A Full Federal Court ruling will cause short-term uncertainty in the application of Australia's transfer pricing rules, according to a tax expert.
Deloitte tax partner Fiona Craig said the dismissal of an appeal by the ATO against a Federal Court ruling last year, in a case it lost against SNF Australia, was a "game changer".
"This decision has now cast significant doubt on the ATO's long-held practice of using profitability, in isolation from other commercial factors, to determine the legitimacy of arm's length pricing," said Craig.
Transfer pricing is the price that is assumed to have been charged by one part of a company for products and services it provides to another part of the same company, in order to calculate each division's profit and loss separately.
In June 2010, Justice John Middleton of the Federal Court ruled that SNF Australia, a domestic subsidiary distributor for the French chemicals group SNF Floerger, had failed to pay income tax between 1998 and 2004 because it was poorly run, rejecting an argument by the ATO that it was artificially inflating prices.
The ATO launched proceedings against SNF Australia after it failed to pay any income tax between 1998 and 2004 due to a series of trading losses. This was despite SNF Floerger boasting profits of around 7.5 per cent during that period.
SNF Australia argued that it incurred a trading loss during the review period due to a combination of intense competition, poor management, excessive stock levels and a series of bad debts.
The ATO countered that the company was in fact "a successful and profitable entity during the relevant period", enjoying strong annual sales growth in Australia. It also argued that despite a strong performance in the Australian market and the fact that SNF Australia received significant equity subscriptions and loans from its parent company, it failed to record any profit.
Justice Middleton rejected this argument, with the ATO appealing against this decision to a full-bench of the Federal Court. The full-bench unanimously rejected the ATO's appeal.
"Ultimately, the result in this case turned on the fact that SNF's evidence was better than the ATO's," said Craig. "The company was able to show that its purchase prices were below those paid by independent companies because it had the evidence to show that independent distributors operating outside Australia were paying comparable prices."
The ruling is a significant blow to the ATO.
Last year it was granted extra funding to enforce transfer pricing laws on companies trading over $250 million worth of goods per annum. It also recruited around 60 extra staff to focus solely on transfer pricing issues.
Middletons successfully acted for SNF Australia on both Federal Court judgments.
"This is a commonsense outcome to a very protracted case," said Middletons tax partner Philip Diviny. "It provides welcome relief to non-residents investing into Australia that the transfer pricing provisions will be interpreted commercially by Australian courts."