Transfer pricing: interest rate on borrowing not arm's length

In a major transfer pricing judgment, the Full Federal Court has unanimously dismissed Chevron Australia's appeal against the Federal Court's rejection of its challenges to ATO transfer pricing determinations concerning the interest rate on borrowings from a subsidiary: Chevron Australia Holdings Pty Ltd v FCT [2017] FCAFC 62.

Background

The litigation revolved around draw-downs under a credit facility agreement entered into on 6 June 2003 between Chevron Texaco Funding Corporation (CFC, a US company) and the taxpayer, Chevron Australia Holdings Pty Ltd (CAHPL, CFC's parent and an Australian resident, owned ultimately by Chevron Corporation (CVX or Chevron)). The funds were used to refinance external AUD-denominated debt that had been taken on to fund CAHPL's acquisition of various operating entities.

The facility was for the "AUD equivalent" of US$2.5 billion. The interest rate was set at one-month AUD London Interbank Offered Rate (LIBOR) +4.14% (approximately equivalent to 9%). Payments were interest-only, payable monthly in arrears. The facility was for a term of five years with an option for early repayment by the borrower without penalty, and it could be terminated at any time by the lender. The facility was unsecured; there was no guarantee of performance given by any Chevron entities, and there were no operational covenants or financial ratio covenants.

CFC had borrowed the funds it advanced to its parent in USD in US financial markets at various rates (approximately 1.2%). After paying its own interest expense, CFC made sizeable profits and paid substantial dividends to CAHPL. These were not taxable to CAHPL because of s 23AJ of the Income Tax Assessment Act 1936 (ITAA 1936).

The Commissioner argued the parties were not dealing at arm's length. By determinations and assessments issued in 2010 and 2012, relying on Div 13 of ITAA 1936 for all years, on Subdiv 815-A of the Income Tax Assessment Act 1997 (ITAA 1997) for some years and Art 9 of the US Convention, the ATO denied a significant proportion of the interest deductions CAHPL claimed.

The Federal Court (Robertson J in Chevron Australia Holdings Pty Ltd v FCT (No 4) [2015] FCA 1092) ruled that CAHPL's challenges to the amended assessments under Div 13 of ITAA 1936 failed and, in the alternative, that CAHPL's challenges to the amended assessments under Div 815-A of ITAA 1997 also failed.

Full Court decision

Justice Pagone gave the main judgment of the Court. In dismissing the taxpayer's appeal, points made by Pagone J included the following:

  • The primary judge was correct in concluding that the relevant ATO officer's lack of formal authority to make the Div 13 determinations did not render the assessments invalid.
  • The relevant rights, benefits, privileges or facilities provided, or to be provided, to CAHPL under the credit facility agreement was the use of the funds advanced – not the consideration paid or given for the use of the funds by way of loan. The credit facility agreement conferred no rights upon CAHPL until CFC, in its absolute discretion, made advances.
  • CAHPL gave its subsidiary no security for the loan, but the absence of security for what CAHPL got is not something that was "acquired" by CAHPL "under" the credit facility agreement. 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.
  • CAHPL's case was that what had to be priced was a loan without security or covenants to be given by a commercial lender to a borrower such as CAHPL.
  • Section 136AD(3) presupposes, and can only operate, where it is possible and practical to ascertain an arm's length consideration for the supply or acquisition in question. Expert reports CAHPL relied on were 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. Robertson J found that the borrowing by CAHPL would not have been sustainable if obtained from an independent party.
  • On CAHPL's construction, it was submitted that the application of s 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. However, Pagone J said that to apply s 136AD(3) in that way, "would be unrealistic and contrary to its purpose".
  • Div 13 is intended to operate in the context of real-world alternative reasonable expectations of agreements between parties and not in artificial constructs.
  • The ultimate object of the task required by Div 13 is to ensure that the consideration deemed by s 136AD(3) is the reliably predicted amount which CAHPL might reasonably be expected to give by way of consideration, rather than a hypothetical consideration without reliable foundation in the facts or reality of the circumstances of the taxpayer in question. In this case, the property to be considered in the hypothetical agreement was a loan of US$2.5 billion for a term of years. What CAHPL obtained were the rights, benefits, privileges and facilities of a loan of US$2.5 billion in accordance with the credit facility agreement for a number of years, for a consideration which did not require it to give security. Robertson J found that an independent borrower like CAHPL dealing at arm's length would have given security and operational and financial covenants to acquire the loan. Pagone J said there was no reason to depart from that conclusion.
  • Pagone J considered that an alternative submission made by CAHPL had some force. The alternative submission was that the hypothetical acquisition would need to assume that CAHPL had paid a fee to its parent for the provision of security on the hypothetical loan. However, Pagone J said there was insufficient evidence on the case as conducted to warrant the conclusion that CAHPL might reasonably have been expected to pay a guarantee fee as part of the consideration that CAHPL might give in respect of the hypothetical loan.
  • Robertson J considered a separate challenge to the assessments in relation to the 2006 to 2008 years, to the effect that any determination made under Div 13 ceased to be operative once the 2002 amended assessments were made under Div 815-A for those years. "The particular vice relied upon by CAHPL was that the retrospective effect of Div 815 was such that in the years in question, it was not aware, and could not have been aware, of the criteria that would many years later become those for liability under Div 815 in the earlier years." Pagone J found that circumstance, however, was "inherent in the nature of retrospective legislation except, perhaps, in a practical sense of legislation purportedly validating acts taken in anticipation of legislation announced to be enacted".
  • In Pagone J's view, Robertson J was correct to reject CAHPL's submission that there had been no profits which had "not accrued" within the meaning of s 815-15(1)(c) or Article 9(1) of the US Convention. He said, "Section 815-15(1)(c) postulates that a consequence of the presence of the conditions in Article 9 was that 'an amount of profits' which might have been expected to accrue did not accrue. The word 'profits' in the provision and in Article 9 is used in a more generic sense than 'taxable income'. The focus of the provision is the tax effect of a dealing not the overall income of a taxpayer. The specific focus in s 815-15(1)(c) is whether 'an amount' of profits had not accrued, just as the focus of Article 9(1) is whether 'any profits' had not accrued. There is no basis in the text of the provisions or in the policy they express to equate the profits referred to with the taxable income of the taxpayer. The fact that CAHPL received dividend income may be relevant in evaluating what might be expected to accrue in the particular facts in question but it does not result in the conclusion that there was no amount of profits which did not accrue by reason of the conditions mentioned in Article 9 for the purposes of s 815-15(1)(c). The condition was satisfied by reason of an amount of profits not accruing but for the conditions mentioned in Article 9."

