Kiwi businesses face higher compliance costs

A strict new Australian approach to transfer pricing will impact New Zealand businesses with Australian operations.

New Zealand might be a small fish in the global pond but it features prominently on the Australian Tax Office (ATO) radar for cross-border related party transactions.

ATO’s statistics show that New Zealand is the sixth most significant country by value of related party revenues and expenses for Australian businesses. We can therefore expect that the ATO will be looking very closely at transactions between Australian and New Zealand entities.

Tough line

Australia amended its transfer pricing rules in 2013.

The ATO has released two draft rulings applying these new rules. They outline a hard-line approach to transfer pricing:

The new rules allow the ATO to disregard or reconstruct related party transactions where the economic substance does not match the legal form.

The test is whether the transfer price and the transaction are at arm’s length. For example, it is not only whether the interest rate on a related party loan is arm’s length but also whether the company could have borrowed, and how much.

This means the ATO can effectively re-characterise a debt instrument as equity. The threshold is whether the transaction would have taken place between independent parties.

This draft ruling confirms a hard-line approach to disregard or reconstruct the form of a related party transaction if (a) the form of the transaction is inconsistent with the substance (b) independent entities entered into alternate commercial or financial relations; or (c) independent entities would not have entered into the transaction.

These give the ATO significant reconstructive powers, particularly in instances such as business restructuring or highly leveraged arrangements, where it may consider there is little financial benefit for the Australian entity.

Base Rule

Under the draft ruling, there is an expectation that identification of the arm’s length conditions will be accomplished mainly through the application of the ‘basic rule.’ This means the form and substance of the actual arrangements will be used to determine the arm’s length contribution of and reward for the Australian entity.

Where there is inconsistency between the economic substance and the legal form of related party transactions, the ATO may seek to reconstruct or disregard altogether the transaction. In assessing this, the ATO will consider various indicators of the true substance of the transaction.

These will include whether (a) the commercial reality of the related party’s rights and obligations are consistent with reasonable commercial practices and there is a commercially realistic return to both entities (b) the related party bears any real economic risk or has the capability to assume the risk it has been allocated; and (c) the transaction results in a ‘fictional loss’ as opposed to genuine economic loss.

The Principles

Consistent with earlier ATO rulings on related party debt, the ATO will continue to apply transfer pricing principles to establish an arm’s length interest rate, with this overlaid on the Australian thin capitalisation rules to establish the deductible amount (or otherwise) of the interest charge.

The new development in the draft ruling emerges from an example intended to demonstrate the ATO’s view on determining the substance of debt versus equity.

In the example, a portion of the debt borrowed by an Australian subsidiary from its overseas parent is re-characterised as equity, effectively overriding the Australian thin capitalisation safe harbour rules.

Chandan Ohri is Partner (Consultancy) at KPMG based in Auckland. The above article is an extract. For further clarifications or details, please email cohri@kpmg.co.nz