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Zara Ritchie BDO Australia
Zara Ritchie is Head of Global Transfer Pricing Services at BDO Australia
Chevron Australia was the longest running transfer pricing legal case in Australia, and the Australian Taxation Office (“ATO”) win is significant in the Australian, and possibly global, transfer pricing landscape. Given the significance of the win, this is definitely not the last intragroup financing case we will see the ATO challenge.
In April 2017, the Full Federal Court ruled against Chevron Australia Holdings Pty Ltd (“Chevron Australia”) in favor of the Australian Taxation Office (“ATO”) on appeal in relation to the transfer prices on intragroup funding between the overseas related party (“the lender”) and the recipient of funds, Chevron Australia (“the taxpayer/borrower”).
The cross-border funding provided to Chevron Australia was unsecured at a rate of approximately 9 percent, supported by extensive transfer pricing analysis. This rate seemed to be out of line with the Group's policy to borrow in the market at the cheapest rate possible, with a parental guarantee.
The court also concluded that Chevron Australia cannot be evaluated as an “orphan,” i.e. independent from the Group. As such, in a hypothetical arm's length scenario, the additional security/guarantee/covenants would have been provided to the lender, in line with the Group's policy to borrow at the cheapest rate possible.
One of the biggest implications for taxpayers is that it is not sufficient to analyze the existing arrangements and legal agreements, instead the first step should be to ensure that the arrangements are commercial in the context of market practice and the Group's internal policies.
This decision will prompt the review of any existing cross-border financing arrangements, and an increased focus and commerciality analysis for any future arrangements, in order to reduce the risk of an ATO review and adjustment.
The lender (i.e. special purpose entity established in the U.S. to raise funds through borrowings from the U.S. commercial market) borrowed approximately US$2.5 billion on a short-term basis, at the rate of interest at or below US$ LIBOR (approximately 1 percent to 2 percent), with a guarantee provided by its ultimate U.S. parent.
These amounts were then on-lent to the taxpayer/borrower under a longer term Credit Facility Agreement. The taxpayer/borrower borrowed the AU$ equivalent of US$2.5 billion for five years with an interest rate at approximately one-month AU$ LIBOR + 4.14 percent per annum, resulting in an interest rate of approximately 9 percent.
The loan was not subject to financial covenants and no parental guarantee or security was provided.
The net outcome was that the lender obtained funds at the rate of between 1–2 percent (on US$ funds), which it then on-lent to the borrower/taxpayer at approximately 9 percent (on AU$ funds).
From a taxation perspective, the net effect of the Credit Facility Agreement was that the taxpayer/borrower generated large interest deductions, where the interest paid was tax-exempt dividend income in the hands of the lender. This was then on paid to the U.S. parent, presumably as an unfranked dividend which, under the Australia/USA Double Tax Agreement, would have no Australian withholding tax payable.
Arguably, the key message from the original Chevron decision surrounded the commerciality of the related party debt transactions (something that has been a continued focus for the ATO). The court contemplated that in a hypothetical arm's length scenario, a security would have been offered together with financial covenants to make the arrangement more commercial and arm's length, resulting in a lower interest rate.
The Full Federal Court decision covers a range of issues.
The first issue is the application of Australia's transfer pricing rules in Division 13 and the interim transfer pricing rules contained within Division 815-A (introduced to apply retrospectively from July 1, 2004 to June 30, 2013). Chevron Australia had contested the retrospective nature of the Division 815-A provisions as unconstitutional.
The judgment supports that Division 815-A can be applied retrospectively.
Historically, the OECD guidelines included limited guidance on the application of arm's length principles to intragroup financing. This often meant that transfer pricing practitioners applied the purest “stand-alone entity concept” (or “orphan” concept), as if the borrowing entity was independent from the global Group.
The ATO has held a long standing view that the notion of implicit support, and interdependence between the parent and the borrower, needed to be taken into account. In October 2015, the OECD issued revised Base Erosion and Profit Shifting (“BEPS”) driven guidelines including Actions 8–10 covering “value creation.” The guidelines included examples showing how the interdependence of the borrower and the lender can lead to a subsidiary enjoying more favorable interest rates due to lenders simply taking account of the Group relationship through “Group synergies” or “passive association” without any inducement of the parent—suggesting that any benefit to the subsidiary in this case is incidental and does not require separate remuneration. At the same time, where the parent company induces a third party lender to provide funding with the reference to the parental credit rating, then an explicit guarantee fee may be payable according to the revised OECD guidelines.
These new OECD guidelines apply to accounting periods beginning after July 1, 2016 for Australian transfer pricing purposes and are not specifically referred to in the Chevron judgment. However, the guidelines reinforce the ATO's historic view. Further, the detailed OECD guidance on the interpretation of the arm's length principle as it relates to intragroup financing is expected to be published within the next 12 months. It is likely that the OECD would scrutinize the Chevron case in the process of drafting such guidance.
