The deductibility of Sarbanes Oxley costs incurred by Australasian companies

Description
This paper aims to examine the nature of Sarbanes-Oxley (SOX) costs incurred by
subsidiaries ofUSAparent companies, and considers whether any value flows to non-USA subsidiaries.
Deductibility is analysed under both the general deductibility provisions and the transfer pricing
regimes of Australia and New Zealand

Accounting Research Journal
The deductibility of Sarbanes-Oxley costs incurred by Australasian companies
J ulie Harrison Mark Keating
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To cite this document:
J ulie Harrison Mark Keating , (2014),"The deductibility of Sarbanes-Oxley costs incurred by Australasian
companies", Accounting Research J ournal, Vol. 27 Iss 1 pp. 52 - 70
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The deductibility of
Sarbanes-Oxley costs incurred
by Australasian companies
Julie Harrison
Department of Accounting & Finance, University of Auckland,
Auckland, New Zealand, and
Mark Keating
Department of Commercial Law, University of Auckland,
Auckland, New Zealand
Abstract
Purpose – This paper aims to examine the nature of Sarbanes-Oxley (SOX) costs incurred by
subsidiaries of USAparent companies, and considers whether any value fows to non-USAsubsidiaries.
Deductibility is analysed under both the general deductibility provisions and the transfer pricing
regimes of Australia and New Zealand (NZ). Reference is also made to the Organisation for Economic
Cooperation and Development (OECD) transfer pricing guidelines and the US transfer pricing
regulations. Australasian and NewZealand subsidiaries of US parent companies frequently incur costs
related to their parent’s regulatory reporting requirements under the Sarbanes-Oxley Act of 2002. Tax
authorities, generally, view these costs as “shareholder activities”, i.e. activities performed for the
beneft of the parent only. As such, they are considered non-deductible to the subsidiaries of USA
parents because an independent party dealing at arm’s length would not pay to receive similar services.
We consider circumstances in which some costs may be deductible.
Design/methodology/approach – Legal analysis.
Findings – We conclude that there can be circumstances where these so-called shareholder activities
do provide value to subsidiaries and, accordingly, may (or should) be deductible in the local jurisdiction.
Research limitations/implications – This analysis is limited to a consideration of Australian, NZ,
OECD and US sources.
Practical implications – This paper provides an analysis of the deductibility of a type of
expenditure commonly encountered by subsidiaries of US parent companies.
Originality/value – Limited research is available that deals with this issue. In most cases, only
general statements on deductibility of similar types of expenditure are available to taxpayers.
Keywords Taxation, Transfer pricing, Deductions
Paper type Research paper
Introduction
In response to a number of high-profle accounting scandals that occurred in the USAin
the early 2000s[1], the Public Company Accounting Reform and Investor Relations Act
of 2002, also referred to as the Sarbanes-Oxley (SOX) Act[2]. was introduced to remedy
The authors would like to thank the anonymous reviewer and participants at the Corporate Law
Teachers Association Conference 2012, Bond University, Gold Coast, Australia, for their valuable
suggestions.
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1030-9616.htm
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Accounting Research Journal
Vol. 27 No. 1, 2014
pp. 52-70
©Emerald Group Publishing Limited
1030-9616
DOI 10.1108/ARJ-09-2013-0064
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perceived weaknesses in the governance and management of US public companies. The
SOX Act established the Public Company Accounting Oversight Board to regulate the
activities of public company auditors. It also introduced a wide range of newregulations
related to internal control, risk management and independence that applied to boards of
directors, company management, public company auditors and security analysts. In
particular, section 404 of the Act requires the management to assess and report on the
effectiveness of the company’s internal controls over its fnancial reporting, and this
report is required to be attested by external auditors. The overall objective of the
changes was to restore public confdence in the US securities market by improving the
accuracy and reliability of corporate fnancial disclosures.
The SOX Act has been criticised for the high compliance costs it introduced,
particularly those related to compliance with section 404 of the Act (Martin and Combs,
2010). There has been extensive research examining these costs and the impact of the
Act on various aspects of company and auditor performance, including corporate
governance, company risk-taking, share prices and fnancial disclosures (Cohen et al.,
2010). The types of costs incurred by public companies include internal labour costs,
external consultants’ fees, newtechnology and auditor attestation costs (Krishnan et al.,
2008). While much of this cost was incurred initially to set up new procedures and
systems to comply with SOX, non-trivial levels of cost continue to be incurred annually
by US public companies. Further, these compliance costs are often also borne by the
foreign subsidiaries of US companies and by foreign companies that issue securities in
US markets. For example, Australian and NewZealand (NZ) subsidiaries of US parents,
and Australasian incorporated companies that issue American Depositary Receipts,
have been found to incur signifcantly higher levels of audit costs than Australasian
companies not subject to the provisions of SOX (Salman and Carson, 2009).
While research has considered the costs and potential benefts of the SOXAct for US
and foreign companies from an accounting perspective, limited academic research has
considered the tax impact of these costs. The Australian and NZ revenue authorities
have addressed this issue to some extent. In particular, the NewZealand Inland Revenue
Department (IRD) considers that SOX costs will “probably” be non-deductible (IRD,
2013). This approach refects the Organisation for Economic Cooperation And
Development (OECD)’s views on intra-group service charges, as set out in its transfer
pricing guidelines (OECD TP Guidelines) OECD, 2010c). The OECD considers
compliance costs incurred by parent companies to be, generally, non-chargeable to
foreign subsidiaries. The rationale for this is that they relate to “shareholder activities”
that only beneft the parent.
Despite this superfcial response, we consider the deductibility of these compliance
costs to be more complex. In particular, in some cases, other benefts (in addition to
benefts of complying with SOX) fowto both the US parent and its foreign subsidiaries.
Accordingly, in this paper, we consider the nature of these possible benefts in light of
both the general deductibility rules for companies and the transfer pricing regimes of
Australia and NZ.
In the next section, we consider the nature of SOXcosts and discuss research that has
considered the level of these costs and their potential wider benefts. Next, we consider
the general tax deductibility rules, followed by a discussion of how the transfer pricing
rules affect the correct tax treatment for Australian and NZ subsidiaries of US parents.
