Dr. Harold McClure, New York City
Multinationals in the extractive sector often charge their mining or oil-producing affiliates substantial intercompany interest and take correspondingly large tax deductions. These deductions are claimed, in part due, to the multinational issuing large amounts of intercompany debt and, in part, due to charging high interest rates.
Here we discuss Australia’s Gorgon natural gas project’s intercompany financing and the Australian Taxation Office’s (ATO) likely challenges to the interest deduction that might be claimed for this financing.
First, though, we note recent UN guidance on transfer pricing in the extractive sector and discuss the ConocoPhillips and Chevron intercompany financing litigations.
UN work on debt versus equity, thin capitalization
The pricing of intercompany debt in the extractive industry was most recently addressed at the United Nations Committee of Experts on International Cooperation in Tax Matters 20th session held in New York City on 3 May.
The committee discussed a proposed new chapter in the handbook on Selected Issues for the taxation of the Extractives Industries by Developing Countries entitled Tax Treatment of Financial Transactions in the Extractives.
According to paragraphs 47 to 49 of the proposed extractives guidance:
If exploration is successful, significant amounts of up-front capital are required for the construction of the mine, production platform and construction of wells and capital continue to be required during the productive life of the mine to maintain operating capacity and to fund possible expansion. The process of raising new equity through the stock market is complex and expensive and the project proponents try to avoid to excessively dilute their ownership in the project by excessive reliance on equity. As a consequence, debt financing will be dominant…The provision of debt from related parties including, centralized financial centers may give rise to profit shifting and transfer pricing issues in developing countries. First, the high level of intra-group debt can lead to thin capitalization, consequently a high amount of interest is paid to affiliated companies, reducing the taxable profit which is attributed to the local mining company. Second, the significant size of financing for a mining business means that even minor mispricing can have a material impact on profitability.
Chapter 9 of the United Nations Practical Manual on Transfer Pricing for Developing Countries, which was last updated on 21 April, addressed both the pricing of intercompany loans as well as thin capitalization issues.
The UN transfer pricing manual notes that one way that tax authorities may limit intercompany interest deductions is to recharacterize debt as equity.
This approach seems to be at the heart of the “accurate delineation of the transaction” discussions in the OECD transfer pricing guidelines on financial transactions, released on 11 February.
While the UN transfer pricing manual noted this accurate delineation of the transaction concept, its focus was more on the approach in the guidance developed as a result of Action 4 of the OECD/G20 base erosion and profit shifting (BEPS) plan, which states:
One approach is to implement a rule that would limit net interest expense deductions based on earnings before interest, taxes, depreciation, and amortization (EBITDA) …As recommended by the OECD BEPS Action 4 Final Report. The following measures might complement this rule: − Countries could adopt a “group ratio” rule to supplement the fixed ration rule and provide additional flexibility for highly leveraged groups or industry sectors.
Intercompany interest rates
A clearly defined intercompany loan contract could potentially address the accurately delineated contract, which allows transfer pricing economics to focus on the pricing of loans, as noted by the UN manual:
Once the intercompany financial transaction is accurately delineated, the most appropriate transfer pricing method can be selected and applied. Within this process, potentially comparable financial transactions can be identified, and comparability adjustments might be applicable, to determine the arm’s length price or profit (or range of prices or profits) for the financial transaction(s) under review.
A standard model for evaluating whether an intercompany interest rate is arm’s-length can be seen to have two components — the intercompany contract and the credit rating of the related party borrower.
Properly articulated intercompany contracts stipulate the date of the loan, the currency of denomination, the term of the loan, and the interest rate.
The first three items allow the analyst to determine the market interest rate of the corresponding government bond.
This intercompany interest rate minus the market interest rate of the corresponding government bond can be seen as the credit spread implied by the intercompany loan contract.
Borrower affiliate credit rating and interest rates
The most difficult issue in pricing intercompany loans is the appropriate evaluation of the borrowing affiliate’s credit rating and translated this credit rating into a numerical credit spread.
