Is your profit margin on the ATO’s radar? Transfer Pricing & Inbound Distributors

Articles Written by Andy Milidoni (Partner)

On 23 November 2018, the Commissioner issued Draft Practice Compliance Guide 2018/D8 (PCG 2018/D8) outlining his compliance approach to the transfer pricing outcomes associated with inbound distributors.

PCG 2018/D8 sets out a risk framework which sets the level of compliance activity the Commissioner expects to occur with respect to the transfer pricing outcomes of the specified ‘inbound supply arrangements’.

Key Takeaways

PCG 2018/D8 applies to inbound supply arrangements in respect of finished goods and digital products and services and acquired from related foreign suppliers only.  This is irrespective of how the Australian distributor might be characterised or referred to, whether that be as a ‘routine distributor’, a ‘limited risk distributor’ or a ‘marketer-distributor’.  If the arrangement is an ‘inbound distribution arrangement’, PCG 2018/D8 is intended to apply.

PCG 2018/D8 is not intended to apply where an Australian entity undertakes any significant transformation of the goods, such as by way of manufacturing activities.  It therefore focuses on the distribution of finished goods.

The Commissioner emphasizes that PCG 2018/D8 is intended to provide guidance as to how the Commissioner might assess the transfer pricing risk of inbound distribution arrangements and is not intended to act as a safe harbour regime for taxpayers or as a replacement of the existing legislative regimes[1] or the Commissioner’s compliance approach to them.

The risk ratings are: high, medium and low.  Where the pricing of an entity’s inbound supply arrangement is classified as in the medium or high zones, and is not covered by an existing Advanced Pricing Arrangement (an APA), court or tribunal decision or other settlement with the Commissioner, PCG 2018/D8 sets out some options for such entities:

  1. the making of a voluntary disclosure within twelve (12) months of the issue date of the final PCG which sets out how the entity will adjust its historic and prospective prices so as to fall within the ‘low’ risk zone.  The Commissioner has offered a remission of penalties and reduction in interest charges in respect of any tax shortfall that might arise because of the disclosure;
  2. apply for an APA;
  3. maintain the current position.  Where the entity’s pricing is in the ‘high’ risk zone and its Australian revenue exceeds $250 million, then it might need to file a Reportable Tax Position Schedule setting out the risk.

Four (4) inbound distributor types are covered in PCG 2018/D8 and in more detail in the Schedules.  They are:

  1. general distributors;
  2. life science distributors (covering pharmaceutical, medical devices etc);
  3. information and communication technology distributors; and
  4. motor vehicle distributors.

This is a draft guidance and comments are invited and due by 21 December 2018. 

What is PCG 2018/D8 about?

PCG 2018/D8 is a guide to the Commissioner’s approach to compliance activities in respect of the following arrangements which involve an Australian distributor purchasing:

  • finished goods purchasing from its related foreign supplier and selling these in the Australian market: and
  • digital products or services from its related foreign entity which owns the intellectual property contained in these products and services.

A risk rating framework has been developed to determine the transfer pricing risk of inbound distribution arrangements having regard to a combination of quantitative and qualitative factors.[2]

The risk rating guides the Commissioner’s proposed compliance activities.  Arrangements that fall in the low risk rating are not expected to attract the Commissioner’s attention whereas those that fall in the medium or high risk rating might.

The Commissioner states that taxpayers can use PCG 2018/D8 as follows, to:

  • assess the transfer pricing risk of your inbound distribution arrangements
  • understand the compliance approach we are likely to adopt given the transfer pricing risk profit of your inbound distribution arrangements
  • work with us to mitigate the transfer pricing risk of your inbound distribution arrangements and be confident you have reduced your risk exposure, and
  • understand the type of analysis we use when assessing the transfer pricing risk of your inbound distribution arrangements.

What is the structure of the Guide?

PCG 2018/D8 covers:

  1. the main principles of the risk frameworks for the assessment of the transfer pricing risk of inbound distribution arrangements; and
  2. the qualitative and quantitative indicators relevant to distributors in the four (4) cases covered being:

     (a) general distributors

     (b) life sciences;

     (c) information and communication technology;

     (d) motor vehicles.

     in the Schedules to PCG 2018/D8.

What is an ‘inbound distributor’?

PCG 2018/D8 will apply to an ‘inbound distributor’ defined as follows:

  • in respect of the distribution of finished goods:

… an inbound distributor is an intermediary between the producer of a good and another entity in the distribution channel or supply chain.  A distributor earns a gross profit from the difference between the price at which they sell the good, and the price which they pay.  A distributor will typically incur various selling and administrative costs that must be covered by this gross profit in order for it to make a net profit.

