Australian Tax Agency Reveals Intent to Review Arm’s Length Agreements Involving Intangible Assets – MNE Tax
By David Lewis, Managing Director of Duff & Phelps Australia Pty Ltd., Melbourne, Australia
The Australian Taxation Office (ATO) has been concerned for many years about the migration of intangibles out of Australia, which it suspects is being encouraged by the different corporate tax rates in Australia.
To this end, the ATO has reviewed international agreements to determine whether they distort Australian activities related to the development, enhancement, maintenance, protection and operation (DEMPE) of intangible assets.
In particular, the ATO is concerned that some agreements may not be arm’s length, leading to inappropriate results for Australian tax purposes. As a result, the ATO issued Tax Alert 2020/1 on January 22, outlining its concerns to facilitate a risk assessment by taxpayers.
While the tax alert raises questions regarding Australia’s capital gains tax and general anti-tax avoidance provisions, our comments on this alert are limited to transfer pricing.
In the tax alert, the ATO gives examples of arrangements that concern them. While such arrangements are not uncommon, the alert focuses in our view on more extreme aspects to demonstrate the ATO’s concerns.
Australia’s reconstruction offer
The important thing to note is that Australia has included in its tax laws the so-called âReconstruction Provisionâ first mentioned in the OECD Transfer Pricing Guidelines, which under Australian law authorizes the Commissioner to disregard actual commercial and financial relationships for the purposes of determining arm’s length conditions.
A taxpayer must meet three exceptions for the actual conditions to apply. This is because the form of the business or financial relationship is consistent with the substance, that independent entities would have entered into the actual business or financial relationship rather than different agreements, and that independent entities would have entered into the business or financial relationships. rather than avoiding them altogether.
A key way to manage these risks is to monitor these agreements to ensure that there is no mismatch in contributions to value creation, that there is a clear business rationale for such agreements entered into, and that the Australian entity acts in its economic interest having regard to all the options realistically open to it.
The alert indicates that the ATO is currently reviewing these agreements and engaging with taxpayers who have entered into or are considering doing so.
He also informed that the insurance activities of the ATO will continue as they develop their technical position on these provisions.
The alert comes with a clear warning that taxpayers and advisers entering into these types of arrangements will be subject to further scrutiny. Accordingly, the alert encourages taxpayers to approach the ATO to discuss their situation if they are considering entering into these arrangements.
If a taxpayer has any of these arrangements in their transfer pricing infrastructure, they should assess the inherent risks to determine whether they can be commercially justified and, if so, this should be clearly documented and maintained to support the statement. corporate tax and advocate for an ATO Risk Assessment.
Approaching the ATO to discuss their situation is an option to consider in our opinion after carry out a risk assessment.
The ATO provides examples of problematic provisions in the alert which are summarized under the following headings.
Bifurcation of intangible assets and poor characterization of DEMPE’s Australian activities
The first example refers to contract research and development (R&D) and deals with an Australian company entering into a contract R&D agreement with a related foreign company.
Under this arrangement, the Australian company provides services to a foreign company associated with DEMPE of potentially new or future intangible assets. The Australian company is remunerated by the foreign company on a cost plus basis. All new intangible assets produced under the arrangement are owned by the foreign company and the foreign company derives all income generated from the operation of the new intangible assets, but manages and executes limited activities and assumes limited risks associated with the operations. new intangible assets.
The new intangibles are intrinsically linked to the existing intangible assets of the Australian company, including updated versions and improvements to the patents, trademarks, know-how, copyrights and similar assets, which are part of the existing intangible assets of the Australian company and related to it.
The functions performed, the assets used and the risks assumed by the Australian company do not change substantially in substance after the execution of the R&D contract. The Australian company continues to employ the same specialist staff and use its expertise and assets associated with the existing intangibles to manage, execute and control DEMPE’s activities associated with the new intangibles.
The compensation of the Australian company under the contractual R&D arrangement does not reflect the scope or nature of the functions performed, the assets used and the risks assumed by the Australian company in relation to the new intangible assets or the connection between the new intangibles and the existing intangible assets of the Australian company, which are intrinsically linked.
In these circumstances, the ATO expresses the view ââ¦ that the conditions applicable under the agreement may not be compatible with arm’s length conditions for the purposes of Australian transfer pricing lawsâ.
These arrangements are not uncommon and may arise for business reasons, but clearly create risk when there is a mismatch of functional contributions to value creation.
Non-recognition of Australian activities of DEMPE
ATO is concerned that entities may enter into DEMPE-related arrangements of intangible assets that do not appropriately recognize Australian contributions to DEMPE functions for tax purposes.
This is of particular concern to the ATO where the splitting of the right (s) to exploit the intangible assets associated with these agreements does not result in Australian entities receiving an appropriate or proportional share of the overall income from the operation of these assets.
The first example provided under this heading is where an Australian entity is a party to a cost contribution agreement in which it receives the right to exploit the intangible assets in its local market, but where the Australian entity contributes more to the cost. cost contribution agreement than other contributors. due to its DEMPE activities.
In this example, the proportionate share of an Australian company in the overall contributions to the cost contribution agreement is not in line with the expected benefits received. Specifically, the Australian company does not obtain benefits commensurate with its contributions to the calculation of the overall income from the operation of the intangibles covered by the cost contribution agreement, when those intangibles are used and operated by the company. foreign and related companies in other jurisdictions.
In these circumstances, the ATO states that the Australian company’s entry into the Cost Contribution Arrangement Agreement may not be commercially sound or consistent with its best economic interests given the realistically available business options.
“The agreement may therefore be inconsistent with what could reasonably be agreed upon between independent, arm’s length parties for the purposes of Australian transfer pricing laws,” the ATO said.
While with a cost contribution agreement it is usually difficult to perfectly align functional contributions with exploitation rights, we believe the ATO is focusing on more extreme misalignments to voice concerns while not ceasing to respect any cost contribution agreements or with respect to all cost contribution agreements. as high risk.
The second example covers situations where an Australian company has substantial operations in Australia, allows the use of patents, trademarks and know-how stored in an online database, and is required to register in the database. of data all the know-how developed and obtained by it during its Australian operations.
The Australian company also provides all contractual R&D services for or on behalf of the foreign company and is remunerated on a cost plus basis. The foreign company has no substantial business activities and it employs a limited number of qualified personnel.
The Australian company frequently performs R&D and marketing activities that would be carried out on behalf of or at the request of the foreign company. The foreign company does not own enough assets or does not employ enough qualified personnel to primarily manage, execute and control the DEMPE of the intangible assets.
This is similar to the first arrangement, but the core intangibles are already held overseas, so it focuses on disproportionate additional contributions to intangibles by focusing on DEMPE activities.
The ATO notes that the compensation of the Australian company under the agreement with the foreign company does not reflect the extent or nature of the duties performed, the assets used and the risks assumed by the Australian company in connection with the agreement.
“In these circumstances, the terms applicable under the agreement may not be compatible with arm’s length conditions for the purposes of Australian transfer pricing laws,” the ATO said.