Transfer pricing is not just an issue for large multinational companies – it can also affect small to medium enterprises (SME). If your SME deals with a related overseas company, trust or other entity overseas, Australia’s transfer pricing rules may apply — even if your SME is relatively small.

What is transfer pricing?

1. Transfer pricing concerns the terms and pricing of transactions between related entities located in different countries.
2. Common examples include an Australian business:
   • buying goods from an overseas parent or subsidiary;
   • selling products to a foreign related company;
   • paying management or administration fees overseas;
   • providing services to an overseas group company;
   • borrowing money from, or lending money to, a related overseas entity;
   • paying interest or guarantee fees;
   • paying royalties or licence fees; or
   • transferring intellectual property or other assets within a multinational group.
3. Australia’s principal transfer pricing provisions are contained in Division 815 of the Income Tax Assessment Act 1997 (Cth).
4. Subdivision 815-B is intended to ensure that the amount brought to tax in Australia from cross-border arrangements is not less than it would have been if the entities had been dealing with each other at arm’s length. Where the actual conditions differ from arm’s length conditions and produce an Australian tax advantage, the legislation can substitute the arm’s length conditions for Australian tax purposes.

What does “arm’s length” mean?

5. In practical terms, the question is:

Would independent businesses dealing with each other commercially have agreed to the same price and terms?

6. The issue is not confined to the amount appearing on an invoice. Depending upon the transaction, consideration may need to be given to matters including:
   • the functions performed by each entity;
   • the assets used;
   • the commercial risks assumed;
   • the contractual terms;
   • the economic circumstances;
   • comparable transactions between independent parties; and
   • the commercial substance of the arrangement.
7. Division 815 expressly recognises that the relevant conditions can include matters such as price, gross margin, net profit and the division of profit between entities.

“But we are only a small business”

8. There is no general exemption from Australia’s transfer pricing rules simply because a taxpayer is a small or medium-sized business.
9. If an Australian SME has international related-party dealings, it should still consider whether those transactions comply with the arm’s length principle.
10. However, the ATO recognises that requiring smaller and lower-risk taxpayers to prepare the same level of transfer pricing documentation as a major multinational may impose a disproportionate compliance burden.
11. For that reason, the ATO issued Practical Compliance Guideline PCG 2017/2 – Simplified transfer pricing record-keeping options.

What are the simplified transfer pricing record-keeping options?

12. PCG 2017/2 identifies seven simplified record-keeping options:

• small taxpayers;
• distributors;
• low value adding intra-group services;
• low-level inbound loans;
• materiality;
• technical services; and
• low-level outbound loans.

13. These options relate to transactions or activities the ATO considers comparatively low risk for transfer pricing purposes.
14. A taxpayer must self-assess whether it satisfies the conditions for the particular option.
15. Importantly, the options are not exemptions from the transfer pricing legislation.
16. A business must still consider whether its international related-party dealings comply with Australia’s transfer pricing rules.

The SME option

17. For many SMEs, the most relevant concession is the small taxpayers
18. Under the current PCG 2017/2 criteria, the annual turnover of the taxpayer’s Australian economic group must be under $50 million.
19. In addition, the taxpayer must satisfy all of the following conditions:

• it has not made sustained losses;
• it has not undergone a restructure during the year;
• international related-party dealings involving royalties, licence fees or research and development arrangements do not exceed $500,000 in total;
• specified service-related international related-party dealings do not exceed 15% of turnover;
• the taxpayer is not a distributor; and
• the taxpayer has assessed its compliance with Australia’s transfer pricing rules.

The $50 million test is not necessarily the turnover of one company

20. A common mistake is to look only at the turnover of the particular Australian company entering into the transaction.
21. PCG 2017/2 instead refers to the annual turnover of the taxpayer’s Australian economic group.
22. Businesses operating through several Australian entities should therefore determine the relevant group turnover before assuming that they satisfy the $50 million threshold.

Transactions excluded from the small taxpayer option

23. Even where a taxpayer satisfies the small taxpayer criteria, the concession does not simplify the documentation requirements for every transaction.
24. The small taxpayer option does not reduce the documentation requirements for:

• royalties, licence fees and R&D arrangements;
• international related-party financing arrangements, including loans, guarantees and associated charges; or
• international related-party dealings of a capital nature.

25. This is particularly important because these transactions are common within privately owned international groups.

Example

26. Assume an Australian company has annual Australian economic group turnover of $20 million.
27. During the year it pays its foreign parent:

• $800,000 for administrative services;
• $100,000 in royalties; and
• $250,000 in interest on an intercompany loan.

28. Assume the Australian company otherwise satisfies the small taxpayer eligibility criteria.
29. PCG 2017/2 gives a similar example in which the taxpayer may apply the simplified small-taxpayer option to administrative support services but cannot apply that option to royalty transactions.
30. Likewise, the intercompany loan would not be covered by the small taxpayer option because international related-party financial transactions are expressly excluded.
31. The company would therefore need to separately consider whether another simplified option — such as the low-level inbound loan option — applies to that financing arrangement.