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The paper concludes with a discussion of the circumstances in which we consider SOX
costs may be deductible for Australian and NZ subsidiaries.
SOX compliance costs
The main changes arising from SOX that affected US public companies related to new
requirements for board of director audit committees to increase their level of internal
monitoring, additional disclosures to be made about internal accounting controls, the
majority of boards to be outside directors and chief executive offcers (CEOs) and chief
fnancial offcers (CFOs) to personally certify accounting disclosures (Martin and
Combs, 2010). Each of these new requirements imposed additional compliance costs on
these US companies, particularly, where their existing internal controls were defcient
Christensen, 2005).
Level and types of costs
Based on survey information, Martin and Combs (2010) identifed the average
SOX-related audit fees as US$4.4 million, but noted that this fgure only includes direct
costs incurred with companies’ auditors and does not include indirect costs (Martin and
Combs, 2010). These indirect costs can include additional time spent by companies’
employees dealing with the variety of accounting frms for audit and consulting services
and frequent changes to auditors nowrequired. Further the changes have required new
systems for many companies to ensure compliance with the legislation, and additional
work is now required from auditors and consulting frms to attest to the value and
nature of work performed.
In addition, there may be opportunity costs associated with the SOX Act
implementation and the personal certifcation required by CEOs and CFOs. While this
certifcation should reduce risk-taking behaviour and the potential for new accounting
scandals, it also potentially reduces companies’ proftability, as management are more
likely to reject higher-risk projects with the potential to generate the greatest returns. A
recent study examined the potential impact of these indirect costs on company cash
fows and identifed an average decline of 1.3 per cent of total assets and that the
proftability of companies was affected up to four years following the introduction of the
SOX Act (Ahmed et al., 2010).
In addition, the US Securities and Exchange Commission (SEC) conducted a recent
study examining the costs related to compliance with section 404 of the Act (US
Securities and Exchange Commission, 2009). Using data from a survey of fnancial
executives from publicly listed companies, the study focused on the costs related to
section 404 and considered the impact of the 2007 amendments to this section. The main
fndings of the survey were that compliance costs increased with the size of the
company, decreased with the number of years a company had complied with the
regulations and decreased following the 2007 reforms.
In addition, while larger companies incurred higher absolute costs, smaller
companies had higher costs as a ratio of total assets. The types of compliance costs
identifed included internal labour and non-labour costs, external supplier costs and
increased external auditor fees. The largest portion of the increase in compliance costs
was attributed to increased internal labour costs (approximately 50 per cent of the total
increase), followed by increases in auditor fees (approximately 30 per cent of the total).
The mean (median) increase in costs before the 2007 reform was approximately US$2.8
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million (US$1.2 million), declining to US$2 million (US$900k) in the most recent (2008/
2009) fnancial reports[3].
Potential benefts
Determining and quantifying the benefts of the SOXAct are diffcult, given the number
and variety of confounding factors involved. Potential benefts include reductions in the
cost of capital for companies as a result of increased investor confdence and also the
possibility that for some companies, the introduction of the SOXAct acted as a catalyst
to help them avoid accounting scandals and their related costs (Martin and Combs,
2010).
In a recent SEC study, (US Securities and Exchange Commission, 2009) survey
participants froma range of different companies identifed improvements in the quality
of a company’s fnancial reporting, its internal controls and its ability to prevent and
detect fraud as direct benefts arising fromcompliance with the SOXAct. Further, these
survey participants were more positive about the benefts with the larger the company
they worked for, suggesting that benefts for large multinational groups are higher than
for smaller groups or stand-alone companies. However, most companies surveyed
considered compliance did not improve their ability to raise capital, increase investor
confdence in their fnancial reports, enhance the value of the company or improve the
liquidity of their company’s shares. In contrast, the SEC study also surveyed 30 users of
fnancial statements and obtained a different perspective on the potential benefts of
SOX compliance. The users considered the increased disclosures in relation to the
internal controls over fnancial reporting were benefcial, as they required management
to better understand its fnancial reporting risks, which allowed it to address internal
control defciencies more quickly.
The benefcial effects of SOX have also been considered in a recent NZ decision
involving allegations of tax avoidance resulting from international tax arbitrage, BNZ
Investments Limited v. CIR [2009] 24 NZTC 23,582. There the Judge noted (BNZ
Investments Limited v. CIR [2009] 25 NZTC 23,582):
Mr Shay explained that tax driven (or “tax aggressive”) transactions such as these were
commonplace in the late 1990s and early 2000s when the USA was in a cycle of tax shelters.
Four factors had combined to end this cycle. The frst was the requirement of the USA
Financial Accounting Standards Board that fnancial statements both disclose and make
provision against an uncertain tax position. The second was Sarbanes-Oxley, a USA Federal
lawenacted on 30 July 2002, a reaction to a number of large corporate and accounting scandals,
primarily Enron. Broadly, Sarbanes-Oxley requires greater attention to proper corporate
governance and fnancial reporting standards and procedures by the boards and management
of USA public companies, and public accounting frms acting for them.
So it seems that SOX has also played a (presumably benefcial) role in the reduction of
aggressive tax planning. However, the tax treatment of the resulting compliance costs
remains far from clear.
Tax treatment of SOX costs
The tax lawhas always been unsympathetic to regulatory compliance costs incurred by
taxpayers, including tax compliance itself. For instance, Lord Simonds in Smith’s Potato
Estates Ltd v. Bolland [1948] 2 All ER 367, p. 374 explained:
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[…] neither the cost of ascertaining taxable proft, nor the cost of disputing it with the revenue
authorities is money spent to enable the trader to earn proft in his trade. What proft he has
earned, he has earned before ever the voice of the tax gatherer is heard. He would have earned
no more and no less if there was no such thing as income tax.
That case was followed and applied in Australia in Cliffs International Inc v. FC of T
[1985] 85 ATC 4374 and FC of T v. Ryder [1989] 89 ATC 4250. In that latter case, the
Federal Court characterised legal expenditure on contesting a tax assessment thus:
Its essential character was to obtain a reduction in the amount of tax assessed […] it was not
incurred in gaining or producing the payment of the interest.