The UN transfer pricing manual discusses this issue under the heading considering the creditworthiness of associated enterprises:
In general, when applying the arm’s length principle, the starting point is that the related parties involved in the financial transaction should be treated as if they were entities independent of each other, but otherwise in the same circumstances. However, “the same circumstances” must include any incidental benefits and group synergies that derive from the fact that the related entities belong to an MNE group. This would include the impact of any implicit support (sometimes also referred to as ‘passive association’, ‘parent support’, or ‘group support’) … The credit rating of the debtor tends to be the first creditworthiness analysis to be conducted when analysing intercompany financial transactions. To accurately delineate the actual financial transaction and to be able to seek reliable comparables to test the arm’s length nature of the intercompany financial transaction, the specific features of the financial instrument also play a role. If one considers that associated enterprise ACo makes available a loan to associated enterprise BCo, yet BCo already has obtained three different loans prior to this latest intercompany loan (regardless from what sources the previous three loans are), and the loan BCo gets from ACo is subordinated to the other three loans, then the “status” of the loan between ACo and BCo in essence is lower than that of the other three loans.
The premise that one can view intercompany debt as subordinated debt under the standalone principle has been dubbed the “orphan theory,” which has been rejected by both the ATO and the Canadian Revenue Agency (CRA).
These tax authorities adopted the implicit support view.
The UN manual notes that market-based information on third party interest rates is key for translated credit ratings into credit spreads.
The CUP method may be employed when comparable transactions exist between one party to the intra-group loan transaction and an independent party (“internal comparable”) or between two independent parties, neither of which is a party to the intra-group loan transaction (“external comparable”). When using an external CUP method, the information deriving from third party (syndicated) loans and bonds and other information contained in publicly available databases may be beneficial. Comparable uncontrolled interest rates for borrowers with a range of credit ratings can be accessed through databases made available by professional commercial data vendors. These databases provide information on interest rates for loans and bonds of third parties considering different credit ratings
ConocoPhillips versus the CRA
ConocoPhillips has been battling with the CRA over two similar intercompany guarantee fee issues where the financing originated in 2001.
Before Conoco merged with Phillips Petroleum, it purchased Gulf Canada for USD6.3 billion. This acquisition was later financed by USD3.5 billion in corporate bonds issued on 3 October, 2001.
Examples 15 describes a scenario that describes this intercompany financing:
The yield approach for intra-group financial guarantees – ACo, located in Country X, is an associated enterprise of BCo, located in Country Y. BCo has requested a 5-years loan from a third-party lender. ACo has provided an intra-group financial guarantee for this loan. The third-party lender has provided the loan to BCo at an interest rate of 2%. ACo’s credit rating is A, while BCo’s credit rating (after considering the effect of implicit support) is BBB. Based on information available from public sources, a third-party comparable loan (i.e. considering all the economically relevant characteristics, except for the intra-group financial guarantee) would have an interest rate of 3.25%. Under the yield approach, the interest benefits received by BCo for such intra-group financial guarantee (i.e. its reduced cost for the funding) would be of 1.25% (i.e. 3.25% – 2%). Therefore, the arm’s length maximum intra-group guarantee fee might be 1.25%.
Conoco Funding Corporation (CFC) was a Canadian affiliate, which issued USD 3.5 billion in corporate bonds to finance the new Canadian affiliate. The US parent provided an explicit guarantee charging an intercompany fee equal to 0.5 percent of the debt.
Burlington Resources also purchased Canadian operations using a sequence of corporate bond issues issued by Burlington Resource Finance Corporation (BRFC), which was a Canadian financing affiliate.
The US parent also provided an explicit guarantee charging an intercompany fee equal to 0.5 percent of the debt.
ConocoPhillips acquired Burlington Resources in 2006. Table 1 provides the details for the various corporate bond issuances by CFC and BRFC.
CFC issued corporate bonds with maturities of 5-years, 10-years, and 30-years on 3 October 2001.
Table 1 shows the interest rates on these corporate bonds, an all-in rate which adds the 0.5 percent intercompany guarantee, and the interest rate on the corresponding US government bond (GB rate).
