The Federal Court decision in SNF (Australia) Pty Ltd (“SNF”) v Commissioner of Taxation was handed down on 25 June 2010.  The case provides insights in relation to the selection and application of transfer pricing methods in Australia.

Background

SNF is a wholly owned subsidiary of a French company.  SNF is a distributor of polyacrylamide products acquired from related party manufacturers of the product. SNF has been incurring trading losses from its operations.
 
SNF attributed the losses to a combination of intense competition, poor management, defalcations by an employee, excessive stock levels, an insufficiently high level of sales per sales person and a series of bad debts.  In other words, the poor performance resulted from factors other than the transfer pricing policies of the group.

The taxpayer position and approach

SNF applied the comparable uncontrolled price (“CUP”) method.  The CUP method broadly compares the price charged in a transaction between related parties to the price charged to or between independent parties.  For example, if Company A sells a product to a related party and also sells the same product on comparable terms to an independent customer, the CUP method may be used. 
In this case, SNF relied on sales made by the related party manufacturers to independent distributors.  In making the comparison, SNF would need to show that it is “comparing apples to apples”, so to speak.  If there are material differences, for example in terms of contractual terms, formula, quality, volume, currency etc, SNF would be required to show that adjustments could be made to achieve a reliable comparison.  In this regard, an independent expert report argued that the sales made to the independent distributors were comparable to sales made to SNF. 

SNF’s analysis showed that the majority of the sales to independent customers were for a consideration that was the same or more than that paid by SNF.  With the existence of the CUP, SNF would have concluded that it would provide the strongest evidence of arm’s length pricing and the CUP method would take priority over the profits method.

The ATO’s position and approach

The ATO undertook a transfer pricing audit of SNF and issued notice of assessments in respect to the 1998 to 2000 and 2002 to 2004 years of income.

It is relevant to note that the ATO was probably concerned with the fact that SNF was generating losses over a prolonged period.  The OECD guidelines warn that tax authorities are likely to question situations where an entity consistently incurs losses while the multinational group as a whole is profitable.  This was broadly the case for SNF.

In relation to the methodology applied by SNF, the Commissioner argued that the information used in applying the CUP was not sufficiently reliable.  It argued that inter-alia, the comparable entities (i.e. the independent customers) were vastly different from SNF and that the ability of the parent company to influence prices by the provision of rebates together with the unique features of the Australian market was not present in the other overseas markets.  It was also argued that the comparable entities used were at different market levels than that of SNF. The ATO also argued that SNF has borne the costs of building and penetrating the Australian market and that should have been reflected in a reduced purchase price for the products.

Having argued that there is no reliable CUP, the ATO suggested that the Transactional Net Margin Method (the “TNMM”) would be the most appropriate method to be used.  The TNMM may be used when the traditional transactional methods cannot be reliably applied.  This method examines the profitability of the tested entity relative to an appropriate base.

The ATO broadly compared the profits of SNF to distributors with the same economic function and risk profile as SNF (not necessarily entities selling the same products or in the same industry). The comparable companies selected included four Australian distributors and 7 distributors from countries with relatively strong economies that distribute products broadly similar to polyacrylamides. The median point (being 1.7%) from the calculated profit range was then used.  In effect, the ATO expects SNF to generate an average operating margin of at least 1.7% over the years being reviewed.
The Court rejected the use of the TNMM.  Justice Middleton opined that “In my view, undertaking 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, in effect found that the CUP method can be reliably applied by SNF.  In terms of market differences, Justice Middleton explained that “the focus is on the market in which the products are acquired by the taxpayer, and any ‘unique features’ of the market in which the taxpayer sells, is of no importance”.  It was held that as the relevant market is a global market, the comparability is to be viewed in the global context.

The Court also accepted evidence that the losses incurred by SNF resulted from factors other than the transfer pricing policies of the group.

Other notable points from the case

What are the implications of prolonged losses, if any?

The OECD guidelines assert that an independent entity will not be expected to tolerate losses that continue for long periods of time or indefinitely.  In other words, an independent entity would rather shut down rather than continue to incur prolonged losses.  In this regard Justice Middleton explained that “Genuine losses may occur for many reasons, including the ones relied upon by the taxpayer in this proceeding.  It is not to be assumed that losses, even over a lengthy period, are necessarily artificial.”

However, the ATO, by taking this matter to the courts appears to be sending a strong message that it has issues with companies making sustained losses.

Does the DTA provide a separate taxing power for the Commissioner?

The International tax agreements entered into by Australia usually contain an “Associated Enterprises Article”, which allows tax authorities to adjust the accounts of associated enterprises if the special relations between them result in a non-arm’s length outcome or profit levels.  The Commissioner asserts that apart from Division 13, the Associated Enterprises article provides it with a separate power to make transfer pricing adjustments. This was argued by the Commissioner in the case.  Whilst the Court was not required to decide on this issue, Justice Middleton noted that there may be some force in the Commissioner’s argument that “…there is clear legislative intention…that the Commissioner may in amending an assessment, rely on either s 136AD or the relevant associated enterprises article…” 

Can a CUP be used if it results in an entity incurring prolonged losses?

The Commissioner did submit that the taxpayer would still be exposed to a transfer pricing adjustment even if it was demonstrated that the prices paid by the taxpayer did not exceed the prices paid by independent parties in similar circumstances, if the taxpayer paid prices that generated losses year after year. The Commissioner argued that the task is not to determine the fair value of the purchase from the point of view of the seller, rather it is to ask what price an independent buyer in the position of the taxpayer would have agreed to pay.

The Court rejected this argument and held that the taxpayer would have satisfied the burden of proof if it can show that the prices paid are arm’s length (for example by reference to a comparable sale to an independent party under similar circumstances).

How much weight did the Court place on the OECD transfer pricing guidelines?

Whilst the Court was referred to and considered the OECD Guidelines, Justice Middleton warned that the guidelines do not dictate to the Court any one or more appropriate methods.  Accordingly, greater weight should be given to transfer pricing judgements handed down in Australia.

Implications of global reach on the application of the CUP method

SNF acquired products from various companies in the SNF Group including a related company in China (“China Co”).  China Co does not sell products (comparable to that sold to SNF) to independent parties.  However, the court held that the products sold by SNF China can be treated in the same way as those sold by the other related companies for which comparable sales information were available.  Justice Middleton explained that this was because the acquisition of the products by SNF and the independent parties occurred in the context of a global market.