While this rationale strictly arose in respect of legal and accounting fees in determining
or contesting tax assessments, it has often been understood to apply more widely to
compliance costs generally. The deductibility of the cost incurred by taxpayers on
professional services is not determined in isolation but with respect to what those
services relate to. This long-standing principle was best explained in the Australian
High Court decision of Hallstroms Pty Ltd v. FC of T [1946] 8 ATD 190 where Dixon J
said:
The claimis to deduct legal expenses, and legal expenses, we may assume, take the quality of
an outgoing of a capital nature or of an outgoing on account of revenue from the cause or the
purpose of incurring the expenditure. We are, therefore, remitted to a consideration of the
object in viewwhen the legal proceedings were undertaken, or of the situation which impelled
the taxpayer to undertake them.
This decision has also been consistently followed in NZ, most recently by the Court of
Appeal in Fullers Bay of Islands Ltd v. C of IR [2006] 22 NZTC 19,716. Based on that
reasoning, in NZ, the IRD has published Interpretation Statement INS0033,
Deductibility of Company Administration Costs, Exposure Draft (21 October 2011).
That policy (Taxation Information Bulletin, 2011):
[…] considers whether a range of expenditure incurred by companies is deductible under the
Income Tax Act 2007. […] The expenditure is of a type that is incurred by companies as a
result of their inherent nature and the regulatory environment applicable to them. The costs
considered include audit fees […] costs of fling statutory returns, and associated legal and
accounting costs.
That exposure draft conceded that audit costs incurred in meeting local statutory audit
requirements for fnancial reporting purposes are generally deductible for income tax
purposes under the general permission[4] (i.e. on the grounds that it is a necessary cost
of running a business) but concluded that costs incurred in respect of group auditing
requirements and other internal management and reorganisational costs are not. Whilst
the appointment of an auditor may be a requirement of all companies under the
Companies Act 1993 and, therefore, superfcially not itself linked directly to the carrying
on of a business, the reality is that audit fees will generally only be incurred by
companies that are carrying on a business. It, therefore, reasoned that such audit fees
would be normally deductible as one of the costs of carrying on a business. Yet it failed
to apply the same reasoning with respect to overseas auditing requirements. The basis
for that conclusion was that such costs do not have the necessary nexus with the
operation of the taxpayer’s business in the local jurisdiction. As a result, the exposure
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draft insisted on a clear distinction between the two types of costs, and imposed
stringent record-keeping requirements to substantiate any apportionment.
The feedback on the exposure draft from the New Zealand Institute of Chartered
Accountants was critical (Ng, 2011). It stated:
In our viewthese conclusions: increase compliance costs for those who are able to comply with
the statement; will result in non-compliance by those who cannot practically allocate or
quantify the costs considered in the statement; increase the costs of raising equity; and create
boundary issues between deductible and non-deductible expenses (Ng, 2011, p. 2).
Perhaps given that feedback, the exposure draft has yet to be fnalised. However, it
provides an insight into the revenue authorities’ thinking regarding this type of internal
management expenditure.
The types of costs incurred by taxpayers in complying with the SOX are varied.
Systems and controls tests are likely to be carried out in a number of areas. The specifc
types of tests will depend upon the enterprise concerned, but the reports compiled of
these additional tests may be useful to local management to identify ineffciencies in
their internal systems and to introduce improvements to the business operations.
The cost of such strategic business planning is generally deductible on the grounds
that it is a necessary part of carrying on business, as confrmed in the House of Lord’s
decision in Regent Oil Regent Oil Co Ltd v. Strick (Inspector of Taxes) [1966] AC295 Lord
Reid, p. 324:
Abusiness cannot simply be managed on a day to day basis. There must be arrangements for
future supplies and sales, and it may not be unreasonable to look fve or six years ahead – one
hears of fve-year plans in various connections. So I would think that making arrangements for
the next fve or six years could generally be regarded as an ordinary incident of marketing and
that the cost of making such arrangements would therefore be part of the ordinary running
expenses of the business.
Under SOX compliance, benefts can accrue to the local subsidiary as well as to the US
parent. The reports produced as a result of the SOX compliance process may be relied
upon by a company’s external auditors for the purposes of auditing its fnancial
statements, which may directly reduce the amount of work and cost needed to perform
the local audit. So while the SOX requirements are detailed and specifc, the use of the
resulting reports may be more general.
The dual use of the types of information or professional services arising under SOX
demonstrates how items originally generated for one purpose (SOX compliance) may
often ultimately be used for another (general business) purpose. Case lawhas repeatedly
clarifed that the immediate purpose of the taxpayer when incurring expenditure does
not determine its deductibility. In Magna Alloys &Research Pty Ltd v. FC of T[1980] 80
ATC 4542, the Federal Court said (Magna Alloys &Research Pty Ltd v. FC of T[1980] 80
ATC 4547 Brennan AJ):
The question whether money is expended in and for the production of assessable income
cannot be determined by considering only the immediate reason for making a payment and
ignoring the purpose with which the liability was incurred.
Rather it is the outcome/s generated from that expenditure that is decisive (Lawson v.
Johnson Matthey plc [1992] 65 TC39). As a result, it is irrelevant that the SOX
expenditure may be incurred by a taxpayer to ensure its parent’s compliance with the
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US regulatory requirements. Rather, the test is what information or services were
acquired and how they were used by the local business.
More importantly, the courts have long considered that, within reason, it was for the
taxpayer itself to determine its necessary business expenditure. For instance, in FC of T.
v. Snowden &Willson Pty. Ltd. [1958] 99 C.L.R., p. 444, the court explained that “within
the limits of reasonable human conduct the man who is carrying on the business must be
the judge of what is ‘necessary’”. That reasoning was adopted by the Court in Magna
Alloys & Research Pty Ltd v. FC of T [1980] 80 ATC 4559, which stated:
The controlling factor is that, viewed objectively, the outgoing must, in the circumstances, be
reasonably capable of being seen as desirable or appropriate from the point of view of the
pursuit of the business ends of the business being carried on for the purpose of earning
assessable income. Provided it comes within that wide ambit, it will, for the purposes of sec.
51(1), be necessarily incurred in carrying on that business if those responsible for carrying on
the business so saw it.
So the decision by a local taxpayer to incur expenditure on additional fnancial
compliance for its parent to comply with its SOX obligations would appear to come
within this requirement.
