Transfer pricing and centralised operating models: An Australian perspective

Australia is a country richly endowed with mineral and energy resources. Due to its relatively small population and large mineral wealth, much of the development in this sector has been directed at exporting mineral commodities. In 2016-17, the sector constituted almost 7% of total GDP and 68% of total goods exported. In 2017-18, the total value of energy and resources (E&R) exports was a record A$226 billion ($162 billion), with iron ore, coal (coking and thermal), liquefied natural gas (LNG), base metals and gold the primary commodities exported. Given the sector's size and importance to the economy, the Australian Taxation Office (ATO) has paid considerable attention to arrangements adopted by miners in commodity exports.

Australia adopts an open trade system for exports (that is, there are no mandated requirement for onshore processing). Consequently, a large portion of the exported products for major commodities is in unprocessed form (apart from limited beneficiation and blending in the case of iron ore and coal, and liquefaction for LNG). According to a 2018 energy quarterly by Australia's Department of Industry, the primary export markets in 2016-17 were: China (38%), Japan (17%), South Korea (8%), India (5%) and the European Union's 28 member states (5%).

As supply chains have grown with increasing globalisation and improvements in information technology, many multinational enterprises (MNEs) in the resources sector have sought to locate specific elements of their supply chain (such as marketing and logistics management) within dedicated entities in the group.

When this process involves marketing and distributing commodities, a complex value chain is established to ensure that the right commodity is delivered to the customer in the right form, at the right place, and at the right time.

It is distinct from the industrial or upstream activity of commodities firms, and therefore has a different economic model with different activities and risks that need to be understood and managed.

One aspect of the ATO's approach to monitor these arrangements is a risk-based analysis in Practical Compliance Guidance (PCG) 2017/1, which covers the compliance approach to transfer pricing (TP) issues related to centralised operating models involving procurement, marketing, sales and distribution functions.

The ATO started publishing PCGs in 2016 as an aid to taxpayers. They are meant to:

"Convey… the ATO's assessment of relative levels of tax compliance risk across a spectrum of behaviours or arrangements… [and] enable taxpayers to position themselves within a range of behaviours, activities or transaction structures that the ATO describes as low risk and unlikely to require scrutiny".

For the purposes of the guidance, these centralised operating models have been referred to as 'hubs'. The PCG is a general statement on the issue, and also includes three schedules:

• Schedule 1 covers offshore marketing hubs;

• Schedule 2 targets offshore non-core procurement arrangements; and

• Draft Schedule 3 focuses on offshore shipping service hubs. Schedules 2 and 3 were published in 2018.

Broadly, it may be said that the PCG is directed at MNEs in the resources sector that have extended their value chain to locate certain functions, assets and risks (FAR) offshore. While there are clear commercial reasons to do this, the ATO's concern was whether the pricing and allocation of total value chain profit in these arrangements was consistent with the arm's-length principle.

Despite recent public attention, the use of centralised operating models is not a new phenomenon. The issue of marketing hubs was highlighted in the Treasury's Consultation Paper in 2011, while the 2013-14 federal budget dedicated A$109.1 ($79 million) to increasing ATO compliance checks on offshore marketing hubs.

Furthermore, the ATO issued a taxpayer alert on December 10 2015 (TA 2015/5) to bring attention to arrangements involving offshore procurement hubs (primarily regarding CFC attributions, but TP matters were also discussed).

Perhaps the most important impetus for the ATO's public statement was the 2015 Senate inquiry into corporate tax avoidance and aggressive minimisation, which focused on the energy and resources sector. The interim report from the Senate Economic References Committee maintained the spotlight on marketing hubs, as reflected in Recommendation 1:

"The committee recommends that the Australian Government work with governments of countries with significant marketing hub activity to improve the transparency of information regarding taxation, monetary flows and inter-related party dealings."

It was recently reported that a major Australian mining enterprise reached a settlement with the ATO on a TP dispute relating to its marketing operations in Singapore, and that the company had subsequently restructured. Whilst the terms of the settlement were confidential and contained no admission of tax avoidance, the case highlights the ATO's continued focus on offshore resources marketing hubs.

With Australia set to become the world's largest annual LNG exporter in 2019 according to Department of Industry data by the chief economist (already overtaking Qatar on a monthly measurement in this position in December 2018, according to Refinitiv Eikon data), the ATO's approach presents a cautionary precedent and a troubling question: how are E&R companies to design and defend their TP arrangements in this changing and increasingly aggressive tax environment?

The PCG 2017/1 risk assessment framework provides six different risk zones with colour coding for offshore hubs. They range from a white zone (the safest risk area) to a red zone (very high risk).

A hub will be in the white zone if it has entered into either an advance pricing agreement (APA) or a settlement agreement with the ATO, or if the ATO has conducted a review of the hub and provided it with a low-risk rating within the past two years.

