Transfer Pricing Law Reforms
Discussion Paper on review of permanent establishment tax arrangements
Back in May, the Government commissioned the Board of Taxation (BoT) to investigate the impacts of Australia’s adopting the authorised OECD approach (AOA) to the attribution of profits to permanent establishments (PEs).
The BoT has now released a Discussion Paper to seek comments on various questions it has raised regarding the advantages and disadvantages of Australia’s adopting the AOA.
The BoT review is especially important for the financial services industry, as many banks and insurance companies operate through branch structures. The implications of applying the AOA to these businesses are a particular focus of the Discussion Paper.
The AOA and Australia’s current approach to PE profit attribution are both based on the same arm’s-length principle. In short, the key difference is that the AOA is a ‘functionally separate entity’ approach under which a PE’s taxable profit is based on arm’s-length pricing of its internal dealings with other parts of the enterprise as if the PE were a separate entity, whereas Australia’s current ‘single entity’ approach requires an arm’s-length allocation of the enterprise’s actual third party income and expense to its PE.
In 2010, the OECD released a report detailing the AOA, at the same time approving a new Article 7 (Business Profits) and Commentary incorporating the AOA into its Model Tax Convention. None of Australia’s current tax treaties include the new Article 7. However, the 2010 Commentary also partially implements the AOA for the existing Article 7, and the newly enacted Subdivision 815-A Income Tax Assessment Act 1997 effectively incorporates that Commentary into Australian law. It is strange that the BoT paper does not seem to fully appreciate the implications of this, and accordingly recognise that the step change to the AOA from the position under current Australian law for many of the aspects of profit attribution canvassed in the paper is in fact not that great.
The areas of major focus and questions raised in the Discussion Paper are:
- What would be the revenue risks and impacts for Australia if the AOA were adopted?
- What are other countries doing in relation to adopting the AOA, and why are some countries, including New Zealand, not adopting it?
- Is the AOA more easily administrable and less burdensome for taxpayers than the current approach?
- Would recognising internal derivatives and currency gains and losses from internal dealings for financial services PEs under the AOA pose risks to revenue?
- Does the current special rule (in Part IIIB of the Income Tax Assessment Act 1936) that limits the deemed interest deduction on internal funds used by foreign banks in their Australian branches to LIBOR, remain appropriate? (the LIBOR cap is problematic as it does not reflect banks’ actual average cost of term funding, and therefore there is potentially a significant gap between the rule and an actual arm’s-length cost of funding)
- Should the AOA’s recognition of notional payments for profit attribution purposes also apply for other tax law purposes, such as withholding tax?
- If the AOA were to be adopted, how should this be done; ie. through renegotiation of individual tax treaties (which would take many years) or through a new domestic law provision?
Australia’s adoption of the AOA is a controversial subject. As an OECD member, Australia was one of the leading architects over a long period in developing the AOA. A decision now by Australia not to adopt the AOA would surprise many in the international community and could be expected to embarrass the OECD. However, it has been apparent for some time that there are those within the ATO who are strongly of the view that adopting the AOA would have seriously detrimental tax revenue effects for Australia, particularly through allowing financial services businesses deductions for notional payments on internal loans and derivatives involving PEs.
The financial services industry is essentially supportive of Australia’s adopting the AOA, largely on the grounds that it is a more pragmatic and workable approach to base taxable profits on internal dealings of a branch office than by seeking to trace and attribute to the branch amounts of the entity’s third party income and expense. It is important for Australia’s financial services industry that Australia has an approach to PE profit attribution that is consistent with that of the world’s major financial centres.
The BoT has asked for submissions by 14 December 2012, and is due to report back to Government by 30 April 2013.
Deloitte’s David Grecian and Marc Simpson were both heavily involved with the OECD’s work on the AOA and have consulted with the BoT on its review. We will be making a submission and would welcome the opportunity to receive any comments you may have or to discuss any aspect of the BoT review and the Discussion Paper with you.