In brief 10 min read
On 6 November 2020, the Full Court of the Federal Court of Australia handed down its much anticipated decision dismissing the Commissioner's appeal (save for one issue) against Glencore Investment Pty Ltd in a significant transfer pricing dispute.1
This dispute dealt with the arm's length nature of the pricing arrangements in respect of the sale of copper concentrate by the owner and operator of an Australian mine to its Swiss parent.
The decision has significant implications for the interpretation of Australia's transfer pricing rules, including the interpretative relevance of the OECD Transfer Pricing Guidelines (OECD Guidelines), the court's expectations regarding comparability, the relevance of antecedent intercompany arrangements, the scope of the Commissioner's power to substitute contractual terms and the role of lay and expert evidence in a transfer pricing dispute.
- Australia's transfer pricing provisions are to be interpreted consistently with the OECD Guidelines, but only to the extent they are relevant. Given the highly generalised language deployed in the Guidelines, they may not always be of practical assistance to the task of applying domestic Australian law.
- A taxpayer's pre-existing intercompany arrangements should not form the basis of a comparability analysis. The question posed by domestic Australian law is not whether an independent party would have agreed to a change of terms, but whether the actual conditions (or 'consideration') fall within an arm's length range.
- Transfer pricing is not an exact science. The taxpayer does not need to disprove the case advanced by the Commissioner. It does not need to demonstrate that its transfer pricing is 'more arm's length' than that proposed by the Commissioner. It needs to show that its transfer pricing is consistent with a range of commercially acceptable arm's length outcomes, with the range determined by reference to evidence establishing a 'sufficiently reliable' prediction of what may be seen as reasonable between independent parties.
- Where contractual clauses define the price payable by reference to, for example, a formula or methodology, the Commissioner may substitute different clauses that will result in the ascertainment of arm's length consideration. This power to substitute terms that define transfer prices does not rely upon any power the Commissioner may have to 'reconstruct' transactions.
- In a transfer pricing dispute, a lay witness may be best placed to explain why contracts are, or are not, comparable to the tested transaction. This includes lay observations about the similarities and differences between the contracts and the commercial conditions in which such deals were struck. By contrast, an expert witness may be better placed to provide an opinion about whether pricing clauses contained in tested transactions might be expected to be adopted at arm's length.
In the financial years ended 31 December 2007 to 2009, Cobar Management Pty Ltd (CMPL) managed and operated a mine in New South Wales, Australia. CMPL sold 100% of the copper concentrate it produced to Glencore International AG (GIAG), a related marketing hub tax resident in Zug, Switzerland. Prior to February 2007, part of the treatment and copper refining charges (TCRCs) were negotiated by reference to specified regional benchmark TCRCs (50%) and spot market TCRCs (50%) (Pre-Existing Contract). In February 2007, CMPL and GIAG restructured its pricing arrangements (February 2007 Contract): TCRCs were now set according to the copper reference price on the London Metal Exchange over one of three quotational periods selected by GIAG (QP Optionality Term), with a fixed 23% deduction made off the copper reference price (Price Sharing Term). The restructure was expected to reduce CMPL's risk profile and, therefore, fluctuations in, and the level of, CMPL's profitability.
Relying on former Division 13 of the Income Tax Assessment Act 1936 (Cth) (Division 13) and the transitional rules contained in Subdivision 815-A of the Income Tax Assessment Act 1997 (Cth) (Subdivision 815-A), the Commissioner considered the 'part benchmark and part spot' pricing formula contained in the Pre-Existing Contract was arm's length in nature, arguing that:
- An independent producer would not have agreed to the Price Sharing Term or, in the alternative, the commercial benefits arising from the Term did not justify the amount of revenue foregone; and
- An independent producer would not have agreed to the QP Optionality Term or, in the alternative, there would have been a quid pro quo for such a Term.
At first instance, Justice Davies found in favour of the taxpayer.2 In separate judgments, Justices Middleton & Steward and Justice Thawley largely dismissed the Commissioner's appeal, although the judgments differed in their reasoning in parts.3 The judgments are expected to have relevance in interpreting not only former Division 13 and Subdivision 815-A, but the core transfer pricing provisions used today, contained in Subdivision 815-B of the Income Tax Assessment Act 1997 (Cth) (Subdivision 815-B), and the Associated Enterprises Article contained in most double taxation agreements.