Moving up the risk-metric, an offshore marketing hub will be in the green zone if it has not satisfied the requirements for a white classification, but hub profits are less than (or equal to) 100% of the mark-up of hub costs (Schedule 1). Note that hub costs do not include costs of sales (only operating and associated costs of the hub, effectively a Berry ratio).

For Schedule 2 (offshore non-core procurement hubs), the low-risk zone is reached if the hub's profits are less than (or equal to) 25% of the mark-up of hub costs (again, based on a Berry ratio approach).

For Schedule 3 (offshore shipping service hubs), the low-risk zone is hub profits less than or equal to 25% mark-up of relevant hub costs (Berry ratio-based), or if hub costs are below A$2 million ($1.4 million). In addition, the hub must be both a marketing and shipping hub, and hub profits must be less than or equal to 100% mark up of relevant hub costs.

For all three schedules, if the low-risk thresholds are exceeded, the hub will still remain in the green zone, as long as all hub profits are fully attributed back to Australia under Australia's controlled foreign corporation (CFC) rules.

If the low-risk thresholds are exceeded and the hub profits are not fully attributed back to Australia, the taxpayer will fall within one of the other four colour-coded risk zones. Each zone is calibrated solely by the amount of tax potentially at risk, comparing the actual hub results to the relevant green zone profit. In PCG 2017/1, the tax impact is calculated using the following formula (for each separate schedule).

• Schedule 1 offshore marketing hubs: Tax impact = [hub profit minus 100% mark-up above costs] x non-attributed income ratio x Australian company tax rate;

• Schedule 2 offshore non-core procurement hubs: Tax impact = [hub profit minus 25% mark-up above costs] x non-attributed income ratio x Australian company tax rate; and

• Schedule 3 offshore shipping services hubs: Tax impact = [hub profit minus 25% mark-up above costs] x non-attributed income ratio x Australian company tax rate.

The tax impact will then determine the level of risk and priority of application of the ATO's compliance resources to the hub, with the blue zone at the lower end of the scale and the red zone at the highest priority for review.

However, even if the taxpayer is in the intermediate yellow or amber zones, it will be moved automatically into the red zone if it does not have TP documentation that meets the requirements set out in Taxation Ruling 2014/8. According to PCG 2017/1, the existence of these documents is considered "critical to the assessment of risk related to hubs that are outside the green zone".

The level of detail expected in TP documentation is extensive, and includes primary evidence of legal arrangements, financial outcomes, job descriptions, key performance indicators and cost/benefit analysis. This places a high compliance burden on taxpayers, and thereby increases their chances of inadvertently falling into the red zone.

However, falling into the ATO's high-risk zone does not necessarily mean that the arrangements or pricing are inappropriate, but it does mean that the ATO is likely to apply additional compliance scrutiny. In addition, falling into the ATO's low-risk zones does not necessarily make pricing outcomes low risk in the hub's host country, and may in fact make them a higher risk from the local tax authority's perspective.

Taxpayers must self-report the outcomes of their analysis to the ATO via the international dealings schedule or the reportable tax positions schedule (if applicable).

The underlying assumption in the PCG is that offshore hubs are in effect service provider entities to their affiliate Australian miners. This is evident in the selection of the Berry ratio as the low-risk benchmark indicator. While the PCG acknowledges that hubs may have different risk profiles and therefore may achieve different results, no consideration is given to any form of profit measurement other than the Berry ratio.

While some hubs may indeed be characterised as service providers based on a functional analysis, other hubs will be more properly characterised as marketers/distributors, resellers or full traders of commodities, or as shipping brokers in the case of shipping activities. The Berry ratio calibration of risk means that hubs are virtually always categorised as high risk under the PCG's framework, the consequences of which include increased use of ATO compliance resources and more limited opportunities for the taxpayer to enter the APA programme.

The OECD's TP guidelines indicate that the resale price method (RPM) may be an appropriate TP method for re-sellers of goods when suitable independent benchmarks are available.¹³ There is significant market-based evidence in the form of executed agreements on commercial databases that shows commodity sales agents and re-sellers typically charge a percentage of the final price as their commission/margin (broadly, a resale price margin).

The agreements between third parties are available for multiple commodities. PCG 2017/1 notes that taxpayers have tried to rely on such commission rates used by third parties to establish a CUP in support of their own position (that is, using the market-based agreements as CUPs for the resale margin to be applied). The ATO states that its concern in relying on this data has been the absence of supporting information to establish comparability and the market indicators relied upon.

However, PCG 2017/1 then indicates that the low-risk benchmarks it applies have been determined by the ATO having regard to all available information, including data collected as part of ATO compliance activities. However, because the indicators are provided for the purpose of risk assessment (rather than determining arm's-length methods or outcomes) and include commercially sensitive data, the ATO will not release the supporting data.

