Do you know that a public officer of a company with international dealings can now incur personal liability if the company fails to adhere to strict new rules regarding international transactions?
Do you know that profits from an overseas business could be taxed at 65% or more once the money is paid out to the Australian shareholders?
It is well understood that international transactions are an area of constant focus for the ATO. This is not just for large businesses – SME businesses are also coming under the spotlight.
But what are some key things that you need to look out for?
Transfer pricing – the new rules
The new transfer pricing rules focus specifically on dealings with international related parties – like an overseas subsidiary. The aim of the rules is quite simple – ensure that any business with international related party dealings makes an arm’s length profit and has sufficient documentation in place to justify that the related party dealings took place on an arm’s length basis.
Under the new rules, preparing transfer pricing documentation is effectively compulsory for any business with a material level of international transactions. To get protection from penalties, the documentation needs to be done before the income tax return is lodged.
While the aim of the rules is simple, determining what an arm’s length outcome would be (and justifying it) can be challenging, particularly for small to medium sized businesses. However with some pre-planning, most SME businesses can develop a fairly streamlined approach to managing their transfer pricing position.
Public officer responsibilities
Public officers are now obligated to ensure that their business’ international related party dealings took place on an arm’s length basis (i.e. compliant with transfer pricing requirements) prior to signing the tax return. Failure to support a transfer pricing position by the time a tax return is lodged will result in a minimum penalty of 25% being applied to any subsequent adjustment made by the ATO.
In addition to penalties on the company in the event of non-compliance, public officers can be held personally liable for false or misleading information. In essence, this imposes a mandatory requirement to comply with transfer pricing.
International Dealings Schedule
Taxpayers with international dealings that are more than $2 million need to lodge an International Dealings Schedule (“IDS”) with their annual income tax return.
The IDS is a detailed form requiring full disclosure of all international related party transactions, the main transfer pricing method that is applied to each transaction, along with a disclosure as to the level of specific transfer pricing documentation held for that particular transaction or dealing.
With the IDS, the ATO is better able to assess the transfer pricing risk of each taxpayer. Armed with this information, the ATO is performing increased data matching that will allow it to undertake more targeted and focused compliance activities.
All taxpayers with international related party transactions are subject to transfer pricing rules. However, for taxpayers where these transactions are more than $2 million, there is an increased chance of ATO scrutiny and focussed questions.
For taxpayers who don’t breach the $2 million threshold it may be possible to maintain simplified transfer pricing documentation depending on the nature of the transactions.
Further detail on these changes can be found here.
Foreign exchange gains and losses
Any taxpayer that operates a foreign currency bank account or transacts in a foreign currency has particular tax issues to consider. Over the past few years a range of new rules (the TOFA provisions) have been introduced to set in legislation the way that foreign currency transactions need to be treated for tax purposes.
The main TOFA rules apply to all taxpayers – it is only some of the more specialised rules that are restricted to applying to large businesses.
If you do nothing, a potentially onerous “FIFO” method of calculating foreign currency gains and losses applies. Various elections are available that can simplify the calculations but they can also mean that you get taxed on unrealised gains.
Some of the most common issues are:
- Utilising the correct exchange rates and dates when translating any transactions;
- Correctly accounting for any foreign currency denominated debtors or creditors at year end;
- Correctly accounting for the movement in any foreign currency bank account, including dealing with any capital gains or losses that arise with each transaction in or out of the account;
- Understanding when a foreign currency gain or loss is actually realised for tax purposes (unrealised gains or losses can sometimes be realised for tax purposes); and
- Making the correct written elections to apply particular treatments which have been adopted.
It is important to note that the correct tax treatment of foreign currency transactions is often significantly different to the accounting treatment and can therefore result in unexpected tax liabilities (or refunds). Understanding what choices are available in your client’s particular circumstances is a key aspect to consider.
Taxpayers will often fund their overseas operations through inter-company loans. Under the new transfer pricing rules there is a requirement that the interest rate, as well as the terms and conditions of related party loans, are consistent with what would have been available to an independent party.
Inter-company funding is an area of continued focus by the ATO.
Your clients need to:
- Assess if the quantum of debt meets arm’s length conditions;
- Consider if the capital structure (debt/equity mix) is arm’s length; and
- Re-consider the interest rate having regard to the impact of the rate on profits of the company and whether or not the rate is adjusted as parent company cost of funds changes.
Thin capitalisation can also apply to taxpayers with overseas operations or assets, or with significant levels of overseas owners (e.g. shareholders). Disclosing a large interest expense in the income tax return but not making thin capitalisation disclosures can be an audit trigger for taxpayers with international dealings.
Choosing the best business structure for a client is a key part of the role of the advisor. This can be particularly challenging for clients with international transactions.
One structure may enable foreign dividends to be received in Australia tax free, but access to foreign tax offsets (credits) is lost. Another structure may result in overseas income being taxed to the Australian controllers on an attribution basis – i.e. before it is even paid out as dividends.
Choosing the wrong structure can result in an effective tax rate of 65% or more on foreign income.
To design the most effective structure you will first need to understand the functions the overseas operations will be performing, who its customers will be, and what your client is going to be using the profits for (reinvesting in the business, distributing to the Australian owners for personal use, paying down debt, etc.).
Business restructures continue to be an area of focus with a specific disclosure required on the tax return for certain entities if a restructure was undertaken in the year.
Business restructures are very broadly construed and could include, for instance, your clients moving key personnel offshore or relocating their manufacturing to an overseas country.
Transfer pricing rules apply to these types of transactions.
As a minimum, there would need to be a documented business case for the restructure showing how it benefits the Australian entity and why an arm’s length party would have done a similar thing in the circumstances.
Conclusion on international dealings and director penalties
As an advisor, you should be aware of the potential exposure that both a company and its directors have if they enter into dealings with international related parties. Often small to medium sized entities will not require a comprehensive transfer pricing documentation package. However, there is a minimum level of compliance that is required once there are any international related party dealings.
If a client is selected for an ATO review or audit, not having considered these issues prior to lodging the relevant tax return will expose the directors to penalties. You should ensure that directors are made aware of this when signing tax returns.
William Buck assists many accountants in preparing transfer pricing documentation for their small to medium sized business clients. Depending on the level of international dealings, we can assist in tailoring a suitable approach for your client which ensures that their documentation requirements are kept to a minimum.
Should you require assistance in determining how the new rules could impact on your clients, how to prepare appropriate documentation, or would like further information on this topic, please contact your William Buck advisor.