One key aspect of a comparability analysis is hypothesising a 'depersonalised' enterprise in the position of the taxpayer. Justices Middleton & Steward provide the following guidance:
- Only those attributes or features which can affect consideration should clothe a hypothetical enterprise in the position of the taxpayer;
- Only objective attributes or features are relevant to such an analysis (including, in this case, the means, levels and costs of production, the size and location of the mine, problems arising from the mine's location, the objective circumstances of the market and the fact it was a member of a multinational natural resources group);
- Those attributes or features that are the product of the non-arm's length relationship between the taxpayer, the counterparty to the tested transaction, and the specific multinational group of which it is a member should be excluded (eg internal risk policies);
- The pricing formula or methodology may be supported by reference to what such a depersonalised enterprise in the position of the taxpayer might have done to address risk in the objective circumstances of the market in which it operated;
- There may be a range of arm's length outcomes, each of which would be sufficient to answer the relevant statutory test;
- What controls the range of acceptable arm's length outcomes is what might reasonably be expected based on evidence supporting a sufficiently reliable prediction which can be seen as reasonable; and
- In undertaking the analysis, a degree of flexibility and pragmatism is required.
Justices Middleton & Steward explained that the Commissioner, in arguing that an independent enterprise in the position of the taxpayer would have retained the 'part benchmark and part spot' pricing formula contained in the Pre-Existing Contract, demonstrated a misunderstanding of the questions posed by Division 13 and Subdivision 815-A. The Commissioner's argument was flawed on the basis that it hypothesised an enterprise, standing in the shoes of the actual taxpayer, with attributes referable to the taxpayer's non-arm's length relationship with its parent company (ie its antecedent arrangements). Whether a hypothetical enterprise in the position of the taxpayer would have agreed to the restructure, therefore, is not determinative.
Instead, the relevant question is whether the February 2007 Contract 'fell within that range of hypothetical contracts for the sale of copper concentrate which independent parties dealing at arm's length with each other might reasonably be expected to have entered into'. The hypothetical, according to their Honours, must be made to work, and so one is required to draw upon those 'commercially rational' practices adopted by independent parties.4 The apparent emergence of an overarching 'commercial rationality' principle in Australian transfer pricing jurisprudence is curious as it can be found in the OECD Guidelines only in respect of the OECD's reconstruction guidance. This principle does not appear to have been intended by the OECD to have application beyond the narrow realm of 'reconstruction'.
As a result, the role of the taxpayer is to demonstrate that the pricing formula or methodology did not differ from those which might be expected to have operated between independent enterprises dealing wholly independently with one another in the relevant market at the relevant time. This necessarily requires a consideration of how independent enterprises in such circumstances might be expected to have assessed the issue of risk. It is interesting to note that this is not dissimilar from the principles contained in the OECD's transfer pricing risk framework which were, again, first introduced by the OECD in the 2017 version of its Guidelines.5 Arguably all that is required is for the taxpayer to demonstrate that its risk/reward trade-off might have been made at arm's length. There is no expectation, according to their Honours, for an Australian taxpayer to maximise its profitability at the expense of prudence in managing risk.
Subdivision 815-B, which was not in issue in this case, contains explicit provisions that permit the Commissioner to reconstruct transactions where form does not match substance or where independent entities would have entered into other commercial or financial relations, and to annihilate transactions where independent entities would not have entered into commercial or financial relations at all. These provisions are broadly consistent with the 'exceptional' circumstances in which reconstruction is considered permissible by the OECD in the 2010 and 1995 versions of its Guidelines.6 Neither Division 13 nor Subdivision 815-A contain provisions explicitly permitting the Commissioner to reconstruct or recast the tested transaction.
At first instance, Justice Davies held that the Commissioner's substitution of the QP Optionality and Price Sharing Terms with the antecedent 'part benchmark and part spot' pricing arrangement constituted impermissible reconstruction because it did not meet the exceptional circumstances contained in the OECD Guidelines. On appeal, the Full Court concluded, contrary to the decision of Justice Davies, that the Commissioner's substitution did not amount to reconstruction. It therefore did not need to decide whether the reconstruction provisions contained in the OECD Guidelines could be 'read in' to Division 13, Subdivision 815-A and/or the Associated Enterprises Article.
Justices Middleton & Steward concluded that the term 'consideration' under Division 13, and the term 'condition' under Subdivision 815-A, are not to be given a narrow construction. Rather, the Commissioner is entitled to substitute contractual terms where such terms define the price payable by, for example, a pricing formula or methodology. In this case, it extended to the Commissioner being able to ascertain the reasonably expected consideration by reference to a pricing formula or methodology without the QP Optionality or Price Sharing Terms. (However, the taxpayer was able to demonstrate that these Terms were consistent with the arm's length standard.)