The implied credit spread is the difference between the all-in rate and the GB rate. Table 1 also shows the key information for the corporate bonds issued by BRFC from 12 February 2001 to 25 February 2002.
Table 1: ConocoPhillips intercompany guarantee fee issue (millions of US dollars)
|
Borrower |
Issuance Date |
Principal |
Interest |
Maturity |
GB rate |
All-in rate |
Spread |
|
CFC |
10/3/2001 |
$1250 |
5.45% |
5 |
3.87% |
5.95% |
2.08% |
|
CFC |
10/3/2001 |
$1750 |
6.35% |
10 |
4.50% |
6.85% |
2.35% |
|
CFC |
10/3/2001 |
$500 |
7.25% |
30 |
5.32% |
7.75% |
2.43% |
|
BRFC |
2/12/2001 |
$400 |
6.68% |
10 |
5.05% |
7.18% |
2.13% |
|
BRFC |
8/24/2001 |
$178 |
6.40% |
10 |
4.93% |
6.90% |
1.97% |
|
BRFC |
8/24/2001 |
$575 |
7.20% |
30 |
5.45% |
7.70% |
2.25% |
|
BRFC |
11/16/2001 |
$500 |
5.60% |
5 |
4.24% |
6.10% |
1.86% |
|
BRFC |
11/16/2001 |
$500 |
6.50% |
10 |
5.13% |
7.00% |
1.87% |
|
BRFC |
11/16/2001 |
$500 |
7.40% |
30 |
5.30% |
7.90% |
2.60% |
|
BRFC |
2/25/2002 |
$350 |
5.70% |
5 |
4.26% |
6.20% |
1.94% |
After the acquisition of Gulf Canada but before the explicit guarantee from the US parent, the credit rating agency DBRS upgraded this entity’s credit rating to BBB, citing the implicit support it expected from Conoco.
As such, the appropriate credit rating under the CRA’s implicit support approach was BBB, while the group rating for Conoco at the time was A.
For the 30-year corporate bonds issued on 3 October 2001 by CFC and on 16 November 2001 by BRFC, the third parties were receiving credit spreads near 2 percent during the fall of 2001, which was consistent with the A group ratings for Burlington Resources and for Conoco.
The credit spreads based on the all-in rates implied credit spreads near 2.5 percent, which were consistent with a BBB credit rating at the time.
In another publication on these issues (“Alberta v. ENMAX Energy: Shades of the Chevron Australia Intercompany Interest Issue,” Journal of International Taxation, April 2019), I noted:
Simon Gilchrist and Egon Zakrajšek published an informative paper on credit spreads and business cycles that provided their summary measure of credit spreads—the GZ credit spread. The authors note the 2007-2009 credit crisis; the credit crisis that accompanied the 2001 recession; and the bankruptcy of companies including Enron and Worldcom. Their Figure 1 … shows this GZ spread from 1973-2010 as well as the difference between yields for corporate bonds with BBB credit ratings and yields for corporate bonds with AAA credit ratings. These spreads spiked significantly during the 2007-2009 credit crisis but also were elevated in 2001-2002.
The court rulings to date have insisted that this issue focus on the economics with respect to whether the 0.5 percent guarantee fee is arm’s length.
The CRA, however, appears to be making unconvincing legal arguments that no guarantee should have been allowed.
We should note that Conoco had very little debt financing for its US operations but financed over half of the Canadian assets with debt.
The BEPS Action 4 proposed limitations on interest expenses relative to operating profits, however, was not part of the legal landscape a generation ago.
Chevron versus the ATO
Chevron Australia Holdings Pty Ltd v. Commissioner of Taxation was a dispute between the Australian Tax Office (ATO) and Chevron with respect to an intercompany loan issued on 6 June 2003.
The Tax Court decision described the first intercompany loan this way:
Central to the proceedings is a Credit Facility Agreement dated 6 June 2003 between CAHPL and ChevronTexaco Funding Corporation (CFC) under which CFC agreed to make advances from time to time to CAHPL “in the aggregate the equivalent in Australian Dollars … of Two Billion Five Hundred Million United States Dollars”. Interest was payable monthly at a rate equal to “1-month AUD-LIBOR-BBA as determined with respect to each Interest Period +4.14% per annum” and the final maturity date was 30 June 2008 (the Credit Facility Agreement).
