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14 December, 2017
INSIGHTS
The Chevron decision represents a significant transfer pricing win for the Australian tax authorities that could impact on many existing and future cross-border arrangements with related parties.
The Full Federal Court was prepared to "rewrite" the terms of the taxpayer's loan agreement to determine the arm's length price, demonstrating that it cannot be assumed that the terms of intercompany agreements (other than price) will be respected when courts apply the Australian transfer pricing provisions. That is, taxpayers will need to price arrangements based on hypothetical arm's length terms for matters other than just the price.
Corporate groups with Australian operations should 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.
Background
Transfer pricing is being increasingly scrutinised by tax authorities throughout the world in light of globalisation and the increasing reach of Multinational Enterprises (MNEs). As such, the landmark dispute in Chevron Australia Holdings Pty Ltd v Commissioner of Taxation [2017] FCAFC 62 (Chevron) not only impacts MNEs with Australian cross-border financing arrangements but may also influence transfer pricing law and practice in other jurisdictions.
On 21 April 2017, the Full Federal Court of Australia unanimously dismissed the appeal by Chevron Australia Holdings Pty Ltd (CAHPL) against the Federal Court decision in favour of the Australian Taxation Office (ATO).The amended assessments issued by the ATO were ultimately affirmed, denying a portion of the interest deductions claimed by CAHPL in respect of a loan from its US subsidiary. Although this dispute specifically concerned Australian matters of administrative, procedural and constitutional law, the Full Federal Court decision is most striking in terms of its emphasis on "commercial reality" and the appropriate factors to be weighed up in analysing the transfer pricing risks associated with intra-group financing.
Following this decision, CAHPL settled with the ATO for an undisclosed sum on 18 August 2017.
The ATO has estimated that the decision in Chevron could result in an additional A$10bn in tax revenues over the next 10 years from revised 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 no longer operate, the court's discussion of the "arm's length principle" will be relevant in interpreting similar concepts under the "new" transfer pricing provisions in Division 815 of the ITAA 97.
Although this dispute concerned the "old" transfer pricing rules, which no longer operate, the court's discussion of the "arm's length principle" will be relevant in interpreting similar concepts under the "new" transfer pricing provisions 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), a wholly owned US subsidiary of CAHPL, to CAHPL at the interest rate of LIBOR plus 4.14%. At times, over the loan term, this rate exceeded 9%. No guarantee or security was provided for the loan and there were no financial or operational covenants that bound CAHPL to conduct its business in any particular way. CFC raised the funds by issuing commercial paper in the US, for which it paid interest at rates which were at times as low as 1.2%.
Throughout the period between the income tax years 2004 to 2008, CAHPL claimed significant income tax deductions in Australia for its interest payments to CFC whilst, in due course, having these funds returned back on-shore in the form of non-assessable dividend payments from CFC to CAHPL.
The ATO asserted that CAHPL's interest deductions on the loan exceeded an arm's length amount. In response, CAHPL 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%.
The 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 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. In the case of Chevron, group policy was to borrow externally at the lowest rate possible and it was usual commercial policy for a parent company guarantee to be provided for external borrowings by subsidiaries.
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 of a hypothetical arm's length agreement, a borrower of CAHPL's standing would have offered something additional (e.g, security, covenants, guarantee) for the loan to obtain the best possible interest rate and, as mentioned above, this analysis was consistent with the commercial reality of Chevron's group policy for external borrowings. Accordingly, 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 taxpayer submitted that, if the hypothetical arm's length loan agreement included a parent company guarantee, then the agreement should also assume that a (deductible) fee would be payable to its parent for the provision of that guarantee. Whilst the court acknowledged that this submission had some force, there was insufficient evidence presented by the taxpayer to warrant the conclusion that a fee might reasonably have been expected to have been paid by CAHPL under the hypothetical loan.
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 choose a higher interest rate on a loan by offering lenders slender protections and reflecting the increased risk associated with such loan terms, where that type of arrangement would not reasonably be expected to be seen in an arm's length agreement.
Final comments
The key message from Chevron 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 court was prepared to "rewrite" the terms of an agreement in order to determine the arm's length price means that taxpayers cannot simply assume that the terms of intercompany 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.
It was unfortunate that the taxpayer's submission that a (deductible) guarantee fee should be imputed into the terms of the hypothetical loan was not considered by the court due to insufficient evidence. It would be interesting to know how the court would have chosen between the actual loan and the hypothetical loan where the value of the overall consideration payable by the taxpayer in connection with each loan was similar in amount.
Taxpayers should review their internal borrowing policies, intra-group arrangements and supporting documentation in light of Chevron and consider whether the actual terms of such arrangements would be sustainable between independent parties in the real commercial world.
Success in the Full Federal Court and the subsequent settlement of the appeal will underpin the ATO's continuing focus on international-related party arrangements. The ATO has subsequently released Draft Practical Compliance Guideline PCG 2017/D4, summarising its approach to reviewing such arrangements, and has indicated that a number of taxpayers are already restructuring as a result of the Chevron decision.
Australian taxpayers should review both historic and future arrangements in light of the decision and continue to monitor any updated guidance, rulings or other developments from the ATO.
Please click here for the full Global Tax Insight (Issue 3) Report. (3.43MB)
For further information, please contact:
Peter McCullough, Partner, Ashurst
peter.mccullough@ashurst.com
