Australia’s Federal Court has handed the Australian Taxation Office (ATO) an important victory, concluding that USD 2.5 billion of loans between Chevron’s Australian-resident company and its Delaware subsidiary made between 2004-2008 were not arm’s length and thus generated excessive interest deductions. The Court also ruled that the company received a “scheme benefit” and was liable for a 25 percent penalty on the scheme shortfall amount.
In its decision, released October 23, the Court rejected numerous arguments advanced by the Chevron subsidiary, including a challenge to the constitutional validity of the retroactive transfer pricing rules of Subdivision 815-A of the Income Tax Assessment Act 1997 (Subdivision 815-A).
The case concerned a credit facility agreement dated June 6, 2003, under which Chevron Australia Holdings Pty Ltd (CAHPL) borrowed the Australian equivalent of USD 2.5 billion from its newly created US subsidiary, ChevronTexaco Funding Corporation (CFC).
CFC borrowed funds in the US capital markets at about a 2 percent interest rate and on lent the funds to CAHPL under the credit facility at the rate of AUD-LIBOR + 4.14 percent, which, at the time, was equivalent to about 9 percent.
CAHPL did not provide any guarantee or security over assets to CFC and the agreement allowed the borrower to prepay the loan without penalty – terms which were seemingly designed to justify the high interest rate on the intercompany loan and the associated interest deductions. CFC’s profit on the loan was returned to CAHPL as a tax-free dividend. Over the years, dividends of AUS 1.1 billion were paid by CFC to CAHPL.
The ATO issued assessments for unpaid taxes and scheme shortfall penalties for the 2004–2008 tax years, claiming the consideration CAHPL gave for the loans was not arm’s length under the former transfer pricing rules of Division 13 of Pt III of the Income Tax Assessment Act 1936 (Division 13). The ATO later issued assessments for unpaid taxes and penalties relating to the 2006–2008 tax years under the current retroactive transfer pricing rules of Subdivision 815-A. CAHPL appealed in the Federal Court.
The Federal Court concluded that CAHPL’s challenges to the amended assessments under Division 13 failed, and that, in the alternative, that CAHPL’s challenges to the amended assessments under Subdivision 815-A failed. The Court also agreed with the ATO’s assessment of a penalty of 25 percent on the scheme shortfall amount with respect to its holding under Division 13.
Division 13
In rejecting CAPHL’s challenge to the Division 13 assessments, the Court concluded that CAHPL did not show in its evidence that the consideration in the credit facility agreement was arm’s length or less than the arm’s length or prove that the ATO assessments were excessive.
CAHPL argued that the credit facility could be priced with reference to a Term Loan B institutional loan with adjustments to account for the borrower’s credit rating and the fact that the CAHPL facility was unsecured, lacked financial covenants, and provided for the borrower to prepay the loan without penalty. Based on this analysis it is clear that the interest paid by CAHPL did not exceed the arm’s length price, CAHPL argued.
After noting testimony that Term Loan Bs to non-investment grade borrowers were always secured and always contained financial and restrictive covenants, the Court concluded that CAHPL’s evidence that the credit facility could be priced as a Term Loan B lacked “a realistic foundation.” Such loans were insufficiently related to the market in which the credit facility was made,” the Court said.
The Court said that the determination of whether the consideration provided was arm’s length needed to be assessed from the perspective of a commercial lender. “A commercial lender would not approach the question of the borrower’s creditworthiness in the same way as would a credit rating agency,” the Court said.
Any characteristics shown by the evidence that a borrower and lender would find relevant, including the fact that the borrower is in the oil and gas exploration and production industry or has financial resources, should be taken into account in assessing whether the agreement is arm’s length, the Court said. Such characteristics were not taken into account by CAHPL in its evidence of arm’s length consideration in the instant case.
The Court also said that the CAHPL’s evidence based on credit agency ratings was insufficient because “Division 13 does not permit reasoning that reaches a non-arm’s length interest rate on the basis that the actual interest rate is as high as it is because of the rating attributed to the borrower or borrowing, which rating relies on the absence of arm’s length consideration given by the borrower,” such as the absence of security or operational and financial covenants.
Limited consideration
The Court said that its conclusion was “an addition to, and independent of” its separate finding that the agreement was not arm’s length because the limited scope of the consideration given or agreed to be given by CAHPL, namely, the lack of security or operational and financial covenants, “resulted in the consideration which CAHPL did give, the promise to pay the interest rate, exceeding the arm’s length consideration in respect of the acquisition.”
“I find that CAHPL did not give security or operational and financial covenants, which would have affected that part of the consideration which was the interest rate: the interest rate was higher in the absence of those promises or covenants. If the property had been acquired under an agreement between independent parties dealing at arm’s length with each other, I find that the borrower would have given such security and operational and financial covenants and the interest rate, as a consequence, would have been lower,” the Court said.