  • in respect of the distribution of digital products and services:

... an inbound distributor is an intermediary between the intellectual property owner and the customer or end user of the digital product or service.  We consider you to be an inbound distributor irrespective of whether you distribute digital products or services by granting rights to end users directly, or by facilitating the grant of rights to end users by related foreign entities.

Inbound distributors typically distribute or sell to retailers, merchants, contractors or industrial, institutional or commercial users.  They sell business to business rather than to household customers.

Which arrangements will not be ‘inbound distribution arrangement’?

Arrangements involving any significant transformation of goods[3] including arrangements where the entity engages third party contract manufacturers, will not be considered to be ‘inbound distribution arrangements’ for the purposes of this PCG 2018/D8.

Nor will arrangements involving finance or insurance activities and those linked to sales activities be considered to be ‘inbound distribution arrangements’.  The Commissioner’s views on these activities are contained in Practice Compliance Guide PCG 2017/4 (for arrangements involving cross border finance arrangements) and Law Administration Practice Statement PS LA 2007/8 (for the treatment of non-resident captive insurance arrangements).

What is the value added by inbound distributors?

The Commissioner considers that an inbound distributor, by buying from a foreign supplier and on-selling to business customers in the Australian market, adds value in the following ways and this may result in a higher profit margin:

  • they match sales to the specifications and volumes requested by customers;
  • they gather market and product information and supply that to the foreign supplier. They supply information about product benefits, changes to the product line-up,  expected pricing and also provide technical support for the product;
  • they provide after sales support, procurement and administration;
  • they may undertake functions involving transportation, warehousing, inventory management and regulatory matters;

For the suppliers of digital services and products, the inbound distributor may add value through its understanding of the customer and by matching the customer’s business and technical needs with the digital product or service to be provided.

Functional analysis plays a role in determining the value-generating activities of an inbound distributor.  The more significant the activity performed in Australia by the inbound distributor, the more it is expected that a higher return on those activities be made.

The Commissioner has identified certain value-generating activities based on industry sector and has assigned higher profit markers for the more extensive and value-significant activities.  This is set out for the specific distributor types in the Schedules to PCG 2018/D8.

He also states:[4]

In addition to industry factors, we have regard to whether inbound distributors are significantly developing, enhancing, maintaining, protecting or exploiting intangibles when assessing risk.  As this information becomes available to us, it may influence our view of the arm’s length outcome from the overall activities such as that we perceive a higher level of transfer pricing risk than indicated by the profit markers.

Therefore, the Commissioner will be expect a higher margin where the inbound distributor’s activities include enhancing and developing the intangible assets of the supplier.  This is typically the case where the inbound distributor incurs all such costs in relation to the trademark (for example) and is not reimbursed for them whether directly or indirectly. 

How will the Commissioner determine whether an entity is an inbound distributor?

The Commissioner will look to the following factors in determining whether an entity is an inbound distributor:

  • the main business activity disclosed on your tax return
  • the proportion of tangible property expenditure of a revenue nature relative to cost of goods sold
  • the proportion of tangible property expenditure of a revenue nature relative to total income
  • the proportion of income from the sale of goods or digital products or services relative to other income
  • the extent to which you undertake activities other than distribution activities, for example, the extent of contract research and development services provided, and
  • the operating practice of your specific industry in relation to distribution activities.

What is the risk framework and how does it influence the Commissioner’s compliance activity?

The Commissioner has developed the following risk ratings:

  • low rating (or green zone);
  • medium rating (or yellow zone); and
  • high rating (or red zone).

For the low risk zone:[5]

We will generally not allocate compliance resources to assess your transfer pricing outcomes in relation to you inbound distribution arrangements other than to confirm your characterisation as an inbound distributor, and the extent of the activities you undertake.

For the medium risk zone:[6]

We will monitor your arrangements using available data and may contact you to seek a better understanding of your circumstances before deciding to allocate further compliance resources.

We will be open to entering into early engagement APA discussions with you and may invite you to make a corm APA application.  In addition, you will be eligible to request a pre-qualified unilateral APA process, although your prior year outcomes may be reviewed.

For the high risk zone:[7]

We will consider appropriate treatment options and recommend that you review your transfer pricing policy.  This may involve us:

  • writing to you to express our concern
  • actively monitoring your inbound distribution arrangements, or
  • commencing a review or an audit.

When selecting our compliance activity, we will take into account various factors in addition to the framework in this Guideline.  These factors include consideration of your global supply chain, the tax profile of your related parties and the amount of tax at risk.

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.

