10 April 2020 - Article
The Australian Taxation Office (ATO) has recently won a major transfer pricing victory in the decision of Chevron Australia Holdings Pty Ltd v Commissioner of Taxation (No 4)  FCA 1092. This is a decision at first instance by Justice Robertson in the Federal Court of Australia. If this decision is upheld on appeal, it will serve as an important formulation of the manner in which the arm's length principle is to be applied to analyse international dealings involving an Australian counterparty.
The facts of the decision are straightforward. Chevron Australia Holdings Pty Ltd (CAHPL) is an Australian subsidiary of Chevron Corporation (CVX) which is a well-known American multinational oil and gas major. In 2003, CAHPL entered into a Credit Financing Facility to borrow the Australian dollar equivalent of USD2.5 billion from Chevron Texaco Funding Corporation (CFC). CFC was established as a US subsidiary of CAHPL, and sourced the funds to provide the loan from the US debt markets at a much lower cost. The main features of the loan were as follows:
- Five year tenor, with capacity for early repayment, or provision for extension in certain circumstances.
- Interest payable monthly at the rate of AUD-LIBOR-BBA plus 4.14%. This worked out to be an effective rate of approximately 9%. CAHPL obtained a private ruling from the ATO concerning the application of an exemption from Australian interest withholding tax.
- Unsecured, with there being no parent guarantee provided by CVX.
CAHPL used the funds drawn down under the loan to retire existing debt that it was carrying in relation to the earlier acquisition of Texaco's Australian assets. It also used funds to assist in the further development of upstream assets in the North West shelf, including its participation in the Gorgon gas project (which at that stage had not reached final investment decision).
The interest rate under the loan was determined by CVX's global treasury based in the US in consultation with advice provided by two investment banks. Post draw-down, CAHPL's gearing was 47% of gross assets. An important part of the funding structure was a tax arbitrage that resulted from the payment of the interest by CAHPL. The interest income received by CFC from CAHPL was not subject to US income tax, and given the lower cost of funding incurred by CFC in sourcing funds from the US capital markets, it was able to derive significant profits. These were distributed back to CAHPL in the form of dividends which were non-assessable income for Australian tax purposes. It was admitted by CAHPL that its capacity to make interest repayments under the loan depended in part on recurrent distributions from CFC.
In April 2010, the ATO issued assessments against CAHPL for the 2004 to 2008 tax years denying a portion the interest expenses incurred by CAHPL under the credit facility. These assessments were made on the basis of determinations made under Australia's former transfer pricing provisions within Division 13 of the Income Tax Assessment Act 1936 (ITAA36).
In late 2012, Australia's transfer pricing legislation was amended with the inclusion of Subdivision 815-A of the Income Tax Assessment Act 1997 (ITAA97). Subdivision 815-A was an interim measure designed to give effect to the ATO's longstanding position that it was able to make a transfer pricing adjustment under Article 9 of Australia's network of double tax agreements. The language of Article 9 – the attribution of profits between associated entities – gives a broader basis to adjust an international dealing between related parties than Division 13 of the ITAA36 which looks at each transaction in isolation. The ATO argued the application of a profit-based method in the earlier SNF case1 and lost. Subdivision 815-A was introduced in 2012 but was given retrospective effect to income years starting after 1 July 2004.
With this new transfer pricing weapon in their arsenal, the ATO issued amended assessments against CAHPL under Subdivision 815-A of the ITAA97 for the 2006 to 2008 income years. The constitutional validity of the retrospective operation of Subdivision 815-A was challenged by CAHPL. These were given short thrift by the Court and are not discussed in further detail in this summary. Arguments were also made that the assessments were not validly made by the ATO but this suggestion was also quickly dispatched by the Court, and are not considered further below.
The decision of the Federal Court is extensive. Much of the analysis is a summary of the expert evidence that was led by both parties. The Court ultimately found much of this expert evidence to be unhelpful in analysing the application of Division 13 and Subdivision 815-A to the specific facts and circumstances of the credit facility.
