Transfer pricing:  ATO loses SNF appeal

The case “SNF (Australia) Pty Ltd v Commissioner of Taxation” primarily deals with issues associated with whether the taxpayer paid more than the arm’s length consideration in respect of purchases as defined in sec.136AD (3) of the Income Tax Assessment Act (“ITAA 1936”) and the application of Comparable Uncontrolled Price (“CUP”) method evidenced by comparable transactions. 

The initial Federal Court verdict rejected the ATO’s use of the Transactional Net Margin Method (TNMM) in favour of the taxpayer’s comparable third party transaction information.  The Court considered that comparable data was sufficient evidence to support that the taxpayer had satisfied the burden of proving that its related party purchases were acquired at arm’s length prices.

Appeal grounds
The ATO appealed the Federal Court decision on three grounds:

1. the Trial Judge erred in finding that based on the evidence, the transactions upon which the taxpayer relied were comparable 
2. the Trial Judge acted on inadequate evidence and incorrectly accepted evidence that the French supplier had made losses on its sales to the taxpayer; and 
3. the Trial Judge erred in law because the concept of arm's length consideration required an examination of transactions between independent parties dealing at arm's length and such words forbade any except transactions which share each and every quality of the taxpayer bearing on price other than they are not under the control of SNF France.

Re-examination of the evidence for 3 sets of comparable information was undertaken. It was concluded that while allowing for some deficiencies in the Trial Judge's approach, fundamentally the taxpayer paid less for the same or similar products than arm's length purchasers therefore the conclusions were correct. The Full Federal Court accepted that there was evidence of an extensive range of comparables and as such the ATO’s contention TNMM should be applied in determining an arm’s length price was not correct.
The court stated the Trial Judge followed all established principles in relation to the acceptance of evidence in relation to taxpayer testimonies.

Finally, the court, in a rather blunt assessment, stated that sec.136AD of the transfer pricing rules does not require that the only comparables which can lawfully be examined are those sharing the exact same characteristics as the taxpayer “as the bar will be set at an unattainable height”.

Implications of the decision

For the ATO

• There will be no High Court appeal as the 28 day period to file has lapsed.
• The case outcome and non appeal decision is likely to mean legislative reform to Division 13 or further litigation to resolve the uncertainty created by the decision. 
• TNMM will remain the primary method to minimise the ATO’s level of review and audit activity. The ATO will continue to use the TNMM as a method to assess which taxpayers are at risk and where potential tax leakage is occurring.
• The case has far reaching implications for the ATO in terms of how to apply Division 13 in the Australian court system. Clearly the court favours the use of the traditional transaction transfer pricing methods and does not favour the use of the TNMM as a default methodology. This may limit the way in which the ATO applies this method for the purpose of issuing amended assessments and dealing with court cases, but will not necessarily impact the way in which the ATO applies this methodology for the purpose of selecting its review and audit targets.

For taxpayers

• The major beneficiaries from this case are:
• SNF Group
• taxpayers with losses that can identify potentially comparable transactions (and can therefore use the CUP method)
• taxpayers with losses that can identify and quantify commercial factors that affected profitability.
• For taxpayers who do not have access to CUP data the use of TNMM will likely remain the most appropriate form of documentation defence.
• The appeal decision has shed light on the nature of comparable transactions in determining an arm’s length price: An actual or potential CUP should not be ignored just because the circumstances are not identical.
• Taxpayers that have relied on TNMM historically should review this position, in light of the SNF Australia decision.
• For taxpayers incurring losses the decision reinforces the benefits of documenting on a timely basis the commercial factors that contributed to the loss.

Background
SNF Australia (the taxpayer) was a member of the SNF Group of companies and is a wholly owned subsidiary of SPMC SA (SNF France). During the years 1998 to 2004, SNF Australia distributed polyacrylamides, a product which it acquired from its various related parties including SNF France and incurred many years of trading losses from its operations. The commercial reasons provided by the taxpayer for the sustained losses included intense competition, poor management, fraud by an employee, excessive stock levels, an insufficient level of sales per person and a series of bad debts.

The CUP method, one of the traditional transaction methods, was utilised by SNF Australia to benchmark its related party transactions. The CUP may be used to compare the price of products or services charged to independent parties and to related parties under the same or similar circumstances. According to the Organisation for Economic Co-operation and Development’s (OECD) 1995 transfer pricing guidelines, an adjustment to create reliable comparability, if at all possible, needs to be made by considering factors including the characteristics of the property or services, contractual terms, assets or resources contributed, economic circumstances and business strategies. However, the court stated that factors would not “be taken as imposing on the taxpayer the need to apply with exactness the CUP method in satisfying the burden of proof imposed upon it under Division 13”. This contrasts with the high level of exactness the ATO has always sought in relation to the application of the CUP method.

Based on the application of CUP methodology, the court found that the actual prices paid by the taxpayer were lower than the majority of the prices paid by independent parties on a global basis. The court understood that this was because SNF Group was engaged in a market penetration strategy and therefore charged SNF Australia reduced prices for its related party purchase in order to support this subsidiary through initial set up periods although the initial set up period in Australia was longer than anticipated. The court also concluded that genuine losses may be sustained for many reasons, and not necessarily because the transfer prices of the goods were artificially inflated. This means that losses may lead to ATO inquiries but not always represent arm’s length consideration problems.

Despite high levels of sales performance in the Australian market the taxpayer incurred tax losses and therefore did pay tax in Australia for a substantial period of time. The ATO contested that the taxpayer’s motive was to make losses in Australia and to shift profits to France through transfer pricing and this was the reason why SNF Australia made continuous losses.

The ATO applied the TNMM being one of the transactional profit methods that may be applied where the ATO determines that no reliable data is available. TNMM develops a ratio by comparing a ratio such the net margin relative to an appropriate base, such as costs, sales or assets. It will often require adjustment depends on variable factors including financing arrangements, market conditions, market penetration and differing business strategies. This methodology led the ATO to believe that the prices the taxpayer paid did not represent arms length consideration, and argued if the taxpayer was independent and dealing wholly independently it would have been generating an average operating profit margin of 1.7% rather than continuous losses over an extensive period of time. Based on this approach, in order to achieve a net profit of 1.7% the taxpayer would have paid a total of $12.3 million less for the product over the relevant period than it did in fact pay. Furthermore, ATO argued that the information provided by taxpayer regarding CUP methodology is irrelevant and not ‘truly comparable’ to determining what an arm’s length party in the position of the taxpayer. Reasoning, “each proposed CUP counterparty was a vastly different entity from the taxpayer and the ability of SNF France to influence prices by the provision of price rebates, together with the unique features of the Australian market that are not present in the overseas markets”.

The court soundly rejected the use of TNMM, stating “the TNMM does not provide a proper basis for determining what consideration it was reasonable to expect that an independent purchaser would pay for the products”. The court added that if the ATO had sought to support adjustments based on the double tax agreement’s associated enterprises article, the outcome may have been different.

For more information contact:

Jason Casas
National Leader - Transfer Pricing
T +61 3 8663 6433
M +61 430 023 326
E jason.casas@au.gt.com