You may seek to enter into early engagement APA discussion with us, but you will not be eligible to request a pre-qualified unilateral APA process.

How does the Commissioner assess the risk? How are profit markers used and developed?

The Commissioner assesses the transfer pricing risk by:[8]

… comparing the profit outcome of your arrangements against our profit markers for inbound distributors.  The profit markers relevant to you are based on the industry sector in which you operate and the extent to which your distribution arrangements involves activities that we see as generally adding incremental value in Australia

The entity’s Earnings Before Interest and Tax (EBIT) relative to sales is used.  He assumes that the entity has not entered into substantial debt arrangements.  This approach is similar to applying the OECD’s ‘transactional net margin method’ or TNMM but noting that this may not necessarily be the most appropriate pricing method for the entity’s arrangement.

The profit markers used are based on the benchmarking analysis undertaken by the Commissioner of the net profit margins earned by independent distributors and which are relevant to distributors in certain sectors.

The specific industry sectors chosen are ones where the Commissioner has previously identified transfer pricing risks based on the total value of goods imported into Australia.

The profit performance of the inbound distributor is then measured against these profits markers and the result then informs as to the level of transfer pricing risk posed by the particular inbound distribution arrangement.

In measuring profit performance, a five (5) year weighted average of EBIT margin is calculated.  This will be calculated this from information taken from the entity’s statutory or management accounts or other information.

What are the inbound distributor types?

In the Schedules to PCG 2018/D8, there are four (4) inbound distributor types covered.  They are as follows:
 

Inbound Distributor Type
Description

General Distributor

This covers a wide range of industries and circumstances and therefore the Commissioner intends to assess the transfer pricing risk for general distributors as a single category with one set of profit markers.

While the Commissioner does not intend to specify and identify categories of activities (such as he has done with some other types, see below), he would expect that for inbound distributors that perform more activities then higher profits would be expected.
Life Science

‘Life Science’ consists of activities by way of discovery, development, production and sales, and marketing of medicine.[1]  The industry is taken to consist of five (5) subgroups:

  • innovative/patented
  • medical equipment and devices
  • generic/biosimilar
  • over-the-counter
  • animal health.
The Commissioner intends to assess the transfer pricing risk of life science entities under categories based on the extent to which they undertake activities that incrementally generate value.[2]
 
Category 1 - Life Science This involves the distribution of life science products such as distributors of pharmaceutical product, medical devices and other such products.  The activities of these inbound distributors are detailing and marketing and logistics and warehousing.
Category 2 - Life Science

This comprises Category 1 activities and market access, regulatory approvals and government reimbursement activities.

Category 3 - Life Science

This comprises Categories 1 and 2 and specialised technical services such as training and assistance in conducting surgical procedures involving medical devices.

Information and Communications Technology or ICT

This covers entities involves in the distribution of all types of consumer and enterprise computer hardware and software products, digital communication devised, applications, IT solutions and ancillary services.

Category 1 - ICT

This involves the distribution of ICT products and activities such as sale and marketing activities, pre and/or post-sales services and logistics and warehousing functions.

Category 2 - ICT

This comprises Category 1 activities and complex sales processes, direct selling activities and large customer relationship management.

Motor Vehicles

Motor vehicle inbound distributors are involved in the distribution of passenger vehicles, trucks, buses, motorcycles or other recreational motorised vehicles and associated parts.  The range of functions that support the activity of distribution include marketing and sales, after sales support, procurement and administration, insurance activities, as well as functions involving transportation, warehousing and inventory management.[1]

What are the profit markers?

The profit markers are set out in the Schedules to PCG 2018/D8 by type of inbound distributor.  They are summarised in the table below:

Risk Rating
General Distributor
Motor Vehicle
Life Science - Category 1
Life Science - Category 2
Life Science - Category 3
ICT[1]– Category 1
ICT - Category 2
High
Below 2.1%

Below 2%

Below 3.6%

Below 5.5%

Below 7%

Below 3.5%

Below 4.1%

Medium

Between 2.1% and 5.3%

Between 2% and 4.3%

Between 3.6% and 5.1%

Between 5.5% and 8.9%

Between 7% and 10%

Between 3.5% and 4.1%

Between 4.1% and 5.4%

Low

Above 5.3%

Above 4.3%

Above 5.1%

Above 8.9%

Above 10%

Above 4.1%

Above 5.4%

 

Can the profit markers be relied on outside of PCG 2018/D8?