The Full Federal Court noted that the Chevron Group had a policy to borrow externally at the lowest cost and that the parent will generally provide a guarantee to comply with such a policy. As such, the Full Federal Court ruled that the subsidiary should not be treated as an “orphan” (i.e. independent from the Group), further reinforcing the historic view on the matter from the ATO. Given the limited number of historic court cases dealing with the transfer pricing aspects of intragroup funding arrangements, and impending guidance on the subject from the OECD, the Chevron decision may also have a far-reaching global impact.
No doubt the OECD's guidance will be issued in the spirit of various BEPS initiatives which are likely to be positively received by the ATO. One should look to the 2016–17 Australian Budget measures to see that the ATO is serious about adopting various BEPS measures, as tax advantages from hybrid mismatches will be further restricted.
The judgment does not comment on what the interest rate should have been in Chevron's circumstances as in Australian law the burden of proof is on the taxpayer and not the ATO. From a legal perspective, despite the plethora of transfer pricing analysis prepared by Chevron, the company had not proved their position so the ATO's assessments would stand.
Possibly encouraged by the Chevron Australia decision, on May 16, 2017, the ATO issued a draft Practical Compliance Guidance PCG 2017/D4 (PCG) outlining the risk assessment framework for cross-border related party financing arrangements. This guideline has been anticipated for some time but is clearly timed to be released shortly after the Chevron decision—while the issues surrounding the related party debt are in the media spotlight. The guideline follows the similar traffic light risk rating approach to the widely discussed marketing hubs paper issued by the ATO this year.
In an attempt to produce a “one size fits all” guidance the ATO overlooks the complexity and multitude of possible arrangements when dealing with related party debt and PCG may result in some puzzling outcomes on application. The PCG however is a welcome tool and needs to be taken for what it is—an insight the ATO provides to taxpayers on how it will assess risk under financing arrangements and what to expect from the ATO based on these outcomes. While the risk assessment using the PCG is not compulsory for the majority of taxpayers, multinationals are well advised to use the guidance not only to assess the risk but to plan mitigation strategies, if necessary.
By issuing the PCG, the ATO will be seeking to influence behaviors amongst taxpayers in relation to high versus lower risk financing arrangements, thereby arguably encouraging taxpayers to restructure their funding operations to minimise audit and review risks. The draft PCG deals with taxation issues associated with cross-border related party financing arrangements and is effective from July 1, 2017. It provides no guidance on how taxpayers can comply with the arm's length principle, which underpins the transfer pricing legislation. Instead, it is a risk assessment tool that uses a structured albeit complex checklist approach that allows taxpayers to self-assess their risk.
Chevron decided to appeal on numerous interpretational issues of the law and feels that the judges erred in the way the law is to be applied. This was the first transfer pricing case in Australia in relation to cross-border financing, and interpretation of the law applicable at the time (now superseded) was not previously tested in respect of financing matters.
The appeal points out that there is divergence of approaches of the primary judge and the two approaches taken in the Full Court, which leaves the transfer-pricing world in somewhat uncertain state as to the outcome of proceedings and correct interpretation of the legislation. Although the legislation in question is now superseded, there are certain commonalities with the current legislation.
The uncertainty increased by the fact that the ATO just issued a draft risk assessment framework in relation to cross-border financing, which does not deal with application of the law but provides administrative guidance. This is likely to increase confusion among taxpayers as to the appropriate application of the transfer pricing legislation to cross-border financing.
The Chevron decision shows the importance of properly analyzing, documenting and evidencing intragroup financing arrangements, having regard to commerciality and ensuring that the arrangements do not substantially deviate from Group policies.
Taxpayers should therefore risk assess existing and future arrangements in light of the Chevron decision. Taxpayers should consider and explore all options that would be realistically available to the borrower in a hypothetical arm's length scenario, to ensure that the arrangement entered into is commercially viable and supportable.
In light of the Chevron decision, Groups may wish to consider the impact of any Group financing policies and the potential interdependence of Group companies and how this affects the associated interest rates.
All taxpayers who have existing intragroup financing arrangements and are uncertain how these arrangements are affected by the Chevron decision should risk assess their arrangements. This will be particularly important once the ATO issues its Practical Compliance Guidelines. Some risk mitigation strategies, such as entering into Private Rulings or Advance Pricing Agreements discussions with the ATO are also available to increase certainty.
Zara Ritchie is Head of Global Transfer Pricing Services at BDO Australia.
Copyright © 2017 The Bureau of National Affairs, Inc. All Rights Reserved.
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