On 21 April, Australia’s Full Federal Court handed down its decision in the Chevron appeal. This judgement is a landmark case in the Australian transfer pricing landscape and a significant win for the Australian Taxation Office (ATO).
While reaching the same conclusion as the original Chevron decision, published in October 2015, the Full Federal Court uses a very different analysis, providing insight on transfer pricing for intercompany loans in Australia and worldwide.
Chevron decision mark one
The key message from the original Chevron case concerned the commerciality of related-party debt transactions (something that has been a continued focus for the ATO).
The funding provided by Chevron US to Chevron Australia had been treated by the group as an unsecured intercompany loan carrying a higher risk and an associated high interest rate of 9 percent.
The judge questioned the commerciality of the arrangement and hypothesised that an independent borrower would have sought cheaper secured funding with associated financial covenants prior to taking on unsecured funding, thus ruling in favour of the ATO.
Chevron decision mark two
The Chevron appeal covers a range of issues.
As the loans at issue were made between 2004–2008, the case involved the application of both Australia’s transfer pricing rules in Division 13 and the interim transfer pricing rules contained within Division 815-A (introduced to apply retrospectively from 1 July 2004 to 30 June 2013).
Chevron had contested the validity of assessments under Division 815 where Division 13 assessments had already been made, arguing that the retrospective nature of the 815-A provisions was unconstitutional.
The judgement supports that 815-A can be applied retrospectively.
Australian rules on intragroup loans
Prior to October 2015, the arm’s length standard in the OECD guidelines included limited guidance on financing.
Therefore, the transfer pricing approach traditionally focused on the consideration of what independent parties would have entered into if they were transacting at arm’s length. In relation to intragroup funding arrangements, the purest “stand-alone entity concept” (or “orphan” concept) would require the consideration of the terms and conditions which a borrower could obtain in the /absence of any parental guarantee.
The GE Capital Canada case in March 2010 highlighted the notion of implicit support and interdependence between the parent and the borrower. The concept of implicit support relates to market expectations that the parent would step in to assist a subsidiary in the event of financial difficulty and meet a subsidiary’s debt obligations.
The ATO, in TR 2010/7, reinforced their view of an interdependence between the lender and the borrower, stating:
“Depending on the facts, including the credit standing of the borrower company relative to the parent company, a margin above the interest rate that the parent would be expected to pay for the debt may be appropriate. Where, for example, the operations of the borrower are core to the group in the sense that its functions were a vital part of an integrated business, it would generally be expected that the borrower company would have the same credit standing as its parent.”
So, in the ATO’s view, if the parent entity had a substantially better credit rating than the subsidiary, this parent/ subsidiary interdependence could result in an uplift of the subsidiary’s credit rating and therefore a substantially lower interest rate on intragroup funding.
In October 2015, the OECD issued revised guidelines, including Actions 8–10 covering value creation. This guidance included examples showing the interdependence of the borrower and the lender allowing the credit rating of a subsidiary to be uplifted to take account of the parental relationship through “group synergies” or “passive association.”
However, 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 guidelines.
These new OECD guidelines did not apply until accounting periods beginning after 1 July 2016 for Australian transfer pricing purposes. So, the new guidelines are not specifically referred to in the Chevron judgement, but they reinforce the ATO’s historic stance on transfer pricing for funding transactions.
Chevron’s funding policy
Unlike the first Chevron decision, the Full Federal Court focused on the interdependence of the parent and the subsidiary and implicit guarantees.
The Court agreed with Chevron that, given the construction stage of the project funded by the intercompany loan, there was no favourable security for a lender to provide secured funding. So, the funding potentially could have been unsecured, perhaps even at a higher interest rate than proposed by Chevron.
However, the Court also noted that Chevron had a policy requiring group companies to seek funding externally at the lowest cost backed by a parental guarantee.
Based on this policy, the Court found that it “is the natural and commercially rational comparative analysis when one removes the controlled conditions operating between [the US subsidiary and the Australian subsidiary] and replaces them with the condition of mutual independence. In the circumstances there would have been a borrowing cost conformable with Chevron’s AA rating, which, on the evidence, would have been significantly below 9%.”
It is on this basis that the judges ruled in favour of the ATO. This is a strong win for the ATO and supports the ATO’s position on the interdependence of the relationship between parents and subsidiaries.
It also reinforces the new OECD guidelines on the need to consider the interdependence between the parent and the subsidiary in relation to intragroup funding.
The Court does not comment on what the interest rate should have been in these circumstances as, under Australian law, the burden of proof is on the taxpayer, not the ATO. From a legal perspective, Chevron had not proved their position, so the ATO’s assessments would stand.
Guarantee fees & economic analysis
Interestingly, though, the Court did consider that a guarantee fee could have been charged from Chevron US to Chevron Australia for the benefit of these arrangements.
This is in line with the new OECD guidelines, outlined above, stating that a guarantee fee could be charged to a subsidiary where a third-party bank is induced to provide funding to group companies backed by an explicit parental guarantee.
An area of contention could be the extent to which interdependence impacts the pricing of intragroup loans.
The impact of parental affiliation is normally looked at by advisors on a case by case basis and the credit rating of a subsidiary is usually uplifted based on criteria set out by rating agencies (e.g., Moody’s and Standard and Poor’s) looking at the strategic nature or importance of the subsidiary to the parent.
Benchmarking credit ratings and interest rates can be difficult from a technical and judgement perspective. The judges were critical of the work performed by the advisors and the evidence provided by expert witnesses. Therefore, there is likely to be more emphasis on the quality of economic analysis going forward.
The Chevron case is likely to lead to the ATO arguing in more cases that a subsidiary should have a credit rating closer to that of the parent’s and reducing the interest rate on intragroup loans.
This could result in, effectively, a single global interest rate in an extreme case of a universal group credit rating.
This would not necessarily be out of keeping with the BEPS action 4 on thin capitalisation, which contemplates caps on intragroup debt funding based on the external borrowings of the group. Similarly, this could be a group interest rate cap, although it arguably departs from the spirit of the arm’s length standard.
ATO’s next steps
The ATO’s current rulings on funding arrangements are due to be updated in light of the Chevron decision.
We understand this guidance is imminent and will introduce a “traffic light” system similar to the recent guidance on sales and procurement hubs.
Again, the ATO will be seeking to influence behaviours amongst taxpayers as to high and lower risk financing situations, thereby encouraging taxpayers to restructure their funding operations to minimise audit risks. They will also shortly be issuing revised guidance on quasi-equity arrangements.
Key actions for groups
The Chevron case shows the importance of properly analysing, documenting, and evidencing intragroup funding transactions.
There continue to be planning opportunities available in relation to intragroup funding, particularly in relation to a group’s external treasury funding policies and pricing explicit guarantee fees to take into account group interdependence.
Where a group has not analysed and documented its arrangements, it would be advisable to look at this now in light of the new OECD guidelines and the Chevron decision.
Also, in light of the Chevron case, groups may wish to consider the impact of any group financing policies on the potential interdependence of group companies and the associated interest rate.
Moreover, where transfer pricing documentation is in place for existing transfer pricing structures, consideration should be given to whether the judgement could impact the pricing of group arrangements.
– Nick Drizen is a transfer pricing principal with BDO in Perth, Australia. He can be reached at Nick.Drizen@bdo.com.au.