INTRODUCTION AND OVERVIEW
In a major Australian transfer pricing decision on Friday 21 April 2017, the Full Federal Court dismissed Chevron Australia Holdings Pty Ltd's (CAHPL) appeal related to the deductibility of interest on the Australian dollar equivalent of US$2.45 billion loans from the US subsidiary of CAHPL, Chevron Texaco Funding Corporation (CFC).
The Full Federal Court largely confirmed the judgment at first instance handed down by Robertson J in October 2015 in the Federal Court. Our earlier update on the 2015 Federal Court judgment can be found here.
The unanimous decision of Allsop CJ, Perram and Pagone JJ provides significant guidance on Australia's transfer pricing laws in Division 13 of the Income Tax Assessment Act 1936 (Cth) (Division 13) (which has now been repealed) and Subdivision 815-A of the Income Tax Assessment Act 1997 (Cth) (Subdivision 815-A). Whilst the decision also deals with certain administrative, constitutional and procedural issues, the decision is most important in terms of determining the arm's length consideration (particularly interest rates) applicable to cross border financing arrangements.
The two principal judges (Allsop CJ and Pagone J), taking a commercial and pragmatic approach, found that no independent lender and borrower dealing at arm's length would have entered into the borrowing arrangements in place without taking security or requiring covenants. In coming to this conclusion, their honours gave consideration to the Chevron Group's
external borrowing policy and effectively imputed a parent company guarantee to the loans in order to determine the arm's length consideration. This resulted in a lower interest rate and a subsequent tax bill (including penalties) of approximately $340 million.
CAHPL is indirectly wholly-owned by Chevron Corporation (CVX), a US-based oil and gas company listed on the New York Stock Exchange. CAHPL and CFC effected an internal refinancing, including to fund CAHPL's acquisition of Texaco Australia Pty Ltd, by entering into a 'Credit Facility Agreement'.
CFC, a US company, was established as a whollyowned subsidiary of CAHPL for the sole purpose of raising money through the issue of commercial paper in the US at an interest rate of approximately 1.2%. Under the Credit Facility Agreement, CFC on-lent these funds to CAHPL at an interest rate of approximately 9% and CAHPL drew down, on two separate occasions, a total of the Australian dollar equivalent of US$2.45 billion.
The Credit Facility Agreement was not consistent with the Chevron borrowing policy under which members of the Chevron Group obtained external financing. It contained no financial or operational covenants requiring CAHPL to conduct its business or behave in a certain way, nor was any security provided. In addition, there was no guarantee in respect of the loan, unlike the commercial paper issued by CFC, which was guaranteed by CVX.
CAHPL claimed tax deductions in Australia for the interest it paid to CFC. The income it received from CFC, by way of dividends, were treated as non-assessable non-exempt income pursuant to section 23AJ of the Income Tax Assessment Act 1936. Effectively under this arrangement, CAHPL reduced its Australian taxable income through the deductions claimed, whilst CFC made significant profits by borrowing at a rate of 1.2% and on-lending at 9%. These profits were not taxed in either the US or Australia.
The Commissioner disallowed the deductions claimed by CAHPL for the 2004 to 2008 income years (inclusive). Amended assessments were issued pursuant to both Division 13 and Subdivision 815-A on the basis that the loans between CAHPL and CFC were not at arm's length.
Under the former Division 13, the Court explained that the following tasks were required:
(i) Identify the property acquired by CAHPL
The Court agreed with the findings of the trial judge that the property acquired by CAHPL was the rights or benefits granted under the Credit Facility Agreement, including the sums lent. The lack of security was an absence in the consideration it was required to give for the funds it received (rather than part of what it obtained).
(ii) Identify the consideration given by CAHPL
This is the actual consideration provided by CAHPL in order to obtain the property (funds) above.
(iii) Identify the arm's length consideration
The final step is to identify the consideration that might reasonably be expected to have been given in respect of the loan had that loan been acquired under an agreement between hypothetical independent parties dealing at arm's length with each other in relation to the acquisition of the property above.
