The Australian Taxation Office (ATO) has recently won a major transfer pricing victory in the decision of Chevron Australia Holdings Pty Ltd v Commissioner of Taxation (No 4) [2015] FCA 1092. This is a decision at first instance by Justice Robertson in the Federal Court of Australia. If this decision is upheld on appeal, it will serve as an important formulation of the manner in which the arm's length principle is to be applied to analyse international dealings involving an Australian counterparty.
Background
The facts of the decision are straightforward. Chevron Australia Holdings Pty Ltd (CAHPL) is an Australian subsidiary of Chevron Corporation (CVX) which is a well-known American multinational oil and gas major. In 2003, CAHPL entered into a Credit Financing Facility to borrow the Australian dollar equivalent of USD2.5 billion from Chevron Texaco Funding Corporation (CFC). CFC was established as a US subsidiary of CAHPL, and sourced the funds to provide the loan from the US debt markets at a much lower cost. The main features of the loan were as follows:
- Five year tenor, with capacity for early repayment, or provision for extension in certain circumstances.
- Non-amortising.
- Interest payable monthly at the rate of AUD-LIBOR-BBA plus 4.14%. This worked out to be an effective rate of approximately 9%. CAHPL obtained a private ruling from the ATO concerning the application of an exemption from Australian interest withholding tax.
- Unsecured, with there being no parent guarantee provided by CVX.
CAHPL used the funds drawn down under the loan to retire
existing debt that it was carrying in relation to the earlier
acquisition of Texaco's Australian assets. It also used funds
to assist in the further development of upstream assets in the
North West shelf, including its participation in the Gorgon gas
project (which at that stage had not reached final investment
decision).
The interest rate under the loan was determined by CVX's global
treasury based in the US in consultation with advice provided by
two investment banks. Post draw-down, CAHPL's gearing was 47%
of gross assets. An important part of the funding structure was a
tax arbitrage that resulted from the payment of the interest by
CAHPL. The interest income received by CFC from CAHPL was not
subject to US income tax, and given the lower cost of funding
incurred by CFC in sourcing funds from the US capital markets, it
was able to derive significant profits. These were distributed back
to CAHPL in the form of dividends which were non-assessable income
for Australian tax purposes. It was admitted by CAHPL that its
capacity to make interest repayments under the loan depended in
part on recurrent distributions from CFC.
In April 2010, the ATO issued assessments against CAHPL for the
2004 to 2008 tax years denying a portion the interest expenses
incurred by CAHPL under the credit facility. These assessments were
made on the basis of determinations made under Australia's
former transfer pricing provisions within Division 13 of the
Income Tax Assessment Act 1936 (ITAA36).
In late 2012, Australia's transfer pricing legislation was
amended with the inclusion of Subdivision 815-A of the Income
Tax Assessment Act 1997 (ITAA97). Subdivision 815-A was an
interim measure designed to give effect to the ATO's
longstanding position that it was able to make a transfer pricing
adjustment under Article 9 of Australia's network of double tax
agreements. The language of Article 9 – the attribution of
profits between associated entities – gives a broader basis
to adjust an international dealing between related parties than
Division 13 of the ITAA36 which looks at each transaction in
isolation. The ATO argued the application of a profit-based method
in the earlier SNF case1 and lost. Subdivision
815-A was introduced in 2012 but was given retrospective effect to
income years starting after 1 July 2004.
With this new transfer pricing weapon in their arsenal, the ATO
issued amended assessments against CAHPL under Subdivision 815-A of
the ITAA97 for the 2006 to 2008 income years. The constitutional
validity of the retrospective operation of Subdivision 815-A was
challenged by CAHPL. These were given short thrift by the Court and
are not discussed in further detail in this summary. Arguments were
also made that the assessments were not validly made by the ATO but
this suggestion was also quickly dispatched by the Court, and are
not considered further below.
Analysis
The decision of the Federal Court is extensive. Much of the
analysis is a summary of the expert evidence that was led by both
parties. The Court ultimately found much of this expert evidence to
be unhelpful in analysing the application of Division 13 and
Subdivision 815-A to the specific facts and circumstances of the
credit facility.
Part of the expert evidence provided by CAHPL included a discussion
of the financing of two upstream oil and gas players in the US.