Transfer pricing: draft guideline on cross-border related-party financing

The ATO has released Draft Practical Compliance Guideline PCG 2017/D4, which sets out its compliance approach to the taxation outcomes associated with a financing arrangement or a related transaction or contract, entered into with a cross-border related party (a related-party financing arrangement). 

The draft guideline makes no direct reference to the recent Chevron decision, but has clearly been produced as a risk assessment tool for entities engaging in broadly similar related-party financing arrangements.

The ATO says it uses the framework in the draft guideline and accompanying schedules to differentiate risk and tailor its engagement with taxpayers according to the features of their related-party financing arrangements, the profile of the parties to the related-party financing arrangement and the choices and behaviours of the taxpayer's corporate group.

The tax risk associated with related-party financing arrangements is assessed with regard to a combination of quantitative and qualitative indicators. The ATO's related-party financing arrangement risk framework is made up of six risk zones, ranging from white zone (arrangements already reviewed and concluded by the ATO) and green zone (low risk) to red zone (very high risk). The different zones reflect a cumulative assessment of the presence of various qualitative and quantitative risk indicators:

  • If a related-party financing arrangement is rated as low risk under this framework, the taxpayer can expect the Commissioner will generally not apply compliance resources to review the taxation outcomes, in the relevant schedule, of the related-party financing arrangement, other than to fact-check the appropriate risk rating.
  • If a related-party financing arrangement falls outside the low risk category, the draft guideline says the taxpayer can expect the Commissioner will monitor, test and/or verify the taxation outcomes of its related-party financing arrangement.
  • The higher the risk rating, the more likely the arrangements will be reviewed as a matter of priority.

The draft guideline applies to any financing arrangement entered into with a related party that is not a resident of Australia. It applies to both inbound and outbound related-party financing arrangements.

Penalty remission amnesty

To encourage cooperative future compliance, for a limited period the Commissioner says he is willing to remit penalties and interest if certain preconditions are met. Specifically, the Commissioner undertakes that if a taxpayer makes a voluntary disclosure in relation to the back years and adjusts its pricing or level of debt to come within the green zone (low risk), the Commissioner will exercise his discretion to remit penalties and interest. This undertaking will remain in place for 18 months from either the date of the draft guideline's publication (ie, until 16 November 2018) or the effective date for any schedule to the draft guideline.

Date of effect

The finalised guideline will have effect from 1 July 2017 and will apply to existing and newly created financing arrangements/structures/functions. Each schedule to the guidelines may have effect from a different date. Where this is the case, the date of effect will be stated in the relevant schedule.