Interest on inbound financing: is it arm’s length?

by Annemarie Wilmore, Partner, Johnson Winter & Slattery, Sydney, Australia

Taxpayers with international financing into Australia should take note of the Commissioner of Taxation’s December 2021 win in the Federal Court in Singapore Telecom Australia Investments Pty Ltd v Commissioner of Taxation [2021] FCA 1597 (Singtel). The case turned on the expert and lay evidence regarding whether the key features of the loan arrangement between the related parties were consistent—or different from—those that might be expected between independent parties dealing on an arm’s length basis. The features examined included parental support (guarantee) and the change of the interest rate mechanism from floating to fixed.

The Singtel decision follows the Commissioner’s win in the Full Federal Court in Chevron Australia Holdings Pty Ltd v Commissioner of Taxation [2017] FCAFC 62 (21 April 2017). Both the Singtel and Chevron cases considered the Australian transfer pricing provisions set out in Division 13 of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936) and subdivision 815-A of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997).

The transfer pricing of related-party loans has been a focus of the Australian Taxation Office (ATO) for some time, and is expected to continue with the Federal Court considering the subdivision 815-B of the ITAA 1997 early next year.

In Chevron, the court considered whether a related-party loan (credit facility agreement) between two related entities—one in the U.S., the other in Australia—was on arm’s length terms. A focus of the case was the absence of a guarantee and security to the U.S. entity by the Australian entity. These are matters that would have affected the interest rate in relation to the loan. The Commissioner’s contention was that given the absence of these features, the interest rate was higher (resulting in a larger deduction to the Australian entity). The outcome of the Full Federal Court decision was that if the loan had occurred between independent parties dealing at arm’s length, the Australian borrower would have provided a guarantee and security over assets (such as operational and financial covenants). As a result, the interest rate in relation to the loan should have been lower.

In some respects, the focus of Singtel was similar. The court considered whether there were conditions operating between the two related parties—one in Singapore and the other in Australia—that differed from those that might be expected to operate between independent parties dealing wholly independently with one another. In exploring those conditions—which, in the Commissioner’s view, only existed because of the lack of independence between the parties—there again was a focus on the absence of a guarantee from the parent company. Other conditions were also considered, with the court’s findings including that independent parties dealing at arm’s length would likely have involved a parent providing a guarantee to the subsidiary and might have agreed that interest could be deferred and capitalised. Despite concluding that there would likely have been a guarantee, the court also found that independent parties may not have agreed to pay the parent a guarantee fee in exchange for the guarantee. Further, the court held that the loan in question in Singtel had features that independent parties would not have agreed to, including subsequent amendments to the terms of the loan, and changing the floating rate (Bank Bill Swap Rate plus 1%) of the loan to a fixed rate during the global financial crisis.

Both the Chevron and Singtel cases demonstrate the importance of independent expert evidence to support positions taken in the event of a challenge by the Commissioner. The objective of such evidence is to assist the court in predicting how independent parties dealing in an arm’s length transaction would price a similar transaction. A court will consider the qualifications, experience and expertise of the expert in relation to evaluating expert evidence with a view to determining the weight of such evidence. The nature of the question, the responses provided, and the degree to which the questions asked reflect the statutory test, as well as the specificity of the evidence and its credibility, are also important considerations.

Lay witness evidence also continues to be key in these matters. Taxpayers should carefully consider who within the organisation has the relevant knowledge about the matters to be proved. In Singtel, the lay witness was not involved in the preparation of the loan documentation or in communication about its terms. Judge Moshinsky found that the views the lay witness expressed were not of any assistance in determining the question of whether a guarantee might have been expected.

In Singtel, Moshinsky allowed the parties additional time to put on further submissions following the  December 21, 2021 decision as to how to give effect to the reasons of the court. While one of the outcomes of the decision was that there had been a transfer pricing benefit, the taxpayer claimed that carry forward losses ought to be taken into account and offset against the transfer pricing benefit for all of the years of the loan. The Commissioner had made determinations in applying section 136AD(3) of the ITAA 1936 or section 815-15(1) of the ITAA 1997 only in respect of four years (2010 to 2013) and not in relation to every year the loan was in place (i.e. no determinations for the 2003 to 2009 years). In the reasons of the court published on March 22, 2022, Moshinsky held that section 136AD(3) and section 815-15(1) did not permit this offsetting because these provisions applied only in relation to the particular year. Further, to do so would be inconsistent with the interpretation of the key terms in these provisions, namely consideration in relation to an acquisition (section 136AD(3)) and an amount of profits (section 815-15(1)). Moshinsky did, however, note that it would be open to the taxpayer to write to the Commissioner in relation to his powers under separate provisions (section 136AF(2) of the ITAA 1936 and 815-35 of the ITAA 1997) requesting that he make consequential adjustments to reflect the carried forward losses. It was noted that the existence of these separate provisions further supported his statutory construction of section 136AD(3) and section 815-15(1) to not permit accounting for the carried forward losses in the calculation of the transfer pricing benefit.

Any appeal to the Full Federal Court regarding the Singtel decision must be filed within 28 days from  March 22, 2022.

Given the ATO’s continued focus in testing transfer pricing outcomes of related-party loans, it would be prudent for taxpayers to turn their minds to the benefits of preparing early to defend filed positions. A common evidentiary challenge faced by taxpayers, as evidenced in the Singtel case, is that the persons who can speak to the detail of the loan arrangements—and the rationale for the key terms—may no longer be available. A realistic understanding of potential risks in these matters will be important in shaping the engagement strategy with the ATO.

• Annemarie Wilmore is a partner with Johnson Winter & Slattery in Sydney, Australia.