As a part of this discussion, though, the Court also pointed out that Division 13 does not allow a different agreement to be substituted for the deal struck on the basis that two independent parties would not have entered into such agreement. “It is not, therefore, an appropriate approach under Div 13 of the ITAA 1936 to ask what the terms, other than the consideration, would have been if CAHPL had been negotiating with a third party lender unrelated to it or if two unrelated parties neither of whom was CAHPL or CFC had been negotiating.”
Implicit support, treaty power to tax
CAPHL argued that, in considering whether an arrangement is arm’s length, the proper construction of Division 13 required the exclusion of “implicit support,” namely that the parent will provide the borrower with credit support in the event of default on the obligation to repay the loan, in the absence of any legally enforceable obligation. The Court rejected this argument, but said 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.”
The Court rejected a number of procedural challenges brought by CAHPL. The Court disagreed with CAHPL’s argument that the assessments were invalid because they were made by an ATO officer not authorized to make them. The Court also rejected the argument that, with respect to the 2006-2008 tax years, the assessments became invalid once assessments were made for those years under Subdivision 815-A. “There is nothing in the statutes or in the facts which suggests or supports that contention,” the Court said.
The Court agreed with CAHPL that Article 9 of Australia’s tax treaty with the US does not, independently of the transfer pricing provisions in domestic legislation, provide a power to tax, contrary to the Commissioner’s long-time position on the issue.
Subdivision 815-A
Turning to the transfer pricing rules of Subdivision 815-A , the Court noted that the statute focuses on the broader term “conditions,” whereas Division 13 focuses on “consideration.”
The Court said that the correct analysis involves identifying the non-arm’s length conditions between CAHPL and CFC and then asking if there was an amount of profits which, but for those conditions, might have been expected to accrue to the entity but which has, by reason of those conditions, not so accrued.
The Court agreed with the ATO that non-arm’s length conditions were present in the instant case, including the fact that CAHPL owned CFC and they both had a common parent; that the parent company decided how much debt and at what interest rate CAHPL should borrow from CFC; that there was no bargaining or negotiation between CAHPL and CFC; the terms and conditions of the credit facility agreement, including the terms in respect of the interest rate charged, the duration and the currency of the loan and the absence of covenants; that the sole reason for CFC’s incorporation, and the purpose of its commercial paper program, was to raise funds solely to on-lend to its parent CAHPL; that the credit profiles of CFC and CAHPL could be controlled by decisions made by the parent; that CFC profited from lending to CAHPL at a high interest rate; and the higher the interest-bearing loan from CFC and the higher the interest rate, the more profit CAHPL stood to make.
The Court said that conditions operating between CAHPL and CFC differed from those which might be expected to operate between independent parties dealing wholly independently with one another. As a result, an amount of profits that might be expected to have accrued has not so accrued, the Court said. It follows, the Court said, that CAHPL failed to show that the assessments under the Subdivision 815-A were excessive.
In reaching this decision, the Court disagreed with CAHPL’s argument that the statute does not permit the addition of new “conditions” and only allows an adjustment to the rate of interest or elimination of other terms or conditions upon which CFC lent funds to CAHPL.
The Court also rejected CAHPL’s challenge to the constitutional validity of Subdivision 815-A on the grounds of the arbitrariness of the exaction imposed by the statute’s retroactive operation. “In Australia, the mere effect of a taxing statute to impose a tax by reference to past transactions does not bespeak invalidity,” the Court said.
The Court said also said Subdivision 815-A was not unconstitutional by virtue of uncertainty. Further, the Court disagreed with CAHPL’s argument that it was the legislature’s intent that where Australia’s thin capitalization rules apply, the transfer pricing rules should not.
The Court further rejected CAHPL’s argument that the statutory preconditions to making a Subdivision 815-A determination were not met because Australia’s tax treaty with the US did not contain an associated enterprises article that corresponds to the UK provision, as required under the statute. The “gist of each article is the same,” the Court said.
Penalties
Turning to the issue of penalties, the Court noted that the Commissioner had conceded that CAHPL’s position was reasonably arguable. The Court said that a penalty would arise only by reference to the Court’s holding under Division 13, in which case it would be either 25 percent or 10 percent.
The Court concluded that CAHPL was liable for a penalty of 25 percent of of the scheme shortfall amount under s 284-160(a)(ii) because the company received a “scheme benefit” and had the dominant purpose of obtaining a scheme benefit.
A scheme benefit is apparent, the Court said, because apart from the scheme, CAHPL would have borrowed at an arm’s length interest rate and deducted the lower interest expense.
The Court said it is reasonable to conclude that CAHPL entered into the credit facility agreement for the dominant purpose of obtaining a “scheme benefit,” referencing testimony of CAHPL officers that suggested that the goal of the transaction was for CAHPL to borrow as much as possible at the highest interest rate possible to achieve tax benefits.
“I accept the Commissioner’s submission that refinancing was not the dominant purpose of the scheme as refinancing could be achieved by borrowing at an arm’s length interest rate which CAHPL did not. To limit the scope of matters to be taken into account merely to refinancing is artificially to exclude from consideration the circumstances of that refinancing,” the Court said.
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