New Zealand implications of Australian debt pricing decision
Tax Alert - June 2017
By Graeme Fotheringham and Bart de Gouw
The recent decision of the Australian Full Federal Court (“Full Court”) in the Chevron case is likely to have ramifications for New Zealand entities with cross-border related party debt. Although not binding in New Zealand, the case provides one of the few insights as to how a court views the transfer pricing rules on the issue of related party debt and has been closely followed by the New Zealand Inland Revenue. New Zealand entities with both inbound and outbound cross border related party debt should consider these loans in light of the decision.
On 21 April 2017, the Full Court rejected an appeal by the taxpayer involving a credit facility extended to Chevron Australia Holdings Pty Ltd (CAHPL) by a US resident subsidiary of CAHPL. This is the first Australian transfer pricing court case on the issue of related party loans. The case involved approximately $340m in tax and penalties covering the 2004-08 period.
The US subsidiary had borrowed the funds ($2.5b AUD equivalent) externally in USD at an interest rate of around 1.2%, with the benefit of a guarantee from the ultimate parent company, Chevron Corporation (CVX). The US subsidiary then on-lent the funds to CAHPL at an interest rate of 1 month AUD LIBOR + 4.14% (which equated to around 9% in the period under review). This interest rate was based on a stand-alone credit rating of CAHPL and a transfer pricing analysis using the actual terms and conditions of the facility.
The Australian Tax Office (ATO) issued CAHPL with transfer pricing assessments on the basis that the interest rate on the loans was considered to be in excess of an arm’s length rate.
The Full Court upheld the earlier decision, of the Federal Court, that CAHPL had not shown that the interest paid under the Credit Facility agreement was equal to or less than arm’s length. CAHPL therefore failed in proving that the amended assessments imposed by the Commissioner of Taxation (the Commissioner) were excessive.
Key Points from the case
The case was extremely complex involving multiple facets of tax law. However there are a number of key points from the case that have relevance to the pricing of related party debt in the New Zealand context.
Pricing the actual transaction vs hypothetical third party loan
The court rejected an approach to transfer pricing which involved working out accurate pricing for the transaction which actually occurred between the related parties. Instead, it suggested an approach that substituted the actual transaction with one which reflected how a company in the taxpayer’s position (i.e. the borrower) would achieve the same commercial aims in an arm’s length transaction.
Consideration is wider than just price
In considering what transaction the borrower would have entered into with a third party lender, the court considered not only the price (i.e. interest rate) of the transaction but also the real world commercial terms and conditions of the lending that would have applied to such a transactions. In particular, it reached the view that CAHPL, if it had been acting independently and dealing with a third party lender, would have been expected to have given security and operational and financial covenants to obtain the loan. Such provisions would have had the effect of lowering the interest rate on the borrowing.
The court therefore decided the arm’s length principle is more than the simple pricing of a given transaction (given the actual terms and conditions), but rather also encompasses the question of whether an independent party, acting in its own best interests, would have entered into a transaction on those terms and conditions.
The court also rejected Chevron’s approach that when pricing the related party debt, CAHPL should be considered as standalone entity, completely separate from the wider corporate group. The court instead held that when considering the hypothetical loan CAHPL would have entered into with a third party borrower, CAHPL should also be assumed to be a subsidiary of a major multinational.
The implications of implicit and explicit parental support on the loan pricing were not discussed in any detail by the court. However, it was noted that where an explicit guarantee was provided by the parent to the subsidiary borrower, guarantee fees paid could form part of the consideration for the loan.
Therefore, when pricing related party loans post Chevron, consideration should still be given as to whether adjustments are required to reflect both implicit and explicit parental support.
Burden of proof
If the Chevron dispute had involved a New Zealand taxpayer and been heard by a court in New Zealand, the job of Inland Revenue would have been more difficult than that of the ATO. Under current New Zealand transfer pricing rules, the burden of proof in transfer pricing cases lies with the tax authorities. Under Australia law, the burden of proof lies with the taxpayer.
In the Chevron case, the onus of proof was therefore on CAHPL to prove that the assessments issued by the ATO were excessive. As such, the ATO were not obliged to argue every technical aspect of their assessments.
It is worth noting that one of the proposals in the New Zealand government’s recent BEPS discussion document – Transfer Pricing and Permanent Establishment Avoidance – is to shift the burden of proof from the Commissioner of Inland Revenue to the taxpayer in transfer pricing cases. If such a change was to go through, this may make it easier for Inland Revenue to bring such cases to court in New Zealand in future.
Relevance to New Zealand
Although the Chevron case is not binding in New Zealand, the case has been closely followed by Inland Revenue. Many of the principles from the findings of the court in Chevron have been included in the BEPS discussion drafts issued by the government in March 2017, covered in the March 2017 Tax Alert.
In addition to the proposed changes to the burden of proof discussed above, the government is proposing to introduce reconstruction provisions into the New Zealand transfer pricing rules. The wording in the BEPS reconstruction proposal echoes the findings in Chevron with regard to hypothesising the “real world” commercial conditions of a third party transaction. Had the Chevron transaction involved a New Zealand taxpayer, Inland Revenue may arguably have been able to apply the New Zealand anti-avoidance rules to reconstruct the arrangement. However, introducing similar provisions into the transfer pricing rules would give Inland Revenue another weapon in their armoury to combat perceived avoidance.
Inland Revenue will also no doubt have been encouraged by the court’s approach that it is not only the price of the actual transaction as documented that needs to be arm’s length but also the terms and conditions of the lending arrangement. Indeed, the government is proposing to amend the New Zealand transfer pricing rules to refer to arm’s length “conditions” rather than an arm’s length amount of “consideration” to address this point.
The message from Chevron with regard to parental support is more mixed for Inland Revenue. The Chevron case reaffirms the arm’s length principle in relation to related party debt. This contrasts with the New Zealand government’s proposals to restrict interest deductions based on the parent company’s external cost of debt as detailed in the BEPS discussion document – Strengthening our interest limitation rules.
The approach to pricing related party debt taken by the court in Chevron did not ignore the fact that the borrower was part of a wider multinational group but also did not price the debt by direct reference to the debt of the ultimate parent. Rather, it considered what transaction the borrowing entity would have entered into with an unrelated lender on the assumption that it was part of a wider multinational group.
Whilst all of the proposals in the BEPS discussion documents may not make it onto the statute book, change to the transfer pricing rules in New Zealand is coming and the Chevron case gives an indication of the likely direction of travel in relation to financing arrangements (and potentially other related party transactions).
New Zealand entities with cross-border, related party debt should consider whether their arrangements could withstand such scrutiny.
Senior ATO leadership have described intra-group financing as the number one risk it is focused on with regard to multinational taxation.
Following the Chevron case, the ATO are proposing that Australian companies be required to risk assess all their related party cross-border finance arrangements, both inbound and outbound, and report the risk status to the tax authorities.
Given the level of trans-Tasman financing that exists, this fall out from the Chevron case could have potentially significant implications for New Zealand entities with financing arrangements into or out of Australia.
June 2017 Tax Alert contents
- Material advancement and tangible progress on feasibility expenditure
- New Zealand implications of Australian debt pricing decision
- Good news: resident withholding tax compliance issues relating to dividends are now resolved for companies
- Business Transformation – where are we now?
- GST best practice: a timely reminder
- Mileage rate released by Commissioner of Inland Revenue
- A snapshot of recent tax developments