The Commissioner says no.  At paragraph 51, he states:

The profits markers in the Schedules are provided to give you transparency in relation to our compliance approach.  You should not use the profit markers as a safe harbour to adjust your arrangements so that you sit lower within a particular zone merely because it does not change your overall risk zone.  We will monitor outcomes for inbound distribution arrangements over time to ensure that there is no unexplained ‘drift’ within a risk zone.

Will the Commissioner make an APA available?

The Commissioner states that APAs are available to inbound distributors whatever their risk rating.  However, where an inbound distributor is in the high risk zone, the Commissioner considers that reaching an APA may be difficult in cases where the inbound distributor considers that they will remain in the high risk zone.

For inbound distributors which demonstrate that PCG 2018/D8 applies to them and a pricing method is proposed which aligns with the profit markers in the Guide, then the Commissioner considers that such an inbound distributor should be pre-qualified for an APA.

A pre-qualified APA will save time and cost for inbound distributors as it involves:

  • reduced information gathering – there is instead a focus on confirming the entity’s characterisation as an inbound distributor, the extent of value-generating activities and the applicability of the TNMM;
  • no requirement to prepare benchmarking analysis as the Commissioner will provide the benchmarks for the entity’s specific industry type.

Requesting a pre-qualified APA will also involve the Commissioner undertaking the triage process as set out in PS LA 2015/5 to determine whether the arrangements raise other tax issues.

What about Diverted Profits Tax?

The Commissioner has stated that transactions entered into after 4 April 2017 and covered by an APA will generally be considered to be low risk for the purposes of the Diverted Profits Tax (or DPT).  A clause to this effect can be requested to be inserted in the APA.

What to do for current arrangements and how PCG 2018/D8 might apply?

The Commissioner is offering an amnesty for a period of twelve (12) months from the date of issue of the final PCG in which taxpayer will have an opportunity to make voluntary disclosure in relation to all income years in which the arrangements are in place and to make adjustments to the taxpayer’s historic and prospective pricing to reflect the appropriate transfer pricing outcome.  Where this occurs, the Commissioner is offering penalty remission and a reduction in interest charges.

Concluding Remarks

Comments for on the PCG 2018/D8 are invited until 21 December 2018.  We expect that many will be received.

The Commissioner has been active in auditing and reviewing the transfer pricing arrangements of many multinational enterprises since the introduction of the new transfer pricing regime in Australia and since the Senate Hearings into multinational tax avoidance[13].  During this time, he has gathered a large volume of detailed information regarding the functional profile of businesses in a range of industry sectors and is able to develop extensive benchmarking on profit margins for a variety of supply transactions.

In line with recent legislative changes affecting multinational enterprises (such as the Multinational Anti-avoidance Law, the DPT and changes to transfer pricing) in the context of the broader BEPS project, the Commissioner requires higher profit margins in Australia than he has been prepared to accept in the past. 

Where entities find themselves in the medium or high risk zone, they will need to review their Australian transfer pricing arrangements in light of PCG 2018/D8.  This might also require a review of their global transfer pricing policies.

We intend releasing another note when the final PCG is released.

In the meantime, if you would like to have a discussion about the PCG 2018/D8 please contact Andy Milidoni.

 


 

[1] Such as such as the transfer pricing regime, the withholding tax regime, the anti-avoidance regime in Part IVA of the Income Tax Assessment Act 1936 or the operation of the Subdivision 284-E in Schedule 1 of the Taxation Administration Act 1953 as it applies to reasonably arguable positions in respect of cross-border transactions.

[2] Refer to paragraph 4 of PCG 2018/D8.

[3] Refer to paragraph 24 of PCG 2018/D8.

[4] Refer to paragraph 41 of PCG 2018/D8.

[5] Refer to paragraph 30 of PCG 2018/D8.

[6] ibid

[7] ibid

[8] Refer to paragraph 31 of PCG 2018/D8.

[9] Refer to paragraph 72 of PCG 2018/D8.

[10] Refer to paragraph 73 of PCG 2018/D8.

[11] Refer to paragraph 86 of PCG 2018/D8.

[12] Refers to Information and Communication Technology

[13] Formally known as the inquiry into tax avoidance and aggressive minimisation by corporations registered in Australia and multinational corporations operating in Australia.

Important Disclaimer: The material contained in this article is comment of a general nature only and is not and nor is it intended to be advice on any specific professional matter. In that the effectiveness or accuracy of any professional advice depends upon the particular circumstances of each case, neither the firm nor any individual author accepts any responsibility whatsoever for any acts or omissions resulting from reliance upon the content of any articles. Before acting on the basis of any material contained in this publication, we recommend that you consult your professional adviser. Liability limited by a scheme approved under Professional Standards Legislation (Australia-wide except in Tasmania).

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