ATO releases compliance guidance for intangible arrangements with cross-border related parties
The Australian Taxation Office (ATO) on 19 May 2021 released long-awaited guidance on intangible arrangements with cross-border related parties for public consultation and comment.
Draft Practical Compliance Guidance (PCG 2021/D4) sets out the ATO’s compliance approach to international arrangements connected with the development, enhancement, maintenance, protection and exploitation (DEMPE) of intangible assets and/or the migration of intangibles. The guidance supplements the existing Taxpayer Alerts (TA 2020/1 and TA 2018/2) relating to arrangements involving intangible mischaracterisation and non-arm's-length arrangements and schemes.
The draft PCG is far reaching and sets out the ATO’s compliance approach and risk assessment framework relating to all types of intangible arrangements, including DEMPE activities performed on and offshore and the migration of intangibles. While mainly focused on transfer pricing concepts, the draft guidance considers other tax risk areas arising from intangible arrangements such as withholding tax, capital gains tax, general anti-avoidance provisions (GAAR) and diverted profits tax (DPT).
The draft PCG outlines the ATO’s expectations for taxpayers to maintain a high level of analysis and documentation to support their intangible arrangements, as well as the type of documents the ATO expects to be kept to demonstrate compliance with the arm’s length principle.
As currently drafted, the PCG does not include materiality limits and, as such, is intended to apply irrespective of the taxpayer’s size or the nature of the intangible arrangements.
Once finalised, the PCG is intended to apply to arrangements entered into both before and after the date of issue. For companies required to file a reportable tax position (RTP) schedule, additional reporting obligations will include the need to disclose an assessment of each of the risk factors identified by the ATO and how the arrangements compare to the examples contained in Appendix 2 of the PCG, as well as their risk rating under the PCG.
If finalised in its current form, this PCG will increase the burden for taxpayers seeking to support their existing and future intangibles arrangements.
Overview of the PCG
The PCG is divided into two parts:
- Part one provides an outline of the ATO’s compliance approach; and
- Part two provides an outline of the ATO’s risk assessment framework and how the ATO will assess risk, including 12 examples of intangible arrangements and their risk assessment under the new framework (using the ATO’s high, medium and low risk assessment).
ATO’s compliance approach
The ATO seeks to review intangible arrangements focusing on aspects such as the mischaracterisation of DEMPE activities, non-arm’s-length outcomes and structures or restructures that avoid or reduce Australian tax obligations. The PCG’s compliance approach aims at consistency with Australian legislation, such as the GAAR, DPT and capital gains tax provisions, as well as the OECD transfer pricing guidelines, in particular, Chapters I, VI and IX.
Consistent with previous PCGs, the ATO’s level of engagement will depend on high-risk factors applicable to the intangible arrangement. When one or more of the risk factors are determined to be high, as per the PCG, the ATO will likely take further action, including review or audit.
As with all transfer pricing arrangements, taxpayers may request access to the ATO’s advance pricing arrangement program (the APA program) to obtain certainty with respect to their intangible arrangements. However, the ATO has indicated that documentation and analysis in accordance with the PCG will be required for access to the APA program and taxpayers with low risk factors will more likely be accepted.
ATO’s risk assessment framework
The risk assessment framework is divided into two parts:
- Risk factors that set out features and examples of arrangements used to inform an assessment of risk; and
- Documentation and evidence expectations that outline the (high) level of evidence the ATO will expect when assessing intangible arrangements against the risk factors.
The risk factors focus on the following:
- Commercial considerations and decision-making;
- Understanding the form of the intangibles arrangements;
- Identifying and evidencing the intangible assets and connected DEMPE activities; and
- Analysing the tax and profit outcomes.
These risk factors are classified as high, medium or low risk, depending on a qualitative assessment of the level of supporting documentation and evidence. A lack of sufficient documentation potentially could result in a high-risk rating.
Notably, the PCG includes a non-exhaustive list of documents that may be considered as evidence to determine the risk profile of a particular arrangement. Some examples of expected evidence are:
- Transfer pricing documentation, supplementary analysis, valuation reports, etc., including details (digital or physical records) in relation to DEMPE functions, decision-making and approval processes, organisational charts and correspondence;
- R&D tax incentive claims;
- Minutes of board and other meetings, as well as correspondences with tax advisers or tax personnel in relation to preparing or revising the minutes;
- Guidelines, manuals, policies, procedures, specifications, governance and similar documents relevant to the intangibles arrangements;
- Legal agreements;
- Specific documents and evidence to identify and clarify the intangible assets and DEMPE activities;
- Correspondence of persons identified as involved in DEMPE activities;
- Documents detailing the assets (e.g., intangible asset registers) and capabilities of relevant entities and employees involved; and
- Any financial modeling or projections, including models of anticipated tax impact of options or arrangements prepared by tax personnel or tax advisers.
The list of evidence the ATO has identified may be beyond the level of information readily available by taxpayers and may not be considered commercially realistic.
The draft guidance also includes 12 examples reflecting the ATO’s view of what constitutes high risk, medium risk or low risk, depending on the level of documentation or evidence available. The examples cover various intangible arrangements, including:
- Centralisation of intangible assets;
- Mischaracterisation of intangible assets and DEMPE activities;
- Migration offshore of pre-commercialised intangible assets or rights to use intangible assets; and
- Contract R&D arrangements and cost contribution arrangements.
- The draft guidance is an indication of the ATO’s continued focus on transfer pricing issues relating to intangibles and provides useful examples to taxpayers in relation to the ATO’s concerns. The examples are helpful to understand the ATO’s risk assessment framework, but do not consider practical challenges such as identification, valuation and the pricing of intangibles; this is a controversial topic and taxpayers are often forced to resort to mutual agreement procedures (MAP) in applicable tax treaties to avoid double taxation.
- There is no materiality threshold for application of the guidance, which indicates the ATO’s expectations that all taxpayers, regardless of their size or tax, may be impacted by the arrangement. Whilst the ATO does recognise that the level of documentation will be influenced by the complexity of the taxpayer’s arrangements, it remains to be seen how this plays out in practice. With no materiality threshold, retrospective application and no guidance on how to identify, value and price intangible arrangements, the PCG will significantly increase the compliance burden and uncertainty for many taxpayers with intangible arrangements.
- The draft PCG increases uncertainty and taxpayer compliance obligations by requiring a subjective analysis of the risk factors. Further, the ATO states that “exhibiting Medium or Low Risk Factors may not exclude your Intangibles Arrangements from further review.”
- The risk assessment focuses heavily on the level of documentation taxpayers may need in relation to intangible arrangements. The ATO’s expectations in this regard have increased beyond the traditional approach to documentation and may be considered extensively onerous.
- It is not yet clear how other tax considerations such as GAAR or DPT are intended to apply, although it is understood these anti-avoidance provisions will be applied only in rare circumstances when there is a clear motive to avoid tax.
- To obtain an APA, taxpayers will need to retain the expected documentation and evidence outlined in the draft PCG, which is considered to be a very high benchmark.