CAHPL is Chevron Australia Holdings Pty Ltd. On 6 June 2003, one Australian dollar (AUD) would purchase USD 0.6591, so this loan represented AUD 3793 million.
The CFC had incurred a USD 2500 million loan on the same date using the one-month commercial paper market.
At the time, the one-month US Treasury bill rate was only 0.96 percent, so the CFC’s credit spread was only 0.24 percent based on its AAA credit rating.
On 6 June 2003, the interest rate on a one-month Australian LIBOR rate was 4.7 percent, while short-term Australian government bond rates were 4.2 percent. We can think of this 0.5 percent difference as an Australian TED spread. The 4.14 percent loan margin was consistent with a credit spread near 4.6 percent.
The ATO challenged the intercompany interest rate on two ground. First, the ATO challenged the loan margin arguing for a higher credit rating than was assumed by the taxpayer. Second, the ATO chose to ignore the contractual currency of denomination on the claim that it would have been less expensive to borrow in US dollars than in Australian dollars.
The taxpayer’s expert witnesses defended this high loan margin on the premise of an “orphan theory,” which basically combines the standalone principle with the claim that the intercompany loan was subordinated debt.
The court rejected this view, adopting the ATO’s implicit support approach. Its expert witnesses argued for a 1.44 percent loan margin on the basis that the appropriate credit spread should be BBB.
The court rejected the ATO’s attempt to recharacterize the terms of the loan from being denominated in Australian dollars to being denominated in US dollars.
The ATO’s experts argued that the cost of borrowing in US dollars at the time was less than the cost of borrowing in Australian dollars. Paragraph 77 of Practice Guide 2017/D4:
Generally, the ATO expects any pricing of a related party debt to be in line with the commercial incentive of achieving the lowest possible ‘all-in’ cost to the borrower. The ATO expects, in most cases, the cost of the financing to align with the costs that could be achieved, on an arm’s length basis, by the parent of the global group to which the borrower and lender both belong.
The all-in cost includes not simply the interest rate but also the expected appreciation of the foreign currency, whereas the expert witnesses for the ATO focused solely on relative interest rates. Their position was fallacious economic reasoning.
The international Fisher effect, which is also known as uncovered interest rate parity, asserts that the expected change in nominal exchange rates reflect the expected devaluation of the Australian dollar with respect to the US dollar.
The macroeconomic environment at the time of the intercompany loan was one where the US was pursuing an expansionary monetary policy to restore full employment while Australian had higher interest rates, given the strength of its economy.
The Dornbusch intercompany macroeconomic model predicts the behavior of exchange rates at the time of the intercompany loan.
Financing for the Gorgon project
The Gorgon gas project is a natural gas project in Western Australia, which involves a massive amount of intercompany financing.
Affiliates for Exxon and Royal Dutch Shell each have 25 percent stakes in this project, and several minor players have shares that approximate 2.5 percent of the project, while an Australian affiliate of Chevron has a share that is nearly 47.5 percent of this project.
Neil Chenoweth of the Australian Financial Review has reported on the intercompany financing for this project with certain claims about the extent of debt financing as well as the pricing of the intercompany loans.
Table 2 presents an illustration based on the total assets for the project being USD 60 billion and the assumption that each stakeholder has intercompany debt that represents two-thirds of these assets.
Table 2: Assets and Debt for the Gorgon Project (US dollars)
|
Billions |
Assets |
Debt |
|
Chevron |
$28.5 |
$19.0 |
|
Exxon |
$15.0 |
$10.0 |
|
Royal Dutch Shell |
$15.0 |
$10.0 |
|
Others |
$1.5 |
$1.0 |
|
Total |
$60.0 |
$40.0 |
The precise terms of the intercompany financing have not been disclosed, but Chenoweth’s writings suggest that Chevron and its partners have chosen a less aggressive credit spread than was the case in the prior litigation with the ATO.