What if my business is a distributor?

32. A business that is a distributor cannot use the small taxpayer option merely because its turnover is below $50 million.
33. PCG 2017/2 contains a separate distributor option.
34. Broadly, an eligible distributor must have Australian economic group turnover below $50 million and satisfy additional conditions, including that its relevant profit-before-tax ratio is not below 3%, it has not undergone a restructure during the year and the relevant royalties, licence fees and R&D dealings do not exceed the specified threshold.
35. Distributor businesses should therefore consider the distributor criteria separately rather than applying the general small-taxpayer test.

Other concessions may be available even where turnover exceeds $50 million

36. A taxpayer with turnover above $50 million should not automatically assume that simplified record keeping is unavailable.
37. For example, PCG 2017/2 contains a materiality option where international related-party dealings are no more than 2.5% of Australian economic group turnover, subject to further conditions including group turnover not exceeding $100 million.
38. Other options may apply depending on the particular transaction.
39. Eligibility should therefore be considered transaction by transaction, rather than simply by asking whether the business is “small”.

What is the benefit of using the simplified options?

40. The principal advantage is a reduction in the transfer pricing record-keeping burden for qualifying transactions.
41. The purpose of PCG 2017/2 is to provide a practical administrative approach for lower-risk dealings and assist taxpayers to comply with Australia’s transfer pricing rules.
42. A taxpayer relying on a simplified option should nevertheless retain sufficient records to demonstrate:

• which option it relied upon;
• why the eligibility requirements were satisfied;
• which transactions were covered;
• which transactions were excluded; and
• that it considered its compliance with the substantive transfer pricing rules.

43. Simply having turnover below $50 million is not enough.

International Dealings Schedule

44. Transfer pricing documentation should also be distinguished from the taxpayer’s tax return disclosure obligations.
45. Depending on the level and nature of its international dealings, an Australian taxpayer may be required to complete an International Dealings Schedule (IDS) with its income tax return.
46. Eligibility for a PCG 2017/2 simplified record-keeping option does not, of itself, remove an IDS lodgment requirement.
47. Businesses should therefore separately determine:

• whether an IDS must be lodged;
• which international related-party dealings must be disclosed; and
• how the application of any simplified transfer pricing option should be reported.

Why documentation matters

48. Transfer pricing disputes often occur some years after the transaction was entered into.
49. It can be significantly more difficult to establish the commercial rationale for a transaction after the event if there is no contemporaneous documentation explaining matters such as:

• why the arrangement was entered into;
• how the price was calculated;
• what services were actually provided;
• why a particular interest rate was used;
• which entity performed particular functions;
• which entity bore particular risks; and
• what comparable independent businesses would have done.

50. A properly documented position may therefore substantially reduce the practical difficulty and cost of responding to an ATO review.

A practical checklist for SMEs

51. An Australian SME dealing with overseas related parties should ask:

Step 1 — Do we have international related parties?

Identify foreign parent companies, subsidiaries, sister companies, trusts, partnerships and other associated entities.

Step 2 — What transactions occurred during the year?

Identify all payments, receipts, loans, services, royalties, management fees, asset transfers and other dealings.

Step 3 — Are the terms arm’s length?

Consider whether independent businesses would have entered into the transaction on comparable terms.

Step 4 — Can we use PCG 2017/2?

Test each relevant simplified record-keeping option against the ATO’s eligibility criteria.

Step 5 — Are any transactions excluded?

In particular, check financing transactions, royalties, licences, R&D arrangements and capital transactions.

Step 6 — Do we need an International Dealings Schedule?

Consider the taxpayer’s separate income tax return disclosure obligations.

Step 7 — Do we have contemporaneous evidence?

Retain agreements, invoices, calculations, financial records and supporting transfer pricing analysis.

The key point

59. Transfer pricing should not be regarded as an issue relevant only to multinational corporations with billion-dollar revenues.
60. Australian SMEs with overseas related parties may be subject to the same substantive arm’s length principle.
61. The difference is that qualifying taxpayers may be able to take advantage of the simplified record-keeping framework in PCG 2017/2.
62. Correctly identifying and applying those concessions can significantly reduce compliance costs. Incorrectly assuming that they apply, however, can leave the taxpayer without adequate transfer pricing documentation if the ATO later reviews the arrangement.

How Waterhouse Tax Lawyers can assist

Waterhouse Tax Lawyers advises Australian businesses on transfer pricing and international tax disputes, including:

• determining whether Division 815 applies;
• reviewing international related-party transactions;
• assessing eligibility for PCG 2017/2 simplified record-keeping options;
• advising on intercompany services, loans, royalties and other cross-border arrangements;
• reviewing International Dealings Schedule disclosures;
• preparing transfer pricing documentation;
• responding to ATO reviews and audits; and
• preparing objections where the Commissioner makes a transfer pricing adjustment.

If your business has transactions with an overseas related party and you are uncertain whether the transfer pricing rules apply, obtaining advice before lodging the relevant tax return can substantially reduce the risk of a later dispute with the ATO.