Back in February 2013, against a backdrop of media reports on multinational taxpayers allegedly not paying their fair share of tax, the OECD published its seminal report, Addressing Base Erosion and Profit Shifting. At that time, few tax professionals would have foreseen the enormous changes in the international tax framework in the coming decade.

The consensus that emerged from the ensuing debate was that taxation should follow value creation. Taxing rights should not be allocated to jurisdictions in which value is not created, and countries naturally believe that what takes place within their borders is valuable.

Contracts and economic substance

This concept has been at the heart of substantial revisions to the OECD’s Transfer Pricing Guidelines, reissued in July 2017 and more recently in January 2022. Tax administrations, taxpayers and their advisers rely on these guidelines to help them review the arm's length nature of the pricing on intercompany transactions between related parties.

Even though the guidelines consider intercompany contractual terms to be the starting point for reviewing transactions, a much greater emphasis is placed on understanding what actually takes place on the ground: where the economic substance is.

Where are the economically significant functions performed? Where are the economically significant risks controlled and managed? Where are the unique and valuable intangible assets developed, enhanced