Part of the expert evidence provided by CAHPL included a discussion of the financing of two upstream oil and gas players in the US. This evidence was intended to demonstrate to the Court that oil and gas companies do raise finance from third party creditors through the issue of debt which is barely investment grade (and sometimes not even). This evidence was ostensibly provided to help to overcome the lack of a comparable uncontrolled transaction in the market. And this was part of the problem for CAHPL – it was admitted by their bankers at the time of entering into the credit facility that an Australian oil and gas company with the same profile as CAHPL could not place that much debt and on those terms with third party creditors. The tenor and the lack of security meant that this debt would be an unappealing proposition to third party creditors. It was noted by one expert, and accepted by the Court, that no single third party creditor would provide the whole sum and instead the debt financing would take the form of a syndicated loan with up to 75 to 100 lenders. The Court gave no weight whatsoever to expert evidence supporting the categorisation of CAHPL as having a BB+ credit rating. It was accepted by the Court that creditors in these circumstances would perform their own creditor analysis which is independent of the rating that may be given by a third party ratings agency.
The central question considered by the Court in analysing the application of Division 13 and Subdivision 815-A was the construction of the hypothetical against which a transfer pricing adjustment is made. What features of the international dealing may be recast in forming this hypothetical arm's length transaction? Is it merely the interest rate determined within the context of the other features of the loan which is to be considered, or it is appropriate for a loan with substantially different features to be used as the hypothetical transaction? The Court resolved this question by stating at paragraph 76:
‘What is required, in my opinion, is to depersonalise the agreement to acquire so as to make it, hypothetically, between independent parties dealing at arm's length, but not so as to alter the property acquired. Division 13 of the ITAA 1936 does not, in my opinion, require or authorise the creation of an agreement with terms different from those of the actual agreement, other than the consideration.'
The Court held that the 'consideration' of the loan was more than merely the interest payable, and included the totality of the promises given by the borrower under the transaction. The Court held that in an arm's length transaction, security and other operational and financial covenants would have been provided as part of the consideration given by the borrower. Factoring in these amendments only to the terms of the loan in establishing a hypothetical, it was held by the Court that the adjustments made by the ATO were not excessive.
Consistent with their reasoning, the Court rejected any suggestion that the hypothetical loan should be denominated in USD which would have had a lower funding cost. The Court accepted the suggestion that there was an implicit parental guarantee provided by CVX to support the obligations of CAHPL under the loan, but did not consider that this would have had any impact on the pricing given it was not legally enforceable.
This decision is a significant win for the ATO at first instance. If it is upheld on appeal, it will break what has otherwise been a losing streak for the ATO with transfer pricing litigation. Transfer pricing arrangements amongst international resources players are currently the subject of close scrutiny in Australia, and have been swept up in the public debate about ensuring that multinationals pay their 'fair share of tax'. This debate is becoming more fevered as the investment cycle of the local resources boom comes to an end, commodity prices come off the boil, and Australia remains in fiscal deficit. The more immediate and targeted focus is upon offshore marketing hubs2, but intra-group debt arrangements are as equally low-hanging fruit.
Unlike other items of the BEPS action plan, introducing a more stringent approach to transfer pricing is arguably much easier to implement compared to initiatives such as diverted profits taxes and other measures which require legislative intervention. The typical approach of legislating the arm's length principle within a general transfer pricing provision without further elaboration means that this is by nature an ambulatory concept. It is able to bend and flex as jurisprudence around the arm's length principle develops and changes. It also means that the past transactions can and will be viewed through the prism of a more stringent approach to the pricing of international dealings. The decision of the Court in the Chevron case is not a direct product of the current zeitgeist, but one wonders to what extent this context played a part in the vigor with which this was pursued by the ATO and the willingness of the Court to reject the relevance the comparable transactions which were offered up by the taxpayer.
It would seem that one of the only ways to provide absolute certainty going forward for higher value transactions is to engage with tax authorities and obtain an advanced pricing agreement (APA), as time consuming and expensive as this can be. A unilateral APA in the country of greatest transfer pricing risk would be the simplest version, though potentially not as useful as the more comprehensive approach of applying for a bilateral APA. For lower value transactions, selecting a conservative pricing position that is supported by a profit-based pricing methodology may be a pragmatic way forward.
 SNF (Australia) Pty Ltd v Commissioner of Taxation  FCA 635
 Offshore marketing/trading hubs based in Singapore and Hong Kong are under close examination at the moment. This is due to the imposition of little or no taxation imposed on trading gains in these jurisdictions.