Intra-Group Loan Pricing
Chevron Australia Holdings Pty Ltd v Commissioner Of Taxation (2017) FCAFC 62
The recent ruling by the Full Federal Court in Chevron Australia Holdings Pty Ltd v Commissioner of Taxation  FCAFC 62 marks a watershed moment not just in Australia but globally. It offers profound insights into the application of the arm's length principle in the context of multinational corporations that operate in diverse economic, market and business environments. The decision recognises that multinational enterprises have unique and diverse business practices when it comes to their dealings with independent external entities and intra-group transactions. It further highlights that transfer pricing rules allow a subsidiary to be perceived as an integral part of the larger global group, rather than an isolated entity, when pricing related party loans.
Most notably, the court's introduction of the reasonable expectation test is a ground-breaking development. This new approach considers rational commercial behaviour, expert opinion and evidence to evaluate the outcome of events and transactions involving multinational corporations. The reasonable expectation test is akin to the approach taken by Australian courts in the application of the general anti-avoidance provisions in Part IVA of the Australian Income Tax Assessment Act 1997 (ITAA). This decision firmly reinforces the foundations of Australia's transfer pricing rules, specifically the latest iteration of Subdivision 815-B of the ITAA. Its impact extends beyond the realm of intra-group financing and it offers invaluable insights into the complexities of evaluating multinational transactions and events. Overall, this ruling represents a pivotal moment that will resonate throughout the global business and legal communities.
The Chevron group underwent significant restructuring and refinancing of its Australian sub-group after the merger of Chevron Corporation and Texaco Inc. in October 2001. As part of this restructuring, a new Australian holding company called Chevron Australia Holdings Pty Ltd (the Appellant) was established, which acquired the Australian assets of Chevron and Texaco. To support these steps, the Appellant needed financial assistance. Therefore, a wholly owned US resident subsidiary, Chevron Texaco Funding Corporation (CFC), was created to raise USD 2.5 billion by issuing commercial paper at an interest rate of 1.2%. On 6.6.2003, CFC and the Appellant entered into a Credit Facility Agreement. As per the agreement, CFC provided a loan of around USD 2.5 billion to CAHPL in Australian dollars with an interest rate of approximately 9%.
The interest payments made at a rate of 9% under the agreement had a profound effect of generating a tax deduction for Chevron Australia against its operating revenue from its interest, via subsidiaries in the Northwest Shelf gas project. Of particular note, the interest income in the hands of CFC remained non-taxable in the United States. Moreover, owing to CFC's status as a wholly owned foreign subsidiary of the Appellant, dividends declared by CFC, originating from profits, were shielded from being categorised as assessable income for Australian tax purposes. As such, the upshot of the deduction for outbound interest and receipt of inbound non-assessable dividends was the transformation of operating income, which would otherwise have been perceived as assessable income into non-assessable income.
It is also noteworthy that the unsecured loan contained no financial or operational covenants and was bereft of any guarantees. The crux of the matter pertained to whether the interest paid by Chevron Australia to CFC surpassed the arm's length price concerning the AUD equivalent of the borrowing. It is imperative to underscore that approximately AUD 340 million of primary tax, penalties and interest were at immediate stake, accentuating the gravity of the issue at hand.
Based on the above, amended assessments were issued by the tax authority premised on the determinations under the previous Australian transfer pricing regime. Specifically, Division 13 of the ITAA 1936 was used for the 2004 to 2008 tax years, while sub-division 815-A of the ITAA 1997 was used for the 2006 to 2008 tax years. Aggrieved by the assessments aforementioned, the Appellant appealed to the Federal Court but the appeal was dismissed. Hence, the Appellant’s further appeal to the Full Federal Court.
The Full Federal Court’s Ruling
The Appellant’s appeal was unanimously dismissed. The main point of contention before the Full Federal Court was whether the exorbitant interest rate of roughly 9% imposed by an affiliated offshore financial entity upon the Appellant's loans, which translates to an astronomical premium of nearly 7.8% above the actual 1.2% cost of funding, transcended the consideration that would have been mutually agreed upon by autonomous parties conducting transactions wholly devoid of any semblance of association.
