Tuesday, 20 June 2017

Australian government wins landmark transfer pricing case on debt financing

On 21 April 2017, the Australian Full Federal Court (Full Court) unanimously decided in favor of the Australian Taxation Office (ATO) in the most significant transfer pricing case, and the first transfer pricing case on the issue of related party loans, ever litigated in Australia, rejecting an appeal by the taxpayer. The case concerns interest payments made under a credit facility extended to Chevron Australia Holdings Pty Ltd (CAHPL) by a US resident subsidiary of CAHPL, and involves assessments of approximately AUD 340 million in tax and penalties covering the 2004-08 period.
The US subsidiary borrowed funds (USD 2.5 billion) from an unrelated bank at an interest rate of around 1.2%, with the benefit of a guarantee from the ultimate parent company, Chevron Corporation. It then on-lent the funds (in AUD) to CAHPL at an interest rate of approximately 9% in the period under review. This interest rate was based on the stand-alone credit rating of CAHPL and a transfer pricing analysis using the actual terms and conditions of the facility.
On examination, the ATO issued assessments to CAHPL on the grounds that the related parties were not acting at arm’s length; specifically, that the interest rate on the loans was in excess of an arm’s length rate. The assessments were raised under two separate transfer pricing provisions, i.e. Division 13 of Income Tax Assessment Act 1936 (ITAA 1936) and Subdivision 815-A of Income Tax Assessment Act 1997 (ITAA 1997).
The taxpayer appealed the assessments to the Federal Court, which in 2015 held that CAHPL failed to demonstrate that the interest paid under the credit facility agreement was equal to or less than arm’s length and, therefore, did not prove that the assessments were excessive. This latter point is important, since under the Taxation Administration Act 1953, the burden of proof was on CAHPL and, as such, the government was not obliged to argue every technical aspect of the assessments before the court. The taxpayer subsequently appealed the decision of the lower court to the
Full Court.
The Full Court upheld the earlier decision of the lower court that CAHPL had failed to prove that the assessments under Division 13 and Subdivision 815-A were excessive.
The Full Court ruled that:

  • The transfer pricing law should be applied taking into account both the intent of the legislation and real world commercial considerations, and should not be interpreted in a restrictive manner. The transfer pricing provisions give the tax authorities broad powers to substitute a more commercially realistic transaction where the actual transaction is considered to be, in whole or part, one that could not occur in the open market.
  • The transfer pricing rules do not mean the fact that CAHPL is part of a global group should be ignored. The Full Court found that there was no reason to depart from the lower court judge’s view that an independent borrower like CAHPL, dealing at arm’s length, could have given security and operational and financial covenants to acquire the loan, which would have resulted in a lower interest rate. This is particularly relevant for situations where no senior secured debt is in place in addition to related party debt arrangements.
  • Consideration should be given to the availability of an explicit guarantee by a parent company in a related party financing transaction. Where such a guarantee may be available, the interest rate would be expected to be lower; where the guarantee is not available, the taxpayer should be in a position to explain why not. The court pointed out that even if CAHPL was unable to pledge security or agree to any financial and/or operational covenants, it would have been of “no relevant consequence” if there was a reasonable expectation that Chevron (or a company in Chevron’s position) would provide a guarantee. 

Source: Deloitte