This evidence was intended to demonstrate to the Court that oil and
gas companies do raise finance from third party creditors through
the issue of debt which is barely investment grade (and sometimes
not even). This evidence was ostensibly provided to help to
overcome the lack of a comparable uncontrolled transaction in the
market. And this was part of the problem for CAHPL – it was
admitted by their bankers at the time of entering into the credit
facility that an Australian oil and gas company with the same
profile as CAHPL could not place that much debt and on those terms
with third party creditors. The tenor and the lack of security
meant that this debt would be an unappealing proposition to third
party creditors. It was noted by one expert, and accepted by the
Court, that no single third party creditor would provide the whole
sum and instead the debt financing would take the form of a
syndicated loan with up to 75 to 100 lenders. The Court gave no
weight whatsoever to expert evidence supporting the categorisation
of CAHPL as having a BB+ credit rating. It was accepted by the
Court that creditors in these circumstances would perform their own
creditor analysis which is independent of the rating that may be
given by a third party ratings agency.
The central question considered by the Court in analysing the
application of Division 13 and Subdivision 815-A was the
construction of the hypothetical against which a transfer pricing
adjustment is made. What features of the international dealing may
be recast in forming this hypothetical arm's length
transaction? Is it merely the interest rate determined within the
context of the other features of the loan which is to be
considered, or it is appropriate for a loan with substantially
different features to be used as the hypothetical transaction? The
Court resolved this question by stating at paragraph 76:
‘What is required, in my opinion, is to depersonalise the agreement to acquire so as to make it, hypothetically, between independent parties dealing at arm's length, but not so as to alter the property acquired. Division 13 of the ITAA 1936 does not, in my opinion, require or authorise the creation of an agreement with terms different from those of the actual agreement, other than the consideration.’
The Court held that the 'consideration' of the loan was
more than merely the interest payable, and included the totality of
the promises given by the borrower under the transaction. The Court
held that in an arm's length transaction, security and other
operational and financial covenants would have been provided as
part of the consideration given by the borrower. Factoring in these
amendments only to the terms of the loan in establishing a
hypothetical, it was held by the Court that the adjustments made by
the ATO were not excessive.
Consistent with their reasoning, the Court rejected any suggestion
that the hypothetical loan should be denominated in USD which would
have had a lower funding cost. The Court accepted the suggestion
that there was an implicit parental guarantee provided by CVX to
support the obligations of CAHPL under the loan, but did not
consider that this would have had any impact on the pricing given
it was not legally enforceable.
Takeaways
This decision is a significant win for the ATO at first
instance. If it is upheld on appeal, it will break what has
otherwise been a losing streak for the ATO with transfer pricing
litigation. Transfer pricing arrangements amongst international
resources players are currently the subject of close scrutiny in
Australia, and have been swept up in the public debate about
ensuring that multinationals pay their 'fair share of tax'.
This debate is becoming more fevered as the investment cycle of the
local resources boom comes to an end, commodity prices come off the
boil, and Australia remains in fiscal deficit. The more immediate
and targeted focus is upon offshore marketing hubs2, but
intra-group debt arrangements are as equally low-hanging
fruit.
Unlike other items of the BEPS action plan, introducing a more
stringent approach to transfer pricing is arguably much easier to
implement compared to initiatives such as diverted profits taxes
and other measures which require legislative intervention. The
typical approach of legislating the arm's length principle
within a general transfer pricing provision without further
elaboration means that this is by nature an ambulatory concept. It
is able to bend and flex as jurisprudence around the arm's
length principle develops and changes. It also means that the past
transactions can and will be viewed through the prism of a more
stringent approach to the pricing of international dealings. The
decision of the Court in the Chevron case is not a direct
product of the current zeitgeist, but one wonders to what extent
this context played a part in the vigor with which this was pursued
by the ATO and the willingness of the Court to reject the relevance
the comparable transactions which were offered up by the
taxpayer.
It would seem that one of the only ways to provide absolute
certainty going forward for higher value transactions is to engage
with tax authorities and obtain an advanced pricing agreement
(APA), as time consuming and expensive as this can be. A unilateral
APA in the country of greatest transfer pricing risk would be the
simplest version, though potentially not as useful as the more
comprehensive approach of applying for a bilateral APA. For lower
value transactions, selecting a conservative pricing position that
is supported by a profit-based pricing methodology may be a
pragmatic way forward.
Footnotes
1 SNF (Australia) Pty Ltd v Commissioner of Taxation [2010] FCA 635
2 Offshore marketing/trading hubs based in Singapore and Hong Kong are under close examination at the moment. This is due to the imposition of little or no taxation imposed on trading gains in these jurisdictions.
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