Also noted by the Privy Council in the leading decision of B.P. Australia Limited v.
F.C. of T. [1966] A.C. 224, expenditure can often generate both revenue and capital
benefts. Where payments have a dual character, they are deductible in so far as they are
referable to revenue items and are not deductible to the extent that they are referable to
capital items (or another general limitation).
Unfortunately, in practice, the extent of the deduction available under an
apportionment is often problematic. This diffculty was frst identifed by the
Australian High Court in Ronpibon Tin NL&Tongkah Compound NLv. F.C. of T[1949]
78 C.L.R. 47:
The actual expenditure in gaining the assessable income, if and when ascertained, must be
accepted. The problem is to ascertain it by an apportionment […]. The question of fact is
therefore to make a fair apportionment of each object of the companies’ actual expenditure
where items are not in themselves referable to one object or the other. But this must be done as
a matter of fact […].
The leading case on apportionment of expenditure in NZ is the Court of Appeal decision
in Buckley & Young Ltd. v. CIR [1978] 3 NZTC 61,271 which re-stated the problem
identifed in Ronpibon Tin:
[…] it is impossible to prescribe any precise formula applicable to all cases. Each such case
depends on its own circumstances. It is the yardstick of factual use, or availability for use for
business purposes, that satisfes the requirements that the apportionment must be fair, not
arbitrary, and must be done as a matter of fact […].
The need to fnd a practical solution to this problemwas identifed by Cooke J in Duggan
v. C. of I.R. [1973] 1 N.Z.L.R. 682, 686 where the Court held the onus of proof must be
applied in a broad and common sense way, rather than requiring absolute precision
fromthe taxpayer. So the taxpayer need only point to some intelligible basis upon which
a positive fnding can be made that a defned part of the total sumis deductible (Barron
Fishing Ltd v. C of IR [1997] 18 NZTC 13,059).
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It is clear that some factual basis must be provided by the taxpayer to justify an
apportionment of SOX expenditure. However, the cases make it clear that neither the
taxpayer nor the Commissioner can simply adopt a “short cut” or make an “arbitrary”
apportionment. For instance, in Buckley & Young, the taxpayer was not permitted to
claim 50 per cent of an expense simply on the ground that it produced two separate
outcomes, one of which was deductible. Likewise, in Ronpibon Tin, the court rejected a
fat 2.5 per cent deduction as being “a more or less arbitrary expedient”.
Signifcantly, where precise grounds for apportionment are impossible, the taxpayer
need not be precise but must merely establish a basis that is more reasonable or accurate
than the Commissioner. For instance, in New Zealand Co-operative Dairy Co Ltd. v. C of
IR[1988] 10 NZTC 5,215, the Court accepted that the proposed method of apportionment
used by the Commissioner was “less reasonable, likely to have a more arbitrary effect
and certainly no more closely related to accepted accounting principles and commercial
practices” than that adopted by the taxpayer. But this lack of certainty in apportioning
SOX costs to the local subsidiary’s business under the general deductibility rules is
unsatisfactory. It is clear that some portions of the SOX costs should be permitted as a
deduction, but it is diffculty to qualify. Accordingly, taxpayers may turn to other
specifc provisions to support deduction.
Tax treatment of accounting and legal services
Both the Australia and NZ tax legislation contains specifc categories of allowable
deduction in respect of certain types of accounting and legal expenses that would not
otherwise be permitted. In some instances, those provisions may provide alternative
grounds for deductibility of SOX costs.
Tax-related expenditure
Section 25-5 of the Income Tax Assessment Act, 1997 allows a deduction for “tax-related
expenditure”. This encompasses expenses incurred by a taxpayer in managing their
own tax affairs or in complying with a legal obligation in relation to another entity’s tax
affairs. It includes the costs of preparing and fling tax returns, and any objection to a
subsequent assessment. The equivalent NZ provision is Section DB3(1) of the Income
Tax Act, 2007, which permits a deduction for costs incurred “in connection with […]
calculating or determining the income tax liability for the income year”.
However, courts in both countries have generally adopted a narrowinterpretation of
those provisions, limiting them to costs incurred directly in preparing the taxpayers
annual return or subsequent objection, and have refused to permit any deduction for
expenditure that was “only related to preparatory matters for the calculation” of that tax
liability (Case E84 [1982] 5 NZTC 59,441). At a minimum, the NZ courts have insisted
(Yurjevich v. C of IR [1991] 13 NZTC 8,185):
[…] there must be some link, or a connection in some way, between the expenditure and the
preparation institution or presentation of the objection […]. There must, it seems to me, be a
link or connection which is suffciently close [so] […] that it can reasonably be said that the
expenditure was incurred in connection with it.
Signifcantly, however, the court expressly acknowledged that, in some cases, “a
question of apportionment might well arise”, (Bartlett v. FCT [2003] 23 ATC 4962;
Falcetta v. FC of T [2004] ATC 4514) although the onus of substantiating that
apportionment falls always on the taxpayer (Drummond v. FC of T [2005] ATC 4783).
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Accordingly, SOXreporting costs related to items that assist with the preparation of the
resident company’s tax return may qualify for partial deduction under this provision.
Interestingly, the Australian courts have also indicated that expenditure on business
and tax planning that does not qualify for deduction under Section 25-5 may,
nevertheless, still be deductible under the general provisions.
Legal fees
In NZ, section DB 62 of the Income Tax Act, 2007 permits a blanket deduction for
otherwise non-deductible legal expenses of up to $10,000 per year. This provision was
introduced in 2009 to ameliorate the extent of non-deductible black-hole legal
expenditure suffered by taxpayers. This provision is extremely wide in nature,
potentially applying to any type of advice or assistance provided by a solicitor and,
therefore, would encompass the frst $10,000 of legal services in respect of SOX
compliance. As such, it has already been contrasted with the uncapped but narrowrules
imposed on accounting and tax return services. In fact, this inconsistency has already
drawn complaints fromthe NewZealand Institute of Chartered Accountants (Ng, 2011):
[…] some readers [of the exposure draft] may interpret the discussion of s DB62 as providing
an incentive to taxpayers to engage the services of a lawyer, rather than an accountant. In some
cases that may not be appropriate or in the best interests of the taxpayer. To retain neutrality
we suggest a statement to this effect be added to the analysis.