It is interesting to note that 10-year government bond rates were near 2.5 percent in late 2016 for both Australia and the US.
If these intercompany loans were incurred in late 2016 with a 10-year maturity and an intercompany interest rate = 5 percent, the implied credit spread would be 2.5 percent regardless of the currency of denomination.
The total interest expense implied by this degree of debt financing would be $2 billion even though the intercompany interest rate is only 5 percent.
The ATO may challenge this intercompany on thin capitalization grounds as well as on whether the 5 percent intercompany interest rate exceeds the arm’s length standard.
Whether the 5 percent intercompany interest rate is arm’s length is a question of whether a 2.5 percent credit spread is reasonable.
If these multinationals can present convincing reasoning that their Australian affiliates have a credit rating of BB+, then the intercompany interest rate should be as arm’s length.
The ATO, however, could argue for a credit spread of only 1.5 percent if it could assert that the credit rating for the borrowing affiliate was BBB. This proposed reduction in the intercompany interest rate would lower interest expenses by USD 400 million.
Table 3 also presents the implications of setting the interest rate at 4.5 percent, which would be consistent with a credit rating of BBB-.
Table 3: Interest Deduction for the Gorgon Project Under Alternative Interest Rates (US dollars)
|
Millions |
5.0% |
4.5% |
4.0% |
|
Operating profits |
$6,000 |
$6,000 |
$6,000 |
|
Interest expense |
$2,000 |
$1,800 |
$1,600 |
|
Income |
$4,000 |
$4,200 |
$4,400 |
|
Interest expense/profits |
33.33% |
30.00% |
26.67% |
Given the extent of debt financing, the Australian tax authorities could raise thin capitalization issues depending on the local tax laws.
Consider a rule that limits interest deductions to 30 percent of operating profits. In our example, having this much debt with a 5 percent interest rate could create interest deductions that would slightly exceed this limitation.
If the arm’s length interest rate were 4.5 percent or less, then this form of interest expense limitation would not be binding.
A group limitation would be more restrictive with respect to the extent of intercompany interest deductions.
Over the three-year period ending 31 December 2019, Chevron’s operating profits averaged USD 10,176 million per year, while its interest expenses averaged only USD 618 million per year or 6/07 percent of operating income.
Over the same period, ExxonMobil’s operating profits averaged USD 24,058 million per year, while its interest expenses averaged only USD 732 million per year or 3.15 percent of operating income.
Concluding comments
Well established and highly profitable oil and gas multinationals such as Chevron and ExxonMobil rely predominantly on equity financing, which keeps interest deductions low both in terms of having relatively low amounts of debt but also in terms of being able to borrow at modest interest rates as their credit ratings are quite high.
Multinationals in the extractive sector also tend to impose significant amounts of intercompany debt with their production affiliates and then use the extent of debt financing to argue for low standalone credit ratings to charge high intercompany interest rates.
If a nation’s tax law considers the implicit guarantee approach rather than a standalone approach, then the tax authority could argue for a lower credit spread and thereby a more modest intercompany interest rate.
The fracking segment of the oil and gas sector faces different economics, given their high production costs, which makes their profitability vulnerable to variations in oil prices.
Fracking companies in this way more resemble the typical mining company. Even within this segment of the oil and gas sector, we see a considerable variation of the factors considered by chapter 9 of the United Nations Practical Manual on Transfer Pricing.
Many fracking companies such as Chesapeake Energy have considerable interest expenses relative to operating profits, which leads to poor credit ratings. While Chesapeake Energy’s credit rating is CCC, EOG Resources has an investment-grade credit rating allowing it to borrow using long-term corporate bonds with interest rates less than 5 percent.
Over the three-year period ending 31 December 2019, its interest expenses represented only 8.68 percent of its operating profits. The application of the thin capitalization principles and the pricing of intercompany financing to the extractive sector should adopt the factors noted in chapter 9 with careful consideration of the particular facts for each multinational.
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