13 September, 2017
Chevron has settled its High Court appeal against a decision which held it liable to pay an estimated A$340m
What you need to know
Chevron has settled its appeal against the decision of the Full Federal Court in April that found its related party financing arrangement fell within Australia's transfer pricing rules.
The Full Federal Court decision provides significant guidance on the interpretation of the "arm's length principle", in particular on the meaning of "consideration" and the degree to which a subsidiary can be treated as independent of its parent.
Multinational companies with cross-border related party financing arrangements in Australia should take note of the decision and the surrounding developments to review their historic and future arrangements.
Background
Chevron Australia Holdings Pty Ltd (CAHPL) has settled its High Court challenge to the decision of the Full Federal Court of Australia in Chevron Australia Holdings Pty Ltd v Commissioner of Taxation [2017] FCAFC 62(Chevron) after settling with the ATO for an undisclosed sum.
The ATO has signalled a renewed focus on transfer pricing and has estimated that the decision could bring in up to an additional A$10bn in revenue over the next 10 years from related party financing arrangements.
Full Federal Court Decision
Relevant transfer pricing rules
The relevant transfer pricing rules that were the subject of the dispute in Chevron were the former Division 13 of the Income Tax Assessment Act 1936 (ITAA 36) and the provisions of Division 815-A of the Income Tax Assessment Act 1997 (ITAA 97) (both of which ceased to have effect from 1 July 2013).
Although this dispute concerned the "old" transfer pricing rules, which do not have continued operation going forward, the court's discussion of the "arm's length principle" will be useful in interpreting similar concepts under the current transfer pricing rules in Division 815 of the ITAA 97.
Chevron's inter-company loan
The dispute centred around a US$2.5bn loan from Chevron Texaco Funding Corporation (CFC) to CAHPL at the interest rate of LIBOR plus 4.14%. At times, this rate exceeded 9%. CAHPL provided no guarantee or security for the loan and there were no financial or operational covenants that bound CAHPL to conduct its business in a particular way. CFC raised the funds by issuing commercial paper in the United States, for which it paid interest at rates which were less than the interest rates on the loan from CFC to CAHPL.
The ATO claimed that CAHPL's interest deductions on the loan exceeded an arm's length amount. In response, Chevron argued that the interest amounts were not excessive because the cost of finance for a similar loan (with no guarantee, security or financial or operational covenants) could reasonably be expected to exceed 9%.
Decision
In determining whether the parties had dealt with each other at arm's length, the court found it necessary to account for actual commercial realities when pricing the loan.
For the purposes of applying the relevant transfer pricing rules, the court held that an arm's length borrower should be assumed to be independent from the lender, but not necessarily from its multinational group. In other words, the borrower is not assumed to be an "orphan" and assessed as a stand-alone entity divorced entirely from its parent or wider group. This means, for example, that matters such as the availability of a guarantee from a multinational parent may be a relevant factor in determining the arm's length interest rate on a loan.
The court also held that the "consideration" provided for a loan is not limited solely to the interest rate but can include such matters as the giving of security, financial covenants or a guarantee by a parent company. In the court's view, in a hypothetical arm's length agreement, a borrower of CAHPL's standing would have offered something additional (eg security, covenants, guarantee) for the loan to obtain the best possible interest rate it could. The absence of those elements meant that the actual loan between the parties, which contained none of those elements, was not an arm's length agreement.
The impact of the court's decision is that, in determining an arm's length rate of interest, one needs to hypothetically assume an agreement with arm's length terms – one does not take the actual agreement between the parties and determine an interest rate based on those terms if that agreement does not in fact reflect an arm's length agreement. This means, for example, that parties cannot charge a high interest rate on a loan by offering limited lender protections and a higher rate of interest reflecting the increased risk associated with such a loan, where that type of arrangement would not reasonably be expected to be seen in an arm's length agreement.
Take Aways
The key message from the Chevron decision is that Australian courts will not interpret transfer pricing rules "pedantically" and that the ATO may take a "rational and commercially practical" approach in pricing related party arrangements. In construing what an arm's length arrangement would be, the idea that a Court can assume that a parent would provide a guarantee to reduce the cost of finance for its subsidiary is also a significant development.
Similarly, the fact that the courts are prepared to "rewrite" the terms of an agreement to determine the arm's length price means that taxpayers cannot simply assume that the terms of inter-company agreements (other than price) will be respected, and will need to price arrangements based on hypothetical arm's length terms for matters other than just the price.
Taxpayers should therefore review their intra-group arrangements and supporting documentation and consider whether the actual terms of such arrangements would be sustainable between independent parties in the real commercial world.
The ATO's success in the Full Federal Court and the settlement of the appeal form part of a renewed focus upon related party arrangements. Draft Practical Compliance Guideline PCG 2017/D4 has since been released, signalling the ATO's approach to cross-border related party financing arrangements. The ATO has also indicated that a number of taxpayers have already begun restructuring as a result of the Chevron decision.
Taxpayers should review both historic and future arrangements in light of the decision and monitor any updated guidance, rulings or other developments from the ATO.
For further information, please contact:
Ian Kellock, Partner, Ashurst
ian.kellock@ashurst.com
