Resolving cross border tax disputes through Australia’s investment treaties
1. Global focus on transfer pricing
There has been a recent surge in regulatory attention around the world towards pricing arrangements within multinational corporate groups. Regulators are concerned that these pricing arrangements may be used as a means of profit shifting and therefore tax avoidance.
The price at which an entity within a multinational group transfers goods, intangible property or services cross-border to another member of the group is commonly called the “transfer price”. In order to ensure that transfer prices are set in a manner that does not involve a potential artificial transfer of profits, multinationals in Australia are taxed on the price that arm’s length parties would have agreed in comparable circumstances. The Organisation for Economic Cooperation and Development (“OECD”) publishes transfer pricing guidelines that are widely relied upon by many governments worldwide on its view of how transfer pricing regimes are to be applied to related party transactions.
In 2012, the Australian Government enacted new retrospective transfer pricing laws, contained in Division 815 of the Income Tax Assessment Act 1997, in order to overcome some perceived difficulties in Australia’s existing domestic transfer pricing regime. The operative provisions contained in Subdivision 815-A were enacted with retrospective effect for tax years beginning on or after 1 July 2004 but were restricted in their application to arrangements between Australian taxpayers and taxpayers resident in a country with which Australia had concluded a double tax agreement. Perhaps counterintuitively, the Subdivision did not apply where an arrangement involved a related party resident in a tax secrecy jurisdiction or a tax haven. Subdivision 815-B was introduced in 2013 to effectively replace both Division 13 and Subdivision 815-A for income years beginning on or after 1 July 2013. It is not restricted to arrangements involving Australia’s treaty partners and is the current applicable domestic transfer pricing regime.
The introduction of the retrospective Subdivision 815-A tax, however, created a significant amount of complexity and uncertainty for businesses operating in Australia. Multinationals had to review their historical intragroup transactions to determine whether they complied with laws that were introduced up to 8 years after the fact. In addition, there were also widespread concerns that the retrospective tax was unconstitutional. A constitutional challenge was mounted by the taxpayer in the seminal Chevron Australia case run by King & Wood Mallesons in October 2014. Judgment is still reserved (and therefore, the uncertainty continues) but has already garnered substantial international and Australian interest from both revenue authorities and taxpayers. A number of other multinationals have reached negotiated settlements with the Australian Tax Office (“ATO”) requiring in some case payment of several hundred million dollars.
Transfer pricing is also a key aspect of the OECD’s two year Base Erosion and Profit Shifting (“BEPS”) project. Given that Australia’s new domestic regime requires taxpayers to apply the domestic laws so as best to achieve consistency with the OECD transfer pricing guidance, the impact of the BEPS project on those guidelines will have a critical role in how Subdivision 815-B is to be applied going forward. It is also likely to be a key area of dispute in the coming years.
Multinational companies, especially those with operations in Australia, can therefore expect a tough regulatory environment for many years to come. So much can already be seen from the Australian Senate’s recent inquiry into corporate tax avoidance held on 8, 9, 10 and 22 April 2015, which focussed heavily on transfer pricing issues in the digital economy and the resources sector.
2. The traditional way to resolve cross border disputes
There are a number of issues that multinational companies should consider in preparing for this new tax environment. Without limiting:
Businesses must ensure that they prepare the requisite contemporaneous documentation to justify their transfer pricing positions
This is one of the few areas of the OECD’s BEPS project that has garnered multilateral support. We are likely to see documentation by way of master files and local files in the framework of country-by-country reporting.
In Australia, transfer pricing documentation is now a legislated prerequisite for penalty protection. In the past, such documentation was often prepared with less than ideal rigour. That level of documentation is no longer appropriate and will likely expose taxpayers to automatic base penalties of at least 25%. In light of the more onerous documentation requirements, some relief has also been introduced for small businesses and minor cross-border dealings. This safe-harbour style relief may be found in the Australian Tax Office’s guidance on simplifying transfer pricing record keeping options.
Australia’s domestic tax appeals process
Multinationals are generally aware of their rights under Australia’s domestic tax appeals process. They can appeal adverse revenue authority decisions to either the Federal Court of Australia or the Administrative Appeals Tribunal. In the context of transfer pricing, only a handful of cases have been litigated in Australia. The latest case in this area, and perhaps the most critical so far, is the Chevron Australia case referred to above.
Consider mutual agreement procedures
Another relatively well known recourse for multinationals is the mutual agreement procedure or “MAP” contained in Australia’s double tax agreements. Unfortunately, the MAP process is also notorious amongst multinationals for its inefficiency. For example, the OECD’s statistics show that the average time for completion of a MAP is approximately 2 years, with Australia’s average being slightly longer. Further, between 2008 and 30 June 2013, Australia had been involved in 28 MAPs and only 6 had been completed.
3 Consider Australia’s investment protection treaty network
3.1 The investment treaty network
Bearing the perceived weaknesses of the MAP process in mind, another potential avenue for resolving cross border tax disputes, which is often overlooked, is the application of Australia’s investment treaties.
