Focus: Federal Court judgment in the Chevron transfer pricing case
10 November 2015
In brief: The Federal Court's much-anticipated judgment in Chevron Australia Holdings v Commissioner of Taxation is the next important step in the development of Australia's transfer pricing rules. Partners Martin Fry (view CV) and Toby Knight (view CV) discuss certain implications of the decision.
- Constructing the hypothetical
- Division 13 of the Tax Act 1936
- Subdivision 815-A of the Tax Act 1997
- Onus of proof
How does it affect you?
- The Chevron decision, handed down by Justice Robertson on 23 October 2015, will put a greater focus on collecting evidence and determining the features of arrangements that would be entered into between independent parties.
- Under both Division 13 of the Tax Act 19361 and Subdivision 815-A of the Tax Act 19972, the Federal Court considered it could price the transaction as if certain non-price hypothetical conditions applied rather than the actual terms and conditions – but that this did not, in Justice Robertson's view, involve substituting a different agreement for that actually entered into.
- A potential ongoing implication of Justice Robertson's decision for future income years under Subdivision 815-B of the Tax Act 1997, with its even broader concept of 'arm's length conditions', is that the Commissioner may now argue that a transaction can be priced on different terms and conditions than those actually entered into – even if the Commissioner does not seek to engage a provision that permits the actual terms to be disregarded on the basis that it would not have been entered into by independent parties (section 815-130 in the new Subdivision 815-B). An issue arises as to whether the proper construction of Subdivision 815-B would not permit the approach that Justice Robertson took in relation to Subdivision 815-A had the case arisen in relation to income years to which Subdivision 815-B applied.
- The decision demonstrates that taxpayers may be at risk if they encounter difficulties in proving what the features of an arrangement between independent parties would be, and proving that the taxpayer's own arrangements have, and do not lack, important features which would operate between independent parties dealing wholly independently with one another, where such features would materially affect the price under the transaction.
- The Chevron decision demonstrates the importance of the taxpayer adducing cogent expert evidence in order to discharge the onus of proving that a transfer pricing assessment is excessive, by proving not only that price, but also that non-price conditions, are those that might be expected to operate between independent parties.
The Chevron case related to interest paid by CAHPL (an Australian company) to its subsidiary CFC (a US company) under a Credit Facility Agreement (CFA) between CAHPL and CFC. The CFA provided for CFC to make advances to CAHPL up to the AUD equivalent of US$2.5 billion. Interest was payable at one month AUD LIBOR plus 4.14 per cent. CAHPL and CFC were both members of the Chevron group of companies. CAHPL's obligations under the CFA were not guaranteed by the Chevron parent entity, and CAHPL provided no security or other covenants in favour of CFC.
The Commissioner of Taxation disallowed deductions for interest paid under the CFA in the 2004 to 2008 period. In doing so, the Commissioner relied, depending on the relevant income year, upon the transfer pricing provisions in Division 13 of the Tax Act 1936 and in Division 815-A of the Tax Act 1997.
The underlying issue in the Chevron case is how one should construct the hypothetical transaction between independent parties for the purposes of applying the transfer pricing provisions. The potential tax adjustments that may arise under the transfer pricing provisions will be affected by the features that are to be taken into account in constructing the hypothetical.
In the Chevron case, one of the key issues was whether the features of the hypothetical transaction should include the provision of security or other covenants in favour of the lender. As is clear from the decision of Justice Robertson, where the hypothetical loan between an independent borrower and lender is to include security provided in favour of the lender to secure repayment of the loan, then the inclusion of this feature can affect the conclusion as to the arm's length interest rate for the purposes of applying the transfer pricing rules.
As the statutory tests under Division 13 of the Tax Act 1936 and Division 815-A of the Tax Act 1997 are different, it is necessary to address the question of the hypothetical separately.
Division 13 focuses on the property acquired and consideration provided under the arrangement that is under investigation.
The question at issue was whether the consideration actually provided by CAHPL (ie the interest rate and nothing else) exceeded the arm's length consideration for that property. This task required one to assess what the consideration would be under a hypothetical transaction between independent parties dealing at arm's length, and the importance of the decision in Chevron lies in the guidance that Justice Robertson provided on how one should construct the hypothetical.
In Chevron, Justice Robertson found that the property acquired by CAHPL was the rights or benefits under the CFA, including the loan moneys. However, his Honour found (relying on cases such as Archibald Howie Pty Ltd v Commissioner of Stamp Duties (NSW)) that the 'consideration' to be examined for the purposes of applying the provisions was not limited only to the interest paid by CAHPL to CFC, because there was nothing in Division 13 which restricted 'consideration' in respect of a loan to the interest rate only. Rather, it could include other promises that hypothetically might have moved the advance of the lender's funds, including any promises to provide security and covenants. Accordingly, Justice Robertson, in determining what the arm's length consideration should be, considered himself able to determine both whether in an arm's length dealing there would have hypothetically been that part of the consideration that included promises to provide security and financial covenants and, accordingly, whether that part of the consideration that comprised the interest rate would have been less than actually agreed.
Justice Robertson found that CAHPL did not provide security or operational and financial covenants in favour of CFC and concluded that, because there would have been such security or covenants under an agreement between independent parties dealing at arm’s length with each other, the interest rate paid by CAHPL under the CFA was higher than an arm’s length rate as a result of their absence.