Similar steps to the above are also required for Subdivision 815-A, however, the new rules look more broadly to the arm's length 'conditions' rather than merely the arm's length 'consideration'.
The critical issue for the Court was therefore to identify the arm's length consideration in respect of the Credit Facility Agreement.
How do we assess what is arm's length?
As a matter of statutory interpretation, the Court agreed with Robertson J that to determine whether the Credit Facility Agreement was on arm's length terms would require the agreement to be 'depersonalised' so as to make it hypothetically between independent parties dealing at arm's length (without altering the property acquired).
This means that the terms of the actual agreement may need to be adjusted to arrive at a realistic, commercial hypothetical agreement that independent parties dealing at arm's length would conclude. Importantly, as Allsop CJ provided, the 'degree and extent of the depersonalisation will be dictated by what is appropriate to the task of determining an arm's length consideration that is one that satisfactorily replaces what the taxpayer gave by what it should be taken to have given had it been independent of its counterparty.'
Further, Allsop CJ agreed with the trial judge that 'the hypothetical independent parties have the characteristics relevant to the pricing of the loan so as to enable the hypothesis to work', and accordingly, the hypothetical borrower would be an oil and gas exploration and production subsidiary.
In this way, the parties do not have carte-blanche to define the terms of the cross border related party arrangement and then merely ask a court to price it accordingly. This would be a 'rigid' interpretation of the transfer pricing rules and such 'unrealistic inflexibility would undermine the sensible operation' of the transfer pricing rules in ways controlled by the taxpayer (and therefore be open to manipulation).
Rather, the transfer pricing rules must be applied commercially in a way that is grounded in reality. As Pagone J stated, the transfer pricing rules 'are intended to operate in the context of real world alternative reasonable expectations of agreements between parties and not in artificial constructs.'
The extent of the differences between actual and hypothetical agreements will predictably vary depending
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on the specific facts and circumstances. In each case, Pagone J stated, 'the focus of inquiry must be to identify a reliable comparable agreement to the actual agreement by the actual taxpayer'.
This is to ensure that the consideration in respect of the acquisition in the hypothetical agreement is not distorted by the lack of independence between the parties or by a lack of arm's length dealings in relation to the acquisition. As Pagone J stated, this requires the Court to 'make a prediction about what might reasonably be expected to be given or agreed to be given under a hypothetical agreement if the parties had been independent and were dealing at arm's length in relation to the acquisition'.
Was the loan arm's length?
The Court unanimously agreed with the trial judge that the loan was not on arm's length terms. Allsop CJ, by quoting Robertson J, affirmed the conclusion reached at first instance that '[i]f the property had been acquired under an agreement between independent parties dealing at arm's length with each other, I find that the borrower would have given such security and operational and financial covenants and the interest rate, as a consequence, would have been lower.' This conclusion is supported by the following findings by the Full Federal Court:
As Pagone J stated, to treat CAHPL as an 'orphan' or standalone company 'would distort the application of Division 13' and the commercial reality of the situation.
There was sufficient evidence to predict that, if the parties had been dealing at arm's length, what might reasonably be expected to happen under a hypothetical agreement is for the loan to have been provided to CAHPL on terms that included parental support for CAHPL. This evidence included Chevron Group policy to borrow externally at the lowest rate possible.
The usual commercial policy of the Chevron group was to provide a parent company guarantee for external borrowings by subsidiaries (in order to drive down the cost of debt). Accordingly, Allsop CJ held that the expected arm's length consideration 'would
be an interest rate hypothesised on the giving of a guarantee of CAHPL's obligations to the lender by a parent such as Chevron.'
Had the property been acquired under an agreement between independent parties dealing at arm's length, the borrower would have given security and operational and financial covenants, and accordingly, the interest rate would have been lower.
The Credit Facility Agreement did not in fact provide security for the lender or impose operational or financial covenants on the borrower. Allsop CJ found that this absence of security and covenants 'was not dictated by any commercial or operational imperatives; rather their absence can be explained by the protection given to the lender by common control'.
