US-AU DTA: Article 9 – Associate Enterprises
This week, we will have a closer look at Article 9 of the US/AUS DTA. Article 9 of the DTA incorporates into the treaty the US and Australian arm’s-length principles reflected in the transfer pricing provisions of the Internal Revenue Code Section 482 and in Australia the transfer pricing provisions in ITAA 1997 Division 815.
An arm’s-length transaction is a transaction between independent parties. For the purposes of this blog, a simple example will help in understanding the basic concept of what an arm’s-length transaction is and when transfer pricing provisions will apply to a specific transaction.
Example: USCO A and B are both US companies and co-shareholders of AusCo, a company in Australia. The directors of both USCO A and B are John and Jane who are married. Further, each owns 50% of the stock in AusCo. USCO A is considering selling its 50% stake in AusCo and determined that the market related value of the 50% stake is $10m. However, after further consideration and the adverse tax implications on disposal, John and Jane decided that USCO A should rather sell its 50% stake to USCO B. John and Jane decided that it will sell the 50% stake for $100, to avoid the tax implications and streamline their current structure.
If USCO A sold the 50% stake for $10million to USCO B it would have been sold at arm’s-length as this is the market related price.
USCO A however sold it to USCO B for $100. They would not have sold the same stake to an independent party for $100. Hence the transaction is not at arm’s length and a transfer pricing adjustment needs to be made.
Article 9 provides that when enterprises which are related engaged in a transaction and the enterprises engage in a transaction on terms that are not arm’s length, the Contracting States may make appropriate adjustments to the taxable income and tax liability of such related enterprises to reflect what the income and tax of these enterprises with respect to the transaction would have been had there been an arm’s-length relationship between them.
INTERPRETING ARTICLE 9 OF THE DTA – ASSOCIATED ENTERPRISES
Article 9 provides that, where related persons engage in transactions which are not at arm’s length, the Contracting States may make appropriate adjustments to their taxable income and tax liability.
It should be noted that it is generally accepted that Article 9 is intended to be permissive. It allows contracting states to apply the transfer pricing rules that form part of their tax legislation. It is generally considered that; Article 9 does not create a stand-alone right for countries to make transfer pricing adjustments that go beyond what is authorized by their own domestic rules. This is mainly because the basic purpose of a DTA is to relieve double taxation and it would go way beyond this purpose if a DTA imposed harsher tax treatment on a particular transaction between country A and country B than would have applied if the same transaction had taken place between country A and another country,
Article 9(1) sets out the general rule for this Article and when it will be applicable. Where an enterprise of one Contracting State (US) and an enterprise of the other Contracting State (Australia) are related through management, control, or capital and their commercial or financial relations differ from those which would prevail between independent enterprises, the profits of the enterprises may be adjusted to reflect the profits which would have accrued if the two enterprises had been independent.
Where a reallocation of profits is affected under this paragraph, in such a manner that the profits of an enterprise of one country are adjusted upwards, a form of double taxation would arise if the profits so reallocated continued to be subject to tax in the hands of an associated enterprise in the other country.
Article 9(2) states that where one of the Contracting States has increased the profits of an enterprise of that State to reflect the amount that would have accrued to the enterprise had it been independent of an enterprise in the other Contracting State, the second State shall make an appropriate adjustment, decreasing the amount of tax which it has imposed on those profits.
In determining such adjustments, due regard is to be had to the other provisions of the DTA and the competent authorities of the two States (IRS and ATO) shall consult each other if necessary, in implementing this provision.
Article 9(3) states that each Contracting State may apply its internal law in determining liability for its tax. For example, although Articles 9(1) and 2 refer to allocations of profits and taxes, it is understood that such terms also include the components of the tax base and of the tax liability, such as income, deductions, credits, and allowances.
The US will apply its rules and procedures under section 482 of the IRC and Australia on the other hand will apply the transfer pricing provisions in ITAA 1997 Division 815. It is important that such determinations must be consistent in each case with the principles of arm’s length transactions.
This Article is a great example of how the domestic transfer pricing provisions of the US and Australia are applied on international transactions.