It is often the case that local laws provide little means to challenge the validity of laws or the actions taken by regulators in enforcing them. In the case of Australia, the Government has broad powers to introduce legislation to retrospectively authorise its conduct.
Elsewhere, you may be faced with difficulties in having a dispute with the local government properly and fairly heard before domestic courts. Investment protection treaties may, however, provide a means of redress against government action beyond what is provided by domestic law. Investment treaties are agreements between countries in which each country promises to protect the investments of investors from another country. Today, there are over 3,000 investment treaties in force. Australia has entered into 30 investment protection agreements with several more under negotiation.
Investment treaties generally permit investors to bring claims against the foreign government of the state they have invested in before a neutral tribunal of international arbitrators. Diagram 1 below indicates some of the general types of claims that may be brought under investment treaties.
Diagram 1 – Types of Government action that have given rise to claims
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Many claims are brought by investors against governments based on what is known as the expropriation and fair and equitable treatment protections commonly included in investment treaties.
In the context of taxation, a successful claim based on the expropriation measure is likely to occur only in extreme circumstances, such as those in Yukos Universal Limited (Isle of Man) v The Russian Federation. In Yukos, the three foreign controlling shareholders of OAO Yukos Oil Company (“Yukos”) initiated an international arbitration against the Russian Federation pursuant to the investment protection agreement in the Energy Charter Treaty. Yukos, an Isle of Man company and in May 2002 one of the top ten largest oil and gas companies in the world by market capitalisation, was involved in the exploration, production, refining, marketing and distribution of crude oil, natural gas and petroleum products in Russia.
Yukos then became involved in a dispute with the Russian Government concerning tax minimisation schemes and transfer pricing. This led to a series of government actions against Yukos including criminal investigations and arrests of senior executives, the imposition of value-added taxes (“VAT”) and tax reassessments between 2000 and 2004 (together amounting to approximately US$24 billion), frustration of a corporate merger, freezing of shares and assets, revocation of a business licence and the forced sale of its main oil production subsidiary to a Russian state owned entity. Finally, in 2006, Yukos filed for bankruptcy.
Yukos commenced international arbitration against Russia pursuant to the investment protection agreement in the Energy Charter Treaty. The arbitral tribunal held the Russian Government liable to Yukos for compensation of US$50 billion as it considered that the government measures had the effect of expropriating Yukos’ assets and were in fact designed to do so. In making its decision, the tribunal also held that the US$13 billion of the VAT reassessments had been in respect of exported oil which should have been free of VAT.
Other tax claims will not involve the same amount of adverse government action, deliberately targeted at expropriating the investors’ assets. Such claims are more likely to come within the fair and equitable treatment protection (“FET”) in investment treaties. FET protects against government acts which are “arbitrary, grossly unfair, unjust or idiosyncratic, discriminatory and expose the claimant to sectional or racial prejudice, or involve a lack of due process leading to an outcome which offends judicial proprietary” or where an investor’s legitimate expectations upon which it based the investment are frustrated, say for example, by the revocation of a favourable tax regime or the retrospective application of a new set of taxations laws. This might include, for example, Australia’s introduction of Subdivision 815-A, particularly given its (partial) retrospective operation.
This type of claim was successfully brought by Occidental Exploration and Production Company against Ecuador for the revocation of decisions allowing Occidental to claim reimbursement for VAT paid on purchases required for its exploration and exploitation activities under its participation contract. Occidental claimed that it had relied upon the ability to claim VAT reimbursements in undertaking the investment and Ecuador had therefore breached its legitimate expectations on the basis on which the investment was made.
In finding for Occidental, the arbitral tribunal emphasised that an essential element of FET is a stable and predictable legal and business framework. This is because FET requires the investor to know in advance any and all rules that apply to its investment so that it can plan its investment accordingly and comply with the relevant rules.
3.2 Obtain investment protection
Multinational companies should where possible plan their investment in such a way that it falls under an investment treaty. In addition to commercial considerations involved in planning the location from which to make a foreign investment, investment treaty planning requires consideration of the available investment protection agreements and the scope of protections offered. In many cases the terms of the protection agreement and the rules of international investment law provide protection to direct and indirect investments. An indirect investment is one that is made through a series of entities as shown in Diagram 2 below. If indirect investments are permitted, the parent company can rely upon the protection afforded to country B under an applicable investment agreement.
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In respect of direct or indirect investments, it is important to consider how the proposed structure interacts with the terms of the investment protection agreement, and the rules of international law, to assess whether the investment will be eligible for the protections offered. Importantly, in some cases protection will not extend to ‘shell companies’ incorporated in a jurisdiction only to benefit from that State’s investment protection agreements.
Finally, where possible, investors should seek to enter into direct agreements with the foreign government hosting their investment as to the investment regime which will be applicable. This is particularly important for investments in emerging markets where the regulatory regime can change quickly, or where the viability of your investment is dependent upon the ongoing application of certain regulations or tax exemptions.