On 21 April 2017, the Full Federal Court of Australia handed down its judgment in the landmark transfer pricing dispute between Chevron and the Commissioner of Taxation.
All three judges found for the Commissioner of Taxation and have upheld the first instance decision which also found for the Commissioner of Taxation.
MinterEllison were the instructing solicitors for the Commissioner in these proceedings.
The central issue in the case was whether the interest rate on the AUD equivalent of a USD 2.5 billion loan from a wholly owned US-based Chevron subsidiary to Chevron Australia Holdings Pty Limited (‘CAHPL’) exceeded the arm’s length interest rate.
The assessments in dispute were based on transfer pricing determinations made under Division 13 of the Income Tax Assessment Act 1936 (for 5 years in question) and under Division 815-A of the Income Tax Assessment Act 1997 (in respect of the last 3 years). Although both of these provisions have now been repealed, the Chevron case highlights the difficult statutory interpretation questions which arise in transfer pricing disputes. The case also highlights complex matters of evidence including issues in ensuring expert opinions are admissible, probative and reliable.
The decision of the Full Federal Court is a strong one for the Commissioner. There are important lessons arising for multinationals involved with cross-border financing and those questions are not limited to an Australian tax context. There has been considerable interest from overseas jurisdictions in the issues discussed in this case.
Specific points to note were as follows:
1. The Application of Division 13
The Court upheld the amended assessments based on Division 13 and in so doing, they found that the focus of the Division is to bring ‘commercial reality’, based on an hypothesis of the parties being independent of each other, and viewing the transaction in circumstances where that commercial reality has not been distorted by considerations that are due to a lack of arm’s length dealings between the parties. Division 13 is not to be approached in a rigid or fixed way.
Under Division 13, the ‘property’ acquired was seen to be a five year loan, not the absence of security or financial or operational covenants.
The ‘consideration’ given in respect of the acquisition did not include security and covenants, but at arm’s length would be expected to include security and covenants.
2. Evidence of Bankers
The Full Federal Court found that much of the evidence of the main bankers in the proceedings, being Mr Gross and Mr Martin, was to the effect that a loan such as that obtained by CAHPL would not have been available to a hypothetical company with CAHPL’s credit worthiness as a standalone company.
The Court held ‘as a standalone company, severed from the financial strength of its ultimate parent and corporate group, CAHPL could not secure a loan for an amount equivalent to USD 2.5 billion at the rate obtained by its subsidiary with the backing of the ultimate parent.’
The Court (at paragraph 125) rejected CAHPL’s construction that the application of section 136AD(3) required pricing a hypothetical loan which a hypothetical CAHPL could obtain from a hypothetical independent party on the assumption that the hypothetical CAHPL had the attributes of the actual CAHPL but was otherwise independent. The Court held that to apply s136AD(3) in that way would be unrealistic and contrary to its purpose.
As the bankers were instructed to approach the task on CAHPL’s construction, their evidence was not directed to the statutory question.
3. Independence and the orphan theory
The Full Federal Court affirmed the decision at first instance to reject Chevron’s ‘orphan theory’. The essence of the orphan theory is that CAHPL should be assessed as a stand-alone entity shorn of all affiliation to its parent. On this point Justice Pagone, with whom Justice Perram agreed, said at para 130:
‘The prediction of what might reasonably be expected is not to be undertaken upon the hypothesis submitted on behalf of CAHPL that it was not a member of the Chevron group or, in the language sometimes used in this context, as if it were an orphan. To do so would be to distort the application of Division 13 and fundamentally undermine its purpose of substituting as a comparable a real-world, arm’s length consideration, that consideration which could predictably have been agreed between them on the hypothesis that they had been independent and dealing at arm’s length.’
The Court endorsed what the Commissioner submitted, that whilst the relationship between the borrower and lender needs to be disregarded and the borrower and lender need to be treated as independent, it is not the case that a consequence is that the ownership of the borrower needs to be disregarded.
This point is important in the circumstances of this case as the credit strength of Chevron in the US was far superior to the credit strength of CAHPL as a standalone, meaning that if CAHPL were a standalone, its borrowing cost would have been higher.
4. Interaction between Division 13 and Division 815-A
Challenges made by Chevron to Subdivision 815-A on both technical grounds and also on the basis of constitutional invalidity were rejected by the Full Federal Court.
The Full Federal Court endorsed the Commissioner’s approach that Division 13 and Subdivision 815-A are alternative provisions and each could be used to support the assessments. The Full Federal Court rejected Chevron’s argument that there could be no transfer pricing benefit to negate under Subdivision 815-A where Division 13 determinations had been made.
Chevron had challenged Subdivision 815-A on the basis of its retrospectivity but the Court held that Subdivision 815-A does not impose an arbitrary or incontestable tax and the mere fact that a person may not be aware, at an earlier point in time, what the criteria of liability might consequently be, is not sufficient to make the legislation arbitrary or incontestable in the sense considered in High Court authorities.
The Court also found that ‘conditions’ is a broad and flexible term and the test is a flexible comparative analysis that gives weight but not inflexibility to the form of the actual transaction. The Court found that there would have been a borrowing supported by a parental guarantee at Chevron’s rating (being AA) which was an interest rate much less than the actual interest rate of 9%. Such a reduced interest rate would have had the result that there would have been an amount of profit that would have accrued to CAHPL but did not so accrue by virtue of the non-arm’s length dealings.
5. Profits for Subdivision 815-A purposes
Chevron submitted that the ‘profits’ requirement in Subdivision 815-A was not satisfied because CAHPL received section 23AJ non-assessable dividends from CFC which meant that CAHPL appropriately brought profits to tax in Australia. On this, the Full Federal Court said that one does not simply look at the profit position of CAHPL at year end. The reference in the legislation was to an amount of profits and in determining that an amount of operating profit would have accrued with lower interest deductions, the requirement in the legislation was satisfied that the amount of taxable income would have been greater than the actual amount.
6. Validity of the Division 13 determination
The Court held that CAHPL did not prove excessiveness by showing error in the making of the determinations. Section 175 of the 1936 Act meant the error did not affect the validity of the determination and was within ‘due making’ within the meaning of the conclusive evidence provisions. The error did not go to substantive liability.