By Gary D. Sprague, Esq.
Baker & McKenzie LLP, Palo Alto, CA
The debate at the Organisation for Economic Cooperation and Development (OECD) and national levels over the application of transfer pricing principles to so-called "business restructurings" has placed a spotlight on the issue of when a tax authority may seek to recharacterize a transaction as structured by the taxpayer. The Australian Taxation Office (ATO) has released its most recent entrant into the mix in Draft Taxation Ruling (DTR) 2010/D2, issued on June 2, 2010.1 At its core, DTR 2010/D2 expresses a set of principles that establishes a litmus test relating to business restructurings: a taxpayer's asserted prices will be respected only if the restructuring, and the consideration paid, makes "commercial sense" for the parties. While the draft ruling provides considerable elaboration of the set of principles, it can be expected that many disputes between taxpayers and the tax authorities will boil down to disputes over what does or doesn't make "commercial sense" under the circumstances.
Summary of Approach
The draft ruling applies the Australian transfer pricing rules to business restructurings in a three-step approach.
Step one is to "characterize the international dealings between the associated enterprises in the context of the taxpayer's business." This step is relatively straightforward, in that it involves a traditional factual and functional analysis of the restructuring, including an identification of the transactions involved pursuant to the restructuring, a functional analysis of the pre- and post-restructuring business activities affected by the business restructuring, and an analysis of whether the actions of the parties comport with the documented post-restructuring relationships.
Step two is to "select the most appropriate transfer pricing methodology or methodologies." Under this step, the parties are instructed first to obtain any available data as to arrangements between independent parties dealing at arm's-length under comparable circumstances. In the absence of sufficient third-party data, DTR 2010/D2 then states a core principle of the draft ruling as to how the analysis should proceed:
Depending upon the extent of such comparables data, obtain any other available data relevant to determining whether the pricing of the business restructuring makes commercial sense for the parties, having regard to what is in their best economic interests and the options realistically available to them at arm's length.
Step three is to "apply the most appropriate method in determining an arm's length outcome." In this step, an attempt would first be made to apply any available data developed in the review of third-party comparable arrangements. If third-party data is unavailable or insufficient, the taxpayer and tax administration are directed to "use the functional and comparability analyses and any other relevant available data to examine whether the pricing of the business restructuring makes commercial sense for the parties, having regard to what is in their best economic interests and the options realistically available to them at arm's length." If the pricing is considered to make "commercial sense," then that conclusion determines the amount of arm's-length consideration receivable or payable by the taxpayer.
If this examination shows that the pricing of the business restructuring does not make "commercial sense," then the tax administration may proceed in one of two ways. First, the administration may seek to achieve an arm's-length outcome by means of a pricing adjustment in conformity with the transactions entered into by the parties. Alternatively, if the administration determines that it is not possible or practicable to achieve an arm's-length outcome in that way, the administration may determine arm's-length pricing by disregarding a taxpayer's transaction and substituting one "that might reasonably expect to exist" at arm's-length under comparable circumstances. This approach of disregarding the taxpayer's transaction is explained as follows:
In the exceptional case where it is not possible or practicable to achieve an arm's length outcome in this way, the ATO considers it may apply the transfer pricing provisions to adjust the consideration receivable or payable by the taxpayer by reference to an agreement that might reasonably be expected between independent parties dealing at arm's length in comparable circumstances.
At the core of DTR 2010/D2 is the assertion that the outcome of the business restructuring must make commercial sense to all of the parties involved, and that each of the parties would seek to compare the proposed arrangement to the other options realistically available to them and would enter into the arrangement only if there was no alternative clearly of greater commercial advantage to the affected entity. In elaboration of this concept, DTR 2010/D2 provides at paragraph 83 as follows:
Given the above, where there are insufficient reliable uncontrolled comparables data to establish whether the pricing of a business restructuring arrangement is arm's length, the Commissioner might need to evaluate comparability with what might be expected under an arrangement between independent parties dealing at arm's length by considering the following indicia of arm's length behavior and outcomes that might be expected to shape such an agreement:
(a) an arm's length outcome is one that makes business sense in the circumstances of the particular taxpayer;
(b) an independent party dealing at arm's length would seek to protect its own economic interest;
(c) an independent party dealing at arm's length would compare the options realistically available and seek to maximize the overall value derived from its economic resources;
(d) one option might be not to enter into a transaction because it does not make commercial sense for the particular taxpayer.
Of these elements, the draft ruling provides more elaboration on the concept of "realistically available options." The draft ruling states that an independent entity would be expected to choose the best available option, and would not be expected to choose the business restructuring if it would be worse off by doing so compared to its other options. Paragraph 90 of the draft ruling states as follows:
An entity with other options is in a stronger bargaining position than one without options. Therefore, the independent entity would be expected to use its bargaining position to either refuse the business restructuring if it is not the best available option, or alternatively to negotiate terms for the business restructuring that compensate it for forgoing the benefits of another option.
