Tax Alert – Inbound Distribution Arrangements: Final PCG 2019/1
On 13 March 2019, the Australian Taxation Office (ATO) released Practical Compliance Guideline (PCG) 2019/1 which documents its compliance approach to the transfer pricing aspects of inbound distribution arrangements.
The initial approach places distributors in a low, medium or high-risk zone depending on quantitative profit outcomes without necessarily taking into account the company’s functional profile.
The ATO state that investigate resources will be used to target distributors falling into the high-risk zone.
In summary, the net profit-to-sales ratio levels at which an inbound distributor might previously have been considered informally ‘low-risk’, around 3.0% have been significantly increased.
Although the thresholds vary by distributor industry type, for general distributors, to achieve a low risk rating would now require an Earnings Before Interest and Tax (EBIT): Sales ratio of 5.3% or higher.
Thresholds for the Life Sciences and Information and Communications Technology (ICT) sectors are significantly higher still.
Whilst the ATO (correctly) acknowledge that having a ratio in the high or medium risk zone does not of itself mean that the entity’s transfer pricing is wrong and that a lower return may be justified on its functional profile, this will nevertheless not be taken into account in the allocation of resources.
Entities with sustained losses are considered a “very high transfer pricing risk. We will ordinarily prioritise a review…where [the taxpayer] …has been in an overall loss position for the aggregate of your current and previous two income years”.
The guidance re-emphasises the importance of having Australia-specific transfer pricing documentation in place, particularly where there are necessary functional justifications for lower profit outcomes which will require explanation and substantiation on any ATO review.
In addition, where no such documentation is in place by the time the relevant tax return is lodged, there is no access to mitigation of associated penalties under the “reasonably arguable position” defence.
The risk assessment framework
The PCG applies from its date of publication and affects both new and existing arrangements. It specifically targets multinational enterprises (MNEs) with distribution operations in Australia, irrespective of whether their distribution activities form part of broader business operations.
Under the PCG, the ATO assesses the risks of inbound distributors by comparing their five-year weighted average earnings before interest and taxes (EBIT) margin against the EBIT margin in their relevant industry sector. The risk assessment framework is comprised of three transfer pricing coloured risk zones:
- Green – low risk
- Yellow – medium risk
- Red – high risk
Inbound distributors are categorised into three key industry sectors with the fourth being a general category as follows:
- Motor Vehicles.
- Information and Communication Technology (ICT).
- Life Science.
- General Distributors.
Please refer to the diagram below as an example of the risk assessment framework for the General Distributors category.
ATO’s Compliance Approach
The ATO’s compliance approach varies with its risk classification. As a general rule, the higher the inbound distributor’s risk rating, the more likely the ATO is to review its inbound distribution arrangements as a matter of priority.
According to the PCG, the ATO recommends that taxpayers should self-assess their risk rating to better understand their risk positions and the amount of attention they are likely to receive from the ATO.
Whilst some inbound distributors may generate a high-risk rating under the PCG, the EBIT margin earned by them can be strongly affected by its functional profile and it is important to understand that a high risk rating does not necessarily mean the taxpayers’ transfer pricing arrangement has failed to comply with the Australian rules.
Instead of a ‘blanket’ assessment approach, the ATO will assess the taxpayers on a case-by-case basis, in relation to the taxpayers’ particular circumstances. However, this does not apply to initial allocation of investigative resources which will be driven solely on quantitative rather than qualitative measures.
|Compliance Approach taken by the ATO
The ATO will generally not allocate compliance resources to assess
the taxpayer's transfer pricing outcomes.
The ATO will be open to Advance Pricing Arrangement (APA)
discussions and will be more likely to invite the taxpayer to make a
formal APA application.
The ATO will monitor the taxpayer's arrangements using available
data (e.g. publicly available information and company tax returns) and
may contact a taxpayer to further understand their circumstances
before deciding to allocate further compliance resources.
The ATO will be open to APA discussions and may invite the taxpayer
to make a formal APA application but their prior year outcomes may
The ATO will consider appropriate treatment options and recommend
the taxpayer to review their transfer pricing policy. The ATO may:
- Express concern in writing.
- Commence active monitoring of their inbound distribution arrangements.
- Commence a review or audit.
The taxpayer may seek to enter into early engagement APA
discussions but will be ineligible for a pre-qualified unilateral APA
In particular, the ATO has explicitly stated in the PCG that:
“We consider that entities with inbound distribution arrangements that consistently suffer losses pose a very high transfer pricing risk. We will ordinarily prioritise a review of you where you have been in an overall loss position for the aggregate of your current and previous two income years (emphasis added)”.
In light of the above, MNEs with inbound distribution arrangements should take immediate action to assess their risk rating under the PCG and determine whether any reporting is warranted, along with the action plan to address or alleviate any concerns from the ATO.
Depending on each taxpayer’s existing transfer pricing arrangements, it may be wise to consider transitioning to the low risk zone. While this choice may alleviate the risk of transfer pricing adjustments by the ATO from an Australian tax perspective, it could potentially pose transfer pricing risks for its related supplier/s and thereby adversely impact its group transfer pricing policies in overseas jurisdictions.
Whilst the previously accepted position was that a distributor could have an EBIT margin of at least 3% without being considered a tax risk, this PCG suggests that a general distributor would need an EBIT margin of at least 5.3% to avoid ATO scrutiny. Given this shift in views is likely to cause a greater number of inbound distributor taxpayers to appear on the ATO’s radar, it is strongly recommended that any taxpayer that sits outside the low risk range considers and documents its transfer pricing position.
 PCG 2019/1 paragraph 32