Australia, Canada and Brazil are among the countries that have been increasing their aggressiveness in “enforcing” their transfer pricing regulations during 2009 and 2010. In this article, we are highlighting a recent (June 25, 2010) taxpayer win against the Australian Taxation Office (ATO).
This case (SNF (Australia) Pty Ltd v Commissioner of Taxation  FCA 635) is important because it involves a small distributor and is an example of how the courts interpret Australia’s transfer pricing regulations. In addition, there are a number of interesting facts and circumstances of this case and court decision, including:
- Taxpayer had operating losses for 11 years and paid no taxes for 13 years
- Taxpayer was a distributor that purchased all of its products from related parties
- Taxpayer purchased products were sold to third parties in Australia
- Taxpayer indicated that long-term losses were part of a “market penetration strategy” adopted by its parent company
- Taxpayer used comparable uncontrolled price (CUP) method and ATO used transactional net margin method (TNMM)
Particularly noteworthy are items 1, 4 and 5, which reinforce statements we regularly make to our clients and potential clients that:
- Continuous operating losses are an “audit trigger”
- A potential argument supporting continuous losses can be a “market penetration strategy” by the parent company, if supported by the facts and circumstances of the case
We also noted that it is unusual for a non-U.S. taxing authority to use the TNMM method to support its tax assessment argument rather than a transactional method such as the CUP method. Generally, non-U.S. taxing authorities follow the OECD hierarchy preference of transaction-based methods over results-based methods such as TNMM. Specifically, you may recall the Canada Revenue Agency’s (CRA) 2008 win against Glaxo SmithKline, where the CRA focused on transactions of the Canadian subsidiary with its parent company for an ingredient in Zantac to support a multi-million dollar tax assessment even though the overall operating results were within the range of comparable companies (as argued by the Glaxo parent company).
Summary of Case and Judgment
Australia’s Federal Court on June 25, 2010, granted distributor SNF (Australia) Pty. Ltd.’s appeal challenging a $13 million (US $11.7 million) transfer pricing assessment by the ATO, even though SNF (Australia) had incurred operating losses for 11 years and paid no income tax for 13 years.
Case citation: SNF (Australia) Pty Ltd v Commissioner of Taxation  FCA 635, Judge J. Middleton.
In finding in favor of SNF (Australia), Justice Middleton found that the principal cause of SNF (Australia)’s losses were: unreasonably low level of sales per salesperson; competition in the Australian market; excessive stock levels; and poor management. He also found that the losses were due to the decision by SNF (Australia)’s parent company, French chemical group SNF Floerger, to adopt a “market penetration strategy” whereby SNF (Australia) priced its products based on market conditions not a profitability target. While expecting to incur operating losses, SNF Floerger’s philosophy was to support SNF (Australia) and its other subsidiaries “through initial set up periods, although in Australia the initial set up period was longer than anticipated.”
“The SNF group’s market penetration strategy in Australia was critical to the long-term strategic global plans of the SNF group,” Middleton said. “The price support by the SNF group ensured that SNF (Australia) could continue to operate.”
Judge Middleton accepted the comparable uncontrolled price method used by SNF (Australia) and rejected the transactional net margin method (TNMM) championed by the commissioner. According to Judge Middleton, “The evidence establishes that the reason the suppliers tolerated sales below cost price, and less than the price charged to arm’s length purchasers, was that the SNF group was supporting the taxpayer.”
“I accept that it would be likely that an independent distributor would have exited the marketplace if they made the quantum of losses that the taxpayer had made,” Judge Middleton stated.
However, he added that “the presence of the taxpayer in the Australian marketplace was considered to be critical to the long-term strategic plans of the SNF group globally and continued investment was made to ensure that the taxpayer could continue to operate.”
Regarding SNF (Australia)’s comparable transactions, the court found:
- The prices paid by SNF (Australia) for the products were lower than the large majority of prices paid by the purchasers in the comparable transactions over a similar period of time
- SNF (Australia) sold the large majority of the products to end-users
- The products of the comparable transactions were the same or similar to the products acquired by SNF (Australia)
- The essential terms of the comparable transactions were the same or similar to those of SNF (Australia), including the size of the orders, the terms of payment and delivery, and taking into account currency conversions and isolated rebates
- The purchasers were independent, and were trading in an industry similar to SNF (Australia)’s industry, and were distributors of product in their respective market places
Middleton rejected the ATO’s use of the TNMM, saying “it did not provide a proper basis for determining what consideration it was reasonable to expect that an independent purchaser would pay for the products.”