The draft ruling does acknowledge in paragraph 94 that an entity may not legally have the option of continuing to operate its existing business where its contractual right to do so is legally terminated by the other party. Further, in paragraph 95 the draft ruling notes that the principal as an independent party might realistically have the option of employing other entities in the marketplace to perform the services of, for example, a toll manufacturer or commissionaire. Despite those statements, it is clear that an important directive of the draft ruling is that the Commissioner will seek to identify any asset, relationship, business advantage, or expertise that the restructured entity may possess in order to assert that the restructured entity may have had the market power in the marketplace to refuse to accept the restructuring, at least under the terms and conditions asserted by the taxpayer.
Observations on Determining What Makes "Commercial Sense" for the Parties
As noted above, DR2010/D2 states that in assessing the transaction and the available comparables data, the ATO will determine whether the business restructuring makes "commercial sense" for the parties, having regard to what is in their best economic interests and the options realistically available to them at arm's-length.
This will be the core of many controversies. How will a tax authority determine what makes "commercial sense" to the parties, or what the realistically available options might be?
The concept that the compensation payable to the restructured entity must take into account the alternatives reasonably available to the affected entity is expressed in the OECD Transfer Pricing Guidelines as an element of the comparability analysis at paragraph 1.15. In the Transfer Pricing Guidelines, the concept is used to assess whether a transaction could be used as a comparable, or for making adjustments to a comparable to improve comparability. It is unclear whether the use of the concept in DR2010/D2 will be confined to this scope, or whether the ATO has in mind using the concept to construct a different transaction which would be used to determine the adjustment to the taxpayer's reported prices, based on the transaction as reconstructed.
DR2010/D2 states in a couple of places that one realistically available option to a party (presumably the Australian one in most cases subject to this ruling) is to refuse the restructuring. If the ATO were to raise that argument, the ATO presumably would assert that some transaction other than the proposed restructuring should be the reference transaction for determining the price. Under what circumstances, however, could the realistically available option be to refuse to agree to the restructuring, if the party faced with the decision had no legal right to compel the supplier to keep supplying on the same terms or the intangible property owner to keep licensing on the same terms? The reasonably available alternative in the open market might be to work for another supplier, but absent a legal ability to compel continuation of an existing arrangement, it normally would not be able to "refuse" the restructuring.
The litmus test of whether a transaction makes "commercial sense" for the parties does not have a direct foundation in the OECD Transfer Pricing Guidelines for purposes of assessing the sufficiency of the price paid. The author understands from his Australian colleagues that the concept similarly lacks a foundation in Australian domestic law for this purpose. A similar concept exists in paragraph 1.37 of the Guidelines, but its purpose there is to be part (and only a part) of a test to determine when a tax administration could disregard a taxpayer's transaction. Paragraph 1.37 of the Guidelines provides that a tax administration may consider disregarding a transaction as structured by the taxpayer when the form and substance of the transaction "differ from those which would have been adopted by independent enterprises acting in a commercially rational manner and the actual structure practically impedes the tax administration from determining an appropriate transfer price." The circumstances under which a tax administration could disregard the transaction chosen by the taxpayer should be limited to "exceptional" cases, as the OECD Guidelines state. It is to be hoped that the use of similar language in the provisions of DR2010/DR2 relating to assessing comparability and testing the price does not indicate an intention by the ATO that it will approach these cases with a predilection towards disregarding the structure, on the basis that the tax authorities have a different idea of what constitutes "commercial sense" for the companies involved. The only purpose of this concept should be to assess the comparability of other transactions, or to support adjustments to the comparables.
The draft ruling proposes some very substantial documentation requirements, including documentation of decisions taken at the group level with respect to the restructuring and the benefits to be expected by various group members, not just the Australian entity. The ATO proposes that this ruling will be applicable both before and after its date of issue. Accordingly, it can be expected that the ATO would apply the principles expressed in this ruling to existing and future audits, including for transactions entered into prior to the date the ruling is issued. Taxpayers who have engaged in or are contemplating a business restructuring in Australia need to become familiar with this ruling.
This commentary also will appear in the September 2010 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Warner and McCawley, 887 T.M., Transfer Pricing: The Code and the Regulations, and Blackwood and Lewis, 898 T.M., Transfer Pricing: Foreign Rules and Practice Outside of Europe, Part 2, Chapter 35, "Transfer Pricing Rules and Practice in Australia, and in Tax Practice Series, see ¶3600, Section 482 — Allocations of Income and Deductions Between Related Taxpayers.
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