The Court unanimously affirmed the trial judge's interpretation of Subdivision 815-A. Importantly, it confirmed that:
Unlike Division 13, Subdivision 815-A requires consideration of all conditions operating under the arrangement. That is, Subdivision 815-A permits a broad and wide ranging inquiry into the relations between the enterprises concerned, and is not limited to the consideration under the agreement. The object was to then determine whether the actual conditions that existed between the entities differed from those which might be expected to operate if they had been dealing wholly independently with each other.
The Court confirmed the trial judge's comment that 'independent enterprises dealing wholly independently with one another may still be subsidiaries and may still have subsidiaries even if the enterprises are independent of each other'. That is, it was permissible to have regard to matters such as implied parental guarantees over the debt in determining what might reasonably be expected to have occurred.
Section 815-15(1)(c) requires a hypothetical consideration of what profits might have accrued but for the operation of the conditions under the
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arrangement. This postulate is considered in the context of the relevant 'associated enterprises' article, in this case the US/Australia Double Tax Treaty (Article 9).
CAHPL's submissions that the arrangement had not resulted in an actual reduction in profits (as opposed to a reduction in taxable profits/income) due to the receipt of dividends received (which were nonassessable non-exempt income) were rejected. The Court found that while 'profits' should be construed in accordance with its ordinary meaning, in this case the dividends could not be offset against reduced profits caused by non-independent party conditions.
CONSTITUTIONAL VALIDITY OF SUBDIVISION 815-A
The Court also unanimously upheld the trial judge's findings that Subdivision 815-A was constitutionally valid. In particular, it confirmed that:
The tax imposed was not arbitrary or incontestable as argued by CAHPL because it was based on ascertainable criteria with sufficiently general application. The fact that the tax was imposed retrospectively did not make the tax arbitrary or incontestable.
The direction under Subdivision 815-A to consider documents including OECD guidelines is a 'direction given in aid of the operative provision' and is 'for the purpose of interpretation'. It does not render the criteria of liability to be uncertain.
Division 13 requires a hypothetical analysis to determine the consideration (interest rates) that would reasonably be expected to be paid under the loans. It is critical that the hypothetical/comparable arrangement is explored on the basis that the relevant parties (ie. lender and borrower) are independent and are dealing at arm's length with one another. However, this does not mean to 'depersonalise' CAHPL to the extent that it was a standalone entity, no longer a member of the Chevron Group, and independent of the group's borrowing policies. The hypothesising that takes
place under Division 13 (and Subdivision 815-A) must be grounded in commercial reality.
Importantly, this decision does not deal specifically with Subdivisions 815-B to E of the Income Tax Assessment Act 1936 (Cth), which are Australia's principal transfer pricing laws operative for income tax years commencing from 1 July 2013. Subdivision 815-B focuses on determining the arm's length conditions (rather than specifically arm's length consideration) in determining whether a transfer pricing benefit arises.
While Division 13 and Subdivision 815-B are both based on the arm's length principle, more specific statutory guidance is provided in, for example, Subdivision 815-B on comparable circumstances to assist in identifying the arm's length conditions.
It appears the two principal judges were mindful of (or perhaps concerned about) the structure of the funding arrangement between CAHPL and CFC and its circular nature. Accordingly, their decision (based on their hypothetical approach) may be more reflective of the specific circumstances of the Chevron Group.
While the decision would appear to provide broader precedent for the general application of Australia's transfer pricing laws, all multinationals should review their current international funding arrangements in the context of this decision. In this context, if security arrangements are to be imputed it may be that a deductible fee can be included for provision of security/support by the ultimate parent company (based on the alternative submission of Chevron Group).
Given the amount of tax at stake, we would expect Chevron to appeal this decision in the High Court.
We expect the ATO to quickly issue a Practical Compliance Guideline dealing with preferred approaches to determining arm's length loan arrangements and related interest rates. It is also likely that the ATO will shortly issue a Decision Impact Statement outlining its formal views of the decision.
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The Australian Government has welcomed the decision of the Full Federal Court as evidence of its strong action, along with the Multinational AntiAvoidance Law, Diverted Profits Tax, updated transfer pricing laws and increased penalties, to
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