The Deputy Commissioner has signalled issue of taxpayer alerts on derivatives.
Over the last 12 months, the Australian Taxation Office (ATO) has been auditing and reviewing financing arrangements, such as cross-currency interest rate swaps (CCIRS) and similar derivative financial instruments. On Friday, 5 February 2016, Jeremy Hirschhorn, Deputy Commissioner of Taxation, Public Groups and Internationals, said:
"We have stated publicly our concern around derivatives - use of related party derivatives ‒ to convert interest, subject to interest-withholding tax, into deductible swap payments, which are not subject to interest-withholding tax. We have stated that we are going to issue a taxpayer alert shortly, and I do not think it should surprise the committee if in the future you see some litigation on that."
Derivatives such as CCIRS used to hedge FX exposure
In basic terms, a CCIRS is an arrangement to exchange a certain amount in one currency, say USD 1 billion, for another currency, say AUD 1.4 billion, after a certain period of time. The arrangement can be understood as two notional loans which may give rise to swap payments. The swap payments are determined by reference to the difference in interest rates which would apply to the two notional loans denominated in the two currencies. For example, the interest rate on the notional USD denominated loan may be determined by reference to the 3 month USD LIBOR which is currently approximately 0.62%. In a similar way, the interest rate on the AUD denominated loan may be determined by reference to the 3 month BBSW which is currently approximately 2.28%. The difference between the two rates of approximately 1.66% would form the basis for the swap payment, subject to a further adjustment for any difference in the credit risk margin on the two loans. According to a ruling issued by the ATO in 1983 (Taxation Ruling IT 2050 ‒ "Interest-Swapping" transactions) interest withholding tax should not apply to swap payments, as these are not considered to constitute "interest" for the purposes of the withholding tax provisions.
It is important to appreciate that derivatives such as CCIRS have been used in Australia and overseas for many years and the ATO has been aware of this, as evident from the above ruling and even more recently Draft TR 2015/D3 which considers the application of section 230-120 to swaps, including CCIRS.
Companies use CCIRS to manage the risk and uncertainty associated with movements in foreign exchange rates (FX exposure) ‒ which can be significant, unpredictable and can move either way. The FX exposure that is managed by CCIRS often relates to foreign currency denominated assets/liabilities. For example, an Australian company which has USD denominated debt may hedge the FX exposure by entering into CCIRS. The CCIRS may mirror the quantum and tenor of the hedged debt. The effect of this type of arrangement is that any FX loss on the USD denominated debt should be offset by a corresponding FX gain on the CCIRS and vice versa. An example of how this would operate is depicted in the following figure.
Click here to view figure.
An Australian company may raise debt in a currency other than AUD for a number of reasons. For example, this could be in order to access overseas debt markets for the purposes of diversification, liquidity, size of the loan, pricing and compliance with a global group policy. Alternatively, the currency of the debt may be dictated by other considerations such as the internal global treasury policy and the currency of the capital expenditure which the debt is intended to fund.
According to a survey undertaken by the Reserve Bank of Australia in 2009, hedging of foreign currency (ie. non-AUD) denominated debt is very common. The survey found that most of Australian entities' foreign currency debt liabilities were hedged into AUD. This is reflected in the following graph.
Click here to view graph.
ATO's concerns regarding CCIRS centre on three issues
We understand the ATO's concerns to be as follows:
1. Interest withholding tax
The issue here is whether the CCIRS are used to synthetically produce AUD interest deductions with no interest withholding tax. The alternative is straight AUD debt, with no CCIRS. The counterargument is that there could be a number of reasons why a company may borrow in a currency other than AUD, and then hedge the FX exposure into AUD. Different considerations may apply, depending on whether the ATO is seeking to apply Part IVA or Subdivision 815-B, as Subdivision 815-B does not have a "purpose" test and the focus is on the expected conditions, and what might be expected independent parties would have done.
2. Currency of borrowing and rationale for hedging
The issue here is whether there is a commercial rationale for borrowing in AUD and/or hedging the FX exposure into AUD. This is premised on the concept of a 'natural currency' of an Australian company being a currency other than AUD, and the company borrowing in that currency, without hedging the FX exposure into AUD. The counterargument is that the question of "currency" is complex and multi‑dimensional, requiring accounting, financial, operational and tax considerations. This is supported by the recent transfer pricing decision in Chevron Australia Holdings  FCA 1092, where the Federal Court was unpersuaded by the Commissioner's submissions that it might have been expected that Chevron Australia would have been borrowed in USD rather than AUD. This was despite the fact that borrowing in AUD resulted in higher interest costs and Chevron Australia's sales income would be in USD.
3. Pricing of CCIRS swap payments
The issue here is the quantum of deductions claimed in respect of the CCIRS swap payments. This relates to the margin that applies to the notional loans under the CCIRS and whether these are more than arm's length. In our experience, the ATO may argue that the margin should be significantly lower than that adopted by the taxpayer and determined by reference to the credit rating of the counterparties, equalised to the rating of the ultimate parent, due to the effect of implicit support. However, this argument faces some challenges for a number of reasons, including the decision in Chevron, where the Federal Court considered that while implicit support may be generally relevant when assessing a borrower's credit rating, in that context, it had very little, if any, impact on the pricing of a loan.
Issues for taxpayers to consider
There may be an expectation that the taxpayer alerts may be comprehensive and detailed. However, that is not the purpose of the taxpayer alerts. Rather, the purpose is to provide early warning of arrangements which the ATO has concerns with and thus to give an incentive to taxpayers to examine their affairs with a view of engaging with the ATO.
The key issues for taxpayers will be:
- commercial context in which the CCIRS were entered into;
- functional currency of the Australian borrower;
- currency, purpose and size of the underlying debt;
- scope and application of the group treasury policy;
- pricing of the swap payments; and
- sufficiently strong evidence supporting the above.
Taxpayers who have entered into sizeable CCIRS arrangements are likely to be currently under review or audit by the ATO or can expect to be under review in the near future. In our experience, the ATO review will be comprehensive.
Those taxpayers should review their arrangements, in light of the above considerations and issues. They may adopt either a reactive or a proactive approach. In the current climate and ATO activities, including the pre-lodgement compliance program, it is highly likely that the ATO would take a close look at a taxpayers' derivative arrangements, including CCIRS. In our experience, a constructive and proactive engagement with the ATO is more efficient, effective and productive.