Justice Thawley's interpretation of the Commissioner's 'substitution' power is arguably broader than Justices Middleton & Steward's interpretation. In respect of Division 13, his Honour considered that this extends to terms which affect consideration, not merely those that define price. However, the greater the substitution or the more different the hypothetical agreement is from the actual agreement, the less likely it is to be probative of arm's length consideration. In respect of Subdivision 815-A, his Honour did not consider the distinction between those terms which define price and those which do not to be a valid distinction, holding that both may be substituted without reference to any reconstruction power that might exist.
Justices Middleton & Steward distinguished the roles of lay witnesses vis-à-vis expert witnesses in the context of a transfer pricing dispute. Lay witnesses (eg current or former employees) are generally considered better placed to provide evidence of facts that will assist in assessing the comparability of contracts and the commercial conditions in which such deals were struck. By contrast, expert witnesses (eg industry experts and pricing economists) are generally considered better placed to provide opinions on whether a clause in a contract pertaining to price is one which independent parties dealing with each other at arm's length might, or might not, be expected to adopt. Further, an expert witness may give evidence about how a commercially rational taxpayer in comparable circumstances might make choices about managing risk.
Justices Middleton & Steward did not dismiss the role of expert witnesses opining on potentially comparable arrangements, but noted there is only so much an expert can legitimately say about a deal with which she or he had nothing to do. In respect of the independent contracts considered by the taxpayer's expert, Justices Middleton & Steward acknowledged the differences identified by the Commissioner's expert diminished, but did not entirely negate, their probative value. These contracts were still valid as a 'reference point' or 'sounding board'.
In respect of the Price Sharing Term, Justices Middleton & Steward accepted the taxpayer's expert's judgment that it was set at a commercially prudent rate. Experts may reasonably differ within a range of commercially acceptable arm's length outcomes and just because there is a difference of opinion does not mean that the taxpayer has not discharged its evidentiary burden.
In respect of the QP Optionality Term, Justices Middleton & Steward did not disturb Justice Davies' finding at first instance that CMPL could have secured a material quid pro quo discount in return for granting optionality in respect of the selection of the relevant quotational period. Their Honours expressed reluctance to reconsider this issue in depth given Davies J's detailed review and consideration of this issue at first instance.
Justice Thawley did not specifically provide an opinion on the Price Sharing or QP Optionality Terms, but agreed with the outcome reached by Justices Middleton & Steward.
- If your transfer prices are set by reference to one or more pricing clauses contained in intercompany contracts, it is helpful if comparable clauses can be found in external contracts. This is particularly the case where the transfer pricing is determined in accordance with a particular formula or methodology. These external contracts may be used to support the formula or methodology even if the numbers contained in the contracts have been redacted.
- Consider whether the allocation of risk between related parties, and pricing thereof, is commercially rational, having regard to the practices adopted by independent entities operating in comparable circumstances.
- Depending on the particular facts of the case, the mere fact that an intragroup restructure has resulted in a material decline in the profitability of an Australian taxpayer arguably has no legal bearing on whether the post-restructure arrangements meet the arm's length standard. Therefore, when assessing the compliance of a business restructure with the arm's length standard, the focus needs to be on whether the post-restructure consideration (under Division 13) or conditions (under Subdivision 815-A / Subdivision 815-B / the Associated Enterprises Article) fall within an arm's length range.
- If you are in the midst of a transfer pricing dispute, you may need to review the extent to which your expert witness is opining on the comparability of contracts or companies and consider whether lay evidence may assist in supporting the factual basis for comparability.
Commissioner v Glencore Investment Pty Ltd  FCAFC 187.
Glencore Investment Pty Ltd v Commissioner  FCA 1432.
Both judgments accepted the Commissioner's appeal in respect of a freight allowance issue due to a lack of evidence led by the taxpayer. As this issue was not central to the judgments of either Middleton & Steward JJ or Thawley J, it is not considered further.
Relying upon comments made by Chief Justice Allsop in Chevron Australia Holdings Pty Ltd v Commissioner (2017) 251 FCR 40, 53.
Chapter I, Section D.1.2.1.
OECD Guidelines (2010), [D.2]; OECD Guidelines (1995), [C.1.36].