There is no Australian equivalent specifcally permitting deduction of legal fees but
Section 40-880 of the Income Tax Assessment Act, 1997 would allow for amortisation
over fve years of certain types of capital professional expenses incurred in relation to a
taxpayer’s business. The requirements under that section are merely that the
expenditure has a direct or indirect connection to that business[5]. The criteria “in
relation to” has been interpreted widely by the courts in most circumstances so would
presumably encompass compliance costs imposed on the business by virtue of its
ownership structure (First Provincial Building Society Limited v. FC of T[1995] 95 ATC
4145).
Unfortunately there remains a lack of guidance on how Section 40-880 applies to
expenditure incurred by Australian companies in relation to members of the group
overseas. Taxpayer groups have called for more clarity regarding a basis of
apportionment where expenditure produces benefts for both the Australian company
and the group overall[6]:
[…] expenditure on professional services incurred by ResCo must be apportioned as it relates
to the incorporation and listing of the overseas entity as well as the business that will continue
to be conducted by ResCo. However, no guidance is provided on how a fair and reasonable
apportionment is to be performed. The objects that the expenditure is designed to achieve
appear to be qualitative in nature unless the apportionment can be performed by reference to
the expected future profts to be derived by the overseas entity and the business carried on by
ResCo over, say, the next fve years.
Accordingly, it appears that taxpayer groups on both sides of the Tasman consider that
SOX costs may be at least partially deductible for tax under the general deductibility
rules and/or the specifc rules related to accounting and legal expenses. While the fees do
not directly relate to the taxpayer’s business operations, they may provide secondary
benefts that assist the taxpayer’s business generally, which would warrant deduction.
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However, given that this expenditure arises because of a taxpayer’s membership of a
US-owned multinational group, consideration must also be given to the applicable
transfer pricing rules.
Transfer pricing rules for services
OECD approach to service charges
The Australian and NZ transfer pricing rules are broadly based on the OECD’s transfer
pricing model. The OECD advocates the use of the “arm’s length principle” to price
transactions cross-border between related parties. The arm’s length principle is
contained in Article 9 of the OECD’s (2010a) Model Tax Convention, and requires the
profts arising from transfer pricing transactions to be the same as would occur in
similar transactions between unrelated parties. The OECDtransfer pricing guidelines[7]
(OECDGuidelines) provide the internationally agreed principles on howto determine an
arm’s length price. Accordingly, where a transfer pricing transaction exists, the pricing
is required to be determined in a manner consistent with the arm’s length principle.
The OECD Guidelines provide fve methods for setting arm’s length prices: the
Comparable Uncontrolled Price (CUP) method, Resale Price method, Cost Plus method,
Proft Split method and Transactional Net Margin Method. These methods calculate
transfer prices with reference to either the prices or profts that should be earned for the
functions performed, risks undertaken and assets contributed by the related parties to
the transfer pricing arrangements. The guidelines also specifcally discuss the
treatment of transfer pricing transactions that involve the provision of intra-group
services (OECD, 2010b). Two key issues arise in relation to the analysis of intra-group
service arrangements. First, it is necessary to determine whether a valuable (chargeable)
service has been provided. Second, if a valuable service has been provided, it is then
necessary to determine an arm’s length price for the service. Both these issues need to be
examined when determining the deductibility of SOXcosts charged by a US parent to its
subsidiary and also whether the local subsidiary needs to charge its US parent for any
SOX costs it incurs[8].
In determining whether a chargeable service has been provided, the OECD requires
that “the activity provides a respective group member with economic or commercial
value to enhance its commercial position”[9]. This test requires that the service provided
must be one that an unrelated party in similar circumstances would be prepared to pay
for or to performfor itself. Therefore, the frst hurdle for SOXcosts to be deductible to a
subsidiary under the arm’s length principle is demonstrating that some beneft or value
has been received or is expected to be received by the subsidiary. Notably, this test only
requires that an unrelated party in “comparable circumstances” would pay for the
service. This allows for the possibility that SOX costs could be deductible to one
subsidiary but not another, depending on the particular facts and circumstances. For
example, SOXcosts might relate to the implementation of a newinternal control system
that complies with SOX. One subsidiary might currently have inadequate internal
controls, and the implementation of a new system will provide a valuable economic
beneft. In contrast, another subsidiary might already have a sophisticated system,
albeit one that is not in compliance with SOX, in which case, the change in system will
provide no economic beneft.
Where an intra-group service is provided because one member of the group requires
that service and would be willing to pay an independent supplier to receive it, then the
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service will be chargeable. However, the OECD Guidelines specifcally identify a group
of services that do not provide valuable benefts to the recipient and are only provided
because of the shareholding of the provider. These services are considered
non-chargeable because they relate to a “shareholder activity”, defned as:
An activity which is performed by a member of an MNE [multinational enterprise] group
(usually the parent company or a regional holding company) solely because of its ownership
interest in one or more other group members, i.e. in its capacity as shareholder[10].
The guidelines do not specifcally mention SOX costs, but examples of shareholder
activities are provided:
a) Costs of activities relating to the juridical structure of the parent company itself, such as
meetings of shareholders of the parent, issuing of shares in the parent company and costs of
the supervisory board;
b) Costs relating to reporting requirements of the parent company including the consolidation
of reports;
c) Costs of raising funds for the acquisition of its participations [11].
As legislative compliance costs, SOXcosts could be considered to fall within (b) above as
costs relate to reporting requirements. In particular, at least some of the costs incurred
by companies may relate to the additional reporting disclosures required under SOX.
However, the OECD makes it clear that not all activities that a parent or other holder
company perform will be regarded as a “shareholder activity”. In this regard, they
consider shareholder activities are only a subset of the wider “stewardship activities”
that may be provided, some of which will be chargeable:
[…] [shareholder activity is] distinguishable from the broader term “stewardship activity”
used in the 1979 Report. Stewardship activities covered a range of activities by a shareholder
that may include the provision of services to other group members, for example services that
would be provided by a coordinating centre. These latter types of non-shareholder activities
could include detailed planning services for particular operations, emergency management or
technical advice (trouble shooting), or in some cases assistance in day-to-day management[12].