Justice Robertson concluded that the hypothetical should have the features which are relevant to the pricing of the loan and market in question. Hence, as the evidence showed that, in pricing a loan of this nature, independent parties would have regard to the characteristics of the borrower, in the hypothetical the borrower is assumed to be an oil and gas exploration and production subsidiary. Similarly, in constructing the hypothetical it will be relevant to take into account the creditworthiness and financial resources of the borrower.
The hypothetical is to be based on two parties who are independent of each other. However, according to Justice Robertson, this does not mean that the borrower is assumed to be a 'stand alone' entity; it simply means that the borrower is assumed to be independent of the lender. Nevertheless, for the purposes of Division 13, the relationship between CAHPL and its parent, and thus the issue of any implicit credit support from its parent, was not determinative in the context of the statutory hypothesis, as to allow it to be would be to incorrectly import the actual identity of CAHPL into that hypothesis contrary to the decision in SNF.3 Later in his judgment, at a factual level, Justice Robertson nevertheless accepted the applicant's submission that, in the absence of a legally binding parental guarantee, implicit credit support had very little, if any, impact on pricing by a lender in the real world.
Within this framework, Justice Robertson concluded that independent parties dealing at arm's length would only enter into a loan arrangement of this magnitude and type on the basis that the borrower would provide security and other covenants in favour of the lender and, as a result, the interest rate payable under the hypothetical arm's length loan would be lower than was paid by CAHPL under the CFA. Accordingly, Justice Robertson concluded that Chevron had failed to establish that the Commissioner's assessments were excessive.
The judgment of Justice Robertson addressed a number of issues that go to the legal structure of the transfer pricing provisions contained in Division 815-A and the validity of determinations made by the Commissioner in the course of applying them. Justice Robertson confirmed the constitutional validity of Subdivision 815-A and confirmed that Article 9 of the US/Australia Double Tax Agreement was an 'associated enterprises' article for the purposes of the Subdivision. These matters will continue to be of interest in the event that Justice Robertson's judgment is appealed by the taxpayer.
However, at its heart Subdivision 815-A focuses on the conditions existing between the parties to the arrangement in question and asks whether those conditions differ from the conditions which might be expected to operate between independent entities dealing wholly independently with one another. As is the case under Division 13, this requires one to compare the actual transaction to a hypothetical transaction between hypothetical independent parties. However, according to Justice Robertson, the question under Division 815-A has a different focus from that which arises under Division 13.
It was necessary for Justice Robertson to respond to the contention that the hypothetical under Division 815-A should not be a vehicle for re-characterising the actual arrangement or otherwise rewriting the terms of the actual arrangement. In particular, that implicit credit support from a parent entity should not be a feature of the hypothetical transaction between independent parties. Justice Robertson dismissed questions of re-characterisation as a diversion from the real question – simply the task is to compare the conditions of the actual arrangement to the conditions that might be expected to operate between independent parties dealing wholly independently of each other. As to independence, it was concluded that one would not fail to recognise a corporate group relationship in the hypothetical where that was a feature of the actual parties to the arrangement in question and the existence of that relationship would be relevant to how independent parties would assess and negotiate the loan. As such, it was concluded that implicit credit support would be a feature of the hypothetical transaction. However, this feature was determined to have little impact on pricing the interest rate.
Justice Robertson agreed with the Commissioner that there were conditions existing which differed from those which might be expected to exist between independent parties, and that therefore there was an amount of profits that, but for those conditions, might have been expected to accrue to CAHPL, which had not. The conditions which differed from those that might be expected to operate between independent parties included the absence of real bargaining to establish the loan and the higher interest rate coupled with the absence of covenants. After rejecting the proposition that the profits of CAHPL should take into account dividends received from CFC, this conclusion provided the foundation for Robertson to conclude that CAHPL had obtained a transfer pricing benefit for the purposes of Division 815-A.
Justice Robertson was not persuaded that the fact that the loan was in Australian currency was a condition which differed from one that might have been expected to operate between independent parties dealing wholly independently with one another. Justice Robertson accepted the taxpayer's submission that borrowings in AUD would avoid or limit foreign currency gains or losses. So this finding, and the finding that implicit credit support had little, if any, impact on pricing by a lender in the real world, were factual findings in the taxpayer's favour. However, critically, Justice Robertson did not accept evidence that the fact that the CFA was unsecured and lacked financial covenants (and any parental guarantee) would not prevent the institutional loan market from having sufficient capacity to deal with such a loan by simply charging a higher interest rate to compensate for the increase in risk. Justice Robertson found that one of the applicant’s experts had agreed that an absence of restrictive or negative covenants meant that CAPHL could not have entered into the arrangement. Justice Robertson also found the evidence of other of the applicant's experts unpersuasive in different respects. Justice Robertson therefore concluded that the applicant had not shown that the consideration in the CFA was the arm’s length consideration or less than the arm’s length consideration.
- Income Tax Assessment Act 1936 (Cth).
- Income Tax Assessment Act 1997 (Cth).
- Commissioner of Taxation v SNF Australia Pty Ltd (2011) 193 FCR 149.
- Martin FryPartner, Practice Leader, Tax,
Ph: +61 3 9613 8610
- Toby KnightPartner,
Ph: +61 3 9613 8590
- Tony KuhnPartner,
Ph: +61 3 9613 8940
- Larry MagidConsultant,
Ph: +61 2 9230 4918
- Malcolm StephensPartner,
Ph: +61 2 9230 4828
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