products purchased by the Australian company from overseas associated entities. In coming to this conclusion, the Tax Office principally relied upon the TNMM and applied it across three divisions of the Roche business - prescriptions, consumer and diagnostic.

Whilst not adopting a direct comparable in relation to the arm's length amount in the prescription division (as there was not one), Downes, J applied a 40% gross margin on all acquisitions by the prescription division. In deciding this was appropriate (which was approximately half way between the taxpayer's and ATO's prices), he relied on an expert adjusted Comparable Uncontrolled Price (CUP) and evidence from third parties (including the 60-65% gross margin for a new patented drug Inhibace licensed to Bayer).

What can we learn from these cases?

There are several key points from these cases:

• The primacy of the ‘comparable' in demonstrating compliance with the arm's length requirement
• Potential revision of some of the main transfer pricing guidelines that have existed since 1991
• It is possible for Australian subsidiaries to have sustained losses while paying arm's length prices to their overseas associates
• Businesses need robust data to support readily understandable transfer pricing reports