These non-shareholder activities include a variety of value-adding services provided by
a parent to its subsidiaries. For example, the guidelines identify planning services,
emergency management, technical advice, assistance in day-to-day management and
assisting in raising funds for use by a subsidiary as stewardship activities that are not
shareholder activities[13]. Therefore, under the OECD Guidelines, SOX costs could be
potentially regarded as related to chargeable stewardship activities if it can be
demonstrated that the subsidiary being charged has received a valuable beneft.
If it can be determined that a chargeable service has been provided, the next step is to
determine the arm’s length price. The OECD Guidelines distinguish between two
methods of charging for services. The “direct-charge method”[14] is appropriate, where
the service provider also provides similar services to third parties. For example, an
engineering company that provides consulting services to unrelated clients and to its
subsidiaries. In such cases, a CUP method could be used to set the transfer price at the
same level as the price charged to independent customers. However, the OECD
acknowledges that, in most cases, this approach will not be possible, as the services are
only provided to related parties. Accordingly, an “indirect-charge method”[15] will be
necessary that uses some form of cost allocation. If an indirect-charge method is used,
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the guidelines require that the cost allocation used refect the facts and circumstances of
the arrangement and the charge itself should be reasonable for the level of service
provided[16].
When using an indirect-charge method, it is likely the Cost Plus method will be used
to set the transfer price. This method requires the transfer price to be set equal to the
third-party costs incurred by the service provider plus an appropriate arm’s length
margin. This raises the question of whether the provider should earn a proft (the “plus”
added to the costs of providing the service). The OECDGuidelines suggest that, in most
cases, it will be appropriate for a proft to be included. However, in limited cases it may
be that the service provider is, in essence, acting as an agent acquiring the services from
an unrelated party, e.g. a new computer system might be developed and installed by a
third-party contractor with the purchase contract between the supplier and the parent. If
the system is made available to subsidiaries and the parent performed no additional
services in relation to developing the system, it could be argued this is an instance where
the parent is effectively acting as an agent for the group. As such, the cost to group
members should be allocated without the addition of a proft for the parent. Similarly, if
a subsidiary requested its local auditor to provide the required attestations under the
SOX Act and is billed for that service, assuming the subsidiary receives no beneft, it
might be appropriate to recharge the auditor’s cost without a mark-up to the US parent,
as the cost itself is arm’s length. This would be equivalent to the auditor charging the
parent directly. In this regard, the guidelines state:
When an associated enterprise is acting only as an agent or intermediary in the provision of
services, it is important in applying the cost plus method that the return or mark-up is
appropriate for the performance of an agency function rather than for the performance of the
services themselves. In such a case, it may not be appropriate to determine arm’s length pricing
as a mark-up on the cost of the services but rather on the costs of the agency function itself, or
alternatively, depending on the type of comparable data being used, the mark-up on the cost of
services should be lower than would be appropriate for the performance of the services
themselves[17].
In summary, the analysis of the OECD Guidelines support the charging of SOX
compliance costs to a local subsidiary where it can be shown that a valuable economic
beneft is received by the subsidiary. Whether there is such a beneft will depend on the
nature of the services received and the particular facts and circumstances of the
subsidiary. As such, the guidelines do not support a blanket exclusion of SOX costs.
IRD view of SOX services
The IRD’s position is that, in most cases, costs related to complying with SOX are not
deductible to NZ subsidiaries because they are shareholder activities. In this regard, the
IRD’s has stated:
Be wary of charges for directors/chief executives (doing no more than investment monitoring),
and overseas regulatory costs (for instance, Sarbanes Oxley compliance costs)-these are most
probably non-chargeable “shareholder services”(Nash, 2011; IRD, 2011).
Expanding on this, the IRDNational Transfer Pricing Advisors have made a number of
comments regarding the deductibility of SOX costs and the department’s view that
these costs relate to shareholder activities. In particular, in discussing emerging issues
in NZ transfer pricing enforcement:
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Other Compliance Costs: We are also reviewing several expenditure claims arising fromcosts
incurred by local subsidiaries in complying with offshore legislation such as the Sarbanes
Oxley provisions in the USA. Prima facie, we consider such costs to be in the nature of
shareholder services. Put shortly, the expenditure would not have been incurred by a third
party stand alone operation in NZ were it not for the shareholder relationship (Nash and
Edwards, 2005).
This view was reiterated recently:
Regulatory costs of the shareholder that do not provide specifc benefts to the NZbusiness, are
costs that an independent enterprise would not have been willing to pay for and would not
have performed in-house itself in comparable circumstances. Therefore, these costs do not
meet the central intra-group services test (Nash and Rakete, 2011).
Accordingly, there is a high probability that on audit, NZ taxpayers will have
SOX-related charges froma US parent treated as non-deductible. It is less clear whether
a similar approach will be taken in relation to any activities performed by a NZ
subsidiary in relation to providing information to its US parent or updating its systems
to be SOX-compliant. Technically, if these are “shareholder activities” undertaken by
the subsidiary on behalf of its parent, then the NZ subsidiary should charge the US
parent an arm’s length price for performing those services. Therefore, NZtaxpayers face
two possible risks in relation to SOX costs:
(1) Costs charged by the USA parent to its NZ subsidiary in relation to the USA
parent’s compliance obligations under SOX are non-deductible to the NZ
subsidiary. The rationale being that the activities giving rise to these costs do
not provide a valuable beneft to the NZ subsidiary.
(2) Any costs incurred by the NZ subsidiary in relation to assisting its US parent to
meet its compliance obligations under SOX, including the cost of employees
engaged in performing activities necessary to assist the US parent, should be
charged by the NZ subsidiary to its US parent at an appropriate arm’s length
price. The rationale being that the activities performed by the NZ subsidiary
provide a valuable beneft to the US parent, but no beneft to the local subsidiary
performing the service.