While it is acknowledged that the PCG approach is for ATO risk assessment purposes only, the lack of transparency on the basis for the benchmarks seems at odds with the OECD's TP guidelines (paragraph 3.36), where it warns against the use of secret comparable information by tax administrations. The imprecision of the Berry ratio approach, combined with the opacity of the analysis, provides little certainty for taxpayers with offshore hubs.

Commodity trading hubs are typically established to be active in the market, build relationships with key clients by understanding their unique needs, manage commodity movements to ensure timely delivery, and oversee all activities to ensure risk levels do not exceed limits. This allows risk exposures of commodity trading to remain isolated and controlled, ensuring swift processing of time-sensitive commodity transactions. These hubs control the group's risk exposure by utilising skilled teams to isolate and manage counterparty credit risk and commodity price movement risk, and to optimise logistical outcomes.

The primary role of the marketing hub is to achieve the highest possible price for the commodities sold, as well as achieving efficiencies through centralisation. In this regard, the term commodity is slightly misleading as it implies a knowable market price at a point in time based on published prices or indices.

However, this is not always correct in the case of mineral commodities such as coal, iron ore and LNG. For example, the published prices for thermal coal are based on certain minimum specifications, so when certain coal supplies exceed specifications, there is an opportunity to achieve higher prices by understanding the customer requirements and meeting these through better quality coal.

Alternatively, the marketer can understand the customer specifications and use this knowledge to direct the coal blending activities in Australia in a way that enables different quality coal to be blended to achieve a better overall price across the board. For long-term LNG contracts, a marketer may achieve a better slope against the oil index price by understanding customers' technical requirements.

Merely targeting a profit outcome linked to operating costs does not capture any of the value or profitability that may accrue to the MNE from the above activities, and is likely to create an incentive for the hub to increase its costs without regard to improving the commodity selling price (as it has no exposure to the upside of better prices).

As a counterpoint to the approach adopted for non-resident hubs in PCG 2017/1, it is useful to consider the differences apparent in draft PCG 2018/D8, released in November 2018. The draft focuses on inbound distribution arrangements and Australian resident resellers.

Given the functional similarities to offshore marketers/distributors, readers may be forgiven for expecting that these entities would also be risk-assessed by the ATO based on a return on their operating expenses.

However, that is not the case, and the draft PCG assesses risk based on an EBIT/sales ratio, or operating margin.¹⁵ This is an asymmetrical approach and, in most cases, will mean a lower level of profitability in outbound distribution hubs.

In addition, the ATO has set profit markers for inbound distributors to remain in the low-risk zone that are relatively high (ranging from above 4% to above 10%) compared with recent market-based benchmark observations.

The 'one size fits all' risk assessment approach adopted in PCG 2017/1 means that many offshore, extended value chain operations of Australian resources-based MNEs are likely to be considered by the ATO to represent a high tax risk to the Australian tax base. Taxpayers in this sector should:

• Carefully consider their pricing methodology with offshore associates;

• Review the robustness of the analysis and documentation they have to support the pricing; and

• Prepare to engage with the ATO to explain their position if they have not already done so.

© 2019. For information, contact Deloitte Touche Tohmatsu Limited.This communication contains general information only, and none of Deloitte Touche Tohmatsu Limited, its member firms or their related entities (collectively, the "Deloitte network") is, by means of this communication, rendering professional advice or services. Before making any decision or taking any action that may affect your finances or your business, you should consult a qualified professional adviser. No entity in the Deloitte network shall be responsible for any loss whatsoever sustained by any person who relies on this communication.

John Bland

Principal Deloitte Australia Tel: +61 (0)7 3308 7275 jbland@deloitte.com.au John Bland is a principal with Deloitte Australia. He has over 20 years' experience as a specialist transfer pricing practitioner, including 13 years as a partner. John is based in Queensland, a major mining and resources state where John has assisted many clients in this sector on TP issues. He has experience across a wide range of mined and extracted resources commodities, and has advised clients on the relevant TP issues at all points of the energy and resources value chain, including pre-exploration feasibility, financing, extraction, beneficiation, marketing, shipping and logistics, trading and sales. John has assisted clients on complex matters including profit split methodologies for upstream/downstream pricing and has successfully concluded a number of advance pricing arrangements in the E&R sector.

Milla Ivanova

Analyst Deloitte Australia T: +61 7 3308 7245 milivanova@deloite.com.au Milla Ivanova is a transfer pricing analyst based in Deloitte Australia's Brisbane office. Along with her work in TP, Milla is writing a thesis in the area of international tax law, focusing on the Multilateral Instrument and its impact on Australia and its largest trading partners. In 2017, Milla published a paper on the Australian Taxation Office's approach to centralised operating models in the energy and resources industry, specifically liquefied natural gas. In 2018, she published a paper on the Multilateral Instrument, focusing on the permanent establishment concept and arbitration in light of Australia's unilateral tax reforms. Milla's interests lie in TP in the energy and resources sector, as well as policy and international tax reform.