In ascertaining whether the parties had engaged in dealings at arm's length, the court deemed it imperative to account for the tangible commercial realities that govern the pricing of the loan. The court ruled that in applying the relevant transfer pricing regulations, it is necessary to presume that an arm's length borrower operates independently from the lender, while not necessarily operating in isolation from its multinational group. In other words, the borrower is not to be considered an "orphan" and evaluated as an autonomous entity completely detached from its parent or wider group. Consequently, issues such as the availability of a guarantee from a multinational parent may impact the determination of the arm's length interest rate on a loan.
Aside from other evidentiary, administrative and constitutional arguments dispensed with in the appeal, the main thrust of the decision of the Full Federal Court was that under Division 13 and sub-division 815-A of the ITAA, it was necessary to construct a comparable arrangement in respect of the borrowing that would have been entered into by independent parties dealing at arm’s length. Hence, the court opined that the "consideration" for a loan is not restricted merely to the interest rate but could also comprise matters like the provision of collateral, financial covenants, or a parent company guarantee. The court's view is that a borrower of the stature of the Appellant would have added more value (e.g. security, covenants, guarantee) to secure the most favourable interest rate possible in a hypothetical arm's length agreement.
In practical terms, this means that parties cannot charge an exorbitant interest rate on a loan while providing limited lender protections and a higher interest rate to account for the heightened risk involved if such an arrangement would not be realistically expected in an arm's length agreement. The court explored the terms of the loan arrangement between CFC and the Appellant, comparing and contrasting the protection an intra-group lender has (by virtue of the common control) with the type of financial or operational covenants by the borrower one might expect in a commercial loan made at arm’s length. The court held that:
“There may be an infinite variety of such covenants, the presence or absence of which, at least as between arm’s length parties, affects risk and thus price or monetary consideration. On the evidence here, their absence was not dictated by commercial or operational imperatives; rather their absence can be explained by the protection given to the lender by common control. Likewise the absence of security given by CAHPL or the absence of a parent company guarantee can be explained by a lack of commercial or legal capacity (the former) and intra-group choice (the latter)”
The lack of such features in the actual loan arrangement between the parties, therefore, signalled that the deal was not transacted at arm's length. Hence, the appeal was dismissed.
In essence, Chevron’s ruling conveys a crucial message that the courts will not apply transfer pricing rules in a pedantic manner but allow the tax authority to adopt a commercially practical and rational approach in determining prices for related party transactions. The court's interpretation of an arm's length arrangement is particularly noteworthy, as it permits the court to presume that a parent company would provide a guarantee to reduce its subsidiary's cost of finance. Moreover, the court's willingness to revise the terms of an agreement to establish an arm's length price means that taxpayers cannot assume that the terms of inter-company agreements (excluding price) will be respected and must instead price arrangements based on hypothetical arm's length terms for all aspects. Consequently, taxpayers must scrutinize their intra-group arrangements and related documentation and evaluate whether the actual terms of these arrangements are reasonable in the real-world commercial context between independent parties.
In furtherance to the above, the analytical approach adopted by the Full Court in applying the reasonable expectation test has clear implications for the type of evidence needed to support the predictions required by Division 13 and Subdivision 815-A (and Subdivision 815-B going forward) in their respective formulations of the arm’s length hypothetical. In particular, it indicates that the evidence required may extend beyond mere pricing information and may include the group's dealings with external parties in the course of its business, its commercial and operational imperatives, and the results achieved through its established processes for dealings with external parties in comparison to its internal dealings.
This case has relevance to taxpayers in Malaysia where it is a timely reminder that taxpayers must be diligent in collecting and presenting a wide range of evidence to establish the arm's length nature of their related party transactions. This evidence must include information on the group's commercial and operational context, as well as any relevant market pricing data. Failure to provide this evidence may result in a challenge by the tax authority, potentially leading to costly disputes and penalties.
3 May 2023