Australian Taxation Offce view of SOX services
The Australian Taxation Offce (ATO)’s view on the appropriate treatment of
intra-group services under Australia’s transfer pricing regime[18] is covered by its
taxation ruling issued in 1999[19]. As this ruling pre-dates SOX, there is no specifc
mention of the deductibility of these costs. The ATO’s requirements are consistent with
the OECD Guidelines. In particular, the ruling splits intra-group services into
“chargeable services” and “non-chargeable services”. Chargeable services include
services that are integral to the core business of the group, and also those that help
facilitate the business of the group[20]. Non-chargeable services are defned to include
any functions performed by one group member “exclusively for its own beneft”,
including “shareholder activities” performed in the member’s capacity as
shareholder[21]. Similar to the OECD Guidelines, the defnition notes that
non-chargeable services include those that a third party would not pay to receive and a
distinction is drawn between “shareholder activities”, which are non-chargeable, and
“stewardship activities”, which are chargeable, with examples of both provided:
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For example, in a decentralised MNE group where the parent company’s involvement is
limited to monitoring performance of subsidiaries, preparation of consolidated statutory
accounts and attendance at annual general meetings of subsidiaries, there would be unlikely to
be any identifable activity that provides suffcient beneft to the subsidiaries to warrant a
charge by the parent company. On the other hand, a parent company that actively participates
in the management and/or operations of subsidiaries, e.g. centralised coordination and control
of fnancial management of the group, marketing and on-call services, cannot be viewed as a
shareholder acting solely in its own interests[22].
Further, where a member of the group provides both chargeable and non-chargeable
services, the ATO notes an apportionment is both allowable and necessary:
Care needs to be taken, where a foreign company is performing a mixture of chargeable and
non-chargeable activities, that a charge for the latter is not simply subsumed within a charge
for the chargeable activities. On the other hand, in this type of situation care is also needed not
to reduce arbitrarily what might be an arm’s length charge for the services that are being
provided[23].
In this regard, the ruling provides that the method used to make the apportionment
between chargeable and non-chargeable costs need only be based on appropriate
accounting principles:
The ATO will accept reasonable efforts to determine the extent of chargeable and
non-chargeable activities within the limitations of the taxpayer’s accounting system.
Taxpayers are not expected to pursue greater accuracy at all costs but to base their analysis on
what would normally be required in ‘a proper application of the recognised principles of
costing to the particular circumstances’ (Kitto J in BP Refnery (Kwinana) Ltd v. FC of T(1960)
12 ATD 204 at 208; [1961] ALR 52 at 57)[24].
Accordingly, the ATO’s treatment of SOX-related costs is likely to be similar to the NZ
approach, given that both follow the OECD Guidelines. However, in the absence of a
statement specifcally addressing the treatment of SOXcompliance activities, there may
be a lower risk of the ATO applying a blanket exclusion to these costs.
US service regulations
The US transfer pricing rules related to services transactions are contained in the
Section 482 of the Services Regulations. These regulations are comparable to the OECD
Guidelines, but with some notable differences in terminology. The equivalent to
“chargeable services” is “controlled service transactions”. These are services that a US
company is required to charge to any affliate it provides services to (Baker and
McKenzie, 2012)[25]. “Non-chargeable services” primarily consist of “stewardship
activities” defned as those activities where the only effect is to protect the shareholder’s
investment or comply with US legal requirements. These services will not, normally, be
chargeable to subsidiaries as controlled service transactions. In particular, as one
commentator explains:
Examples of activities that relate to compliance with legal requirements include the
preparation and fling of items required by law in the parent company’s country. These items
could include periodic reports such as proft and loss statements, balance sheets, and other
material fnancial information concerning the company’s operations that is required by law.
When these types of activities relate solely to the parent’s compliance with reporting, legal, or
regulatory requirements, and when they do not replace the subsidiary’s local country legal
requirements, they are generally considered stewardship. A common item identifed in this
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category in USA-headquartered multinationals is Sarbanes-Oxley (SOX) activities. Unless the
SOX activities are implemented in such a way that the foreign subsidiaries receive a
measurable beneft (e.g. their effciencies are signifcantly enhanced and one can fnd some
objective measure of such improvement), these are usually considered stewardship (Male,
2008).
In determining whether a measurable beneft has been provided, Section 1.482-9(1) of the
Services Regulations provides a threshold test. In general, an activity is considered to
provide a beneft if it results in a “reasonably identifable increment of economic or
commercial value” or is expected to increase the value of intangible property for the
recipient of the service[26]. Further, the defnition provides that if in comparable
circumstances, an independent party would be willing to pay to receive the same service
it can be considered to provide a beneft. This treatment is consistent with the OECD’s
approach and supports the chargeability of some stewardship costs where they relate to
activities that beneft both the parent and subsidiary. However, where services only
provide an indirect or remote beneft or if the services duplicate an activity performed by
the subsidiary, then they are not considered to provide a beneft.
Stewardship activities encompass both duplicate services and “shareholder
activities”, as defned below. Generally, these are not considered to provide a valuable
beneft to the service recipient:
An activity is not considered to provide a beneft if the sole effect of that activity is either to
protect the renderer’s capital investment in the recipient or in other members of the controlled
group, or to facilitate compliance by the renderer with reporting, legal, or regulatory
requirements applicable specifcally to the renderer, or both. Activities in the nature of
day-to-day management generally do not relate to protection of the renderer’s capital
investment. Based on analysis of the facts and circumstances activities in connection with a
corporate reorganisation may be considered to provide a beneft to one or more controlled
taxpayers[27].
While the US regulations include some differences in wording, in essence, the same
approach as under the OECD, Australia, and NZ rules is required. Therefore, the main
hurdle in supporting the deductibility of SOXcosts will be providing suffcient evidence
that the activities provide more than incremental benefts to the subsidiaries. If this is
the case, the IRS would expect the US parent to charge an arm’s length amount for those
benefts. Similarly, if the foreign subsidiary incurs SOX costs directly, the IRS might
require an apportionment of the costs between the subsidiary and the US parent if it
considers that measurable benefts are received by both parties. Accordingly, double
taxation could arise if there is a disagreement between the US and foreign tax authorities
over the value of the benefts.
Conclusion
We consider determination of the correct treatment of SOX compliance costs is
fact-dependent and should refect both the nature of the activities performed and the
circumstances of the US parent and local subsidiary. In particular, neither the general
deductibility provisions nor the transfer pricing regime provide defnitive rules for the
tax treatment of the deductibility of these costs to the local subsidiary. However, the
alternative of treating these costs simply as a black-hole expenditure seems
inappropriate, especially given the potential benefts that indirectly arise for the
taxpayer’s business.
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We consider SOX compliance costs should be deductible to the local subsidiary if a
valuable beneft relating either to increases in local effciency or decreases in local cost
can be demonstrated. This would satisfy both the general deductibility rules related to
business expenditure incurred as a necessary cost of running a business and the transfer
pricing rules related to shareholder services. It would be better for the Revenue
Authorities in both countries to adopt clear and reasonable guidelines for taxpayers
over the treatment of these costs. For example, rather than provide a blanket exclusion,
guidance on this issue could consider ways a business could demonstrate how
improvements in reporting and accounting systems required for SOX compliance also
create increases in effciency or lower cost. This could be done by showing either
reductions in risk (e.g. refected in improvements in access to borrowing or insurance),
improvements in decision-making and internal controls (e.g. refected in reductions in
internal or external audit queries) or reductions in costs at the local level (e.g. related to
reduced accounting infrastructure costs arising from improved computer systems). In
addition, such guidance would need to consider howqualitative benefts or benefts that
relate to future proftability could be incorporated into such an analysis. The present
vacuum of uncertainty is unacceptable.
Notes
1. Most notably, the scandal and subsequent failure of Enron and WorldCom.
2. Also known as the “Corporate and Auditing Accountability and Responsibility Act” in the US
House of Representatives.
3. US Securities and Exchange Commission, 2009, Table 8, pp. 43-44. These fgures relate to
companies required to be compliant with both sections 404(a) and 404(b) of the Act.
4. Section DA1 NZ Income Tax Act 2007. The Australian equivalent is s 51(1) Income Tax
Assessment Act 1936 and s 8(1) Income Tax Assessment Act 1997.
5. Australian Taxation Offce, Taxation Ruling, TR 2011/6, “Income tax: business related
capital expenditure - section 40-880 of the Income Tax Assessment Act 1997 core issues”,
2011.
6. Joint Submission on Draft Taxation Ruling TR 2010/D7 (Income tax: business related capital
expenditure – section 40-880 of the Income Tax Assessment Act 1997 core issues) by CPA
Australia, the Institute of Chartered Accountants in Australia, National Institute of
Accountants, the Taxation Institute of Australia, and Taxpayers Australia, 11 February
2011, at 1.2.
7. In addition, reference in this paper is made to the 1995 version of these guidelines. To
distinguish the versions they will be referred to as the 2010 OECD Guidelines and the 1995
OECD Guidelines.
8. In this regard, the OECD Guidelines (paragraph 7.18) specifcally note that “the absence of
payments or contractual agreements does not automatically lead to the conclusion that no
intra-group services have been rendered”.
9. In this regard, the OECD Guidelines (paragraph 7.6) specifcally note that “the absence of
payments or contractual agreements does not automatically lead to the conclusion that no
intra-group services have been rendered”.
10. In this regard, the OECD Guidelines (Glossary, p. 29) specifcally note that “the absence of
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payments or contractual agreements does not automatically lead to the conclusion that no
intra-group services have been rendered”.
11. In this regard, the OECD Guidelines (paragraph 7.10) specifcally note that “the absence of
payments or contractual agreements does not automatically lead to the conclusion that no
intra-group services have been rendered”.
12. In this regard, the OECD Guidelines (paragraph 7.9) specifcally note that “the absence of
payments or contractual agreements does not automatically lead to the conclusion that no
intra-group services have been rendered”.
13. In this regard, the OECD Guidelines (paragraphs 7.9 and 7.10) specifcally note that “the
absence of payments or contractual agreements does not automatically lead to the conclusion
that no intra-group services have been rendered”.
14. In this regard, the OECD Guidelines (paragraph 7.21) specifcally note that “the absence of
payments or contractual agreements does not automatically lead to the conclusion that no
intra-group services have been rendered”.
15. In this regard, the OECD Guidelines (paragraph 7.23) specifcally note that “the absence of
payments or contractual agreements does not automatically lead to the conclusion that no
intra-group services have been rendered”.
16. In this regard, the OECD Guidelines (paragraph 7.23.) specifcally note that “the absence of
payments or contractual agreements does not automatically lead to the conclusion that no
intra-group services have been rendered”.
17. In this regard, the OECD Guidelines (paragraph 7.36) specifcally note that “the absence of
payments or contractual agreements does not automatically lead to the conclusion that no
intra-group services have been rendered”.
18. Contained in Division 13 of Part III of the Income Tax Assessment Act 1936.
19. Australian Taxation Offce, Taxation Ruling, TR 1999/1, “Income Tax: International
Transfer Pricing for Intragroup Services”, 1999.
20. Australian Taxation Offce, Taxation Ruling, TR 1999/1, “Income Tax: International
Transfer Pricing for Intragroup Services”, 1999, paragraph 6.
21. Australian Taxation Offce, Taxation Ruling, TR 1999/1, “Income Tax: International
Transfer Pricing for Intragroup Services”, 1999, paragraph 25.
22. Australian Taxation Offce, Taxation Ruling, TR 1999/1, “Income Tax: International
Transfer Pricing for Intragroup Services”, 1999, paragraph 27.
23. Australian Taxation Offce, Taxation Ruling, TR 1999/1, “Income Tax: International
Transfer Pricing for Intragroup Services”, 1999, paragraph 29.
24. Australian Taxation Offce, Taxation Ruling, TR 1999/1, “Income Tax: International
Transfer Pricing for Intragroup Services”, 1999, paragraph 46.
25. See Baker & McKenzie (2012) for a discussion of how the US regulations apply to the
calculation of an arm’s length price for controlled services transactions.
26. Section 1.482-9(l)(3)(i) of the Services Regulations for Section 482 of the Internal Revenue Code.
27. Section 1.482-9(l)(3)(iv) of the Services Regulations for Section 482 of the Internal Revenue
Code.
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Corresponding author
Julie Harrison can be contacted at: [email protected]
To purchase reprints of this article please e-mail: [email protected]
Or visit our web site for further details: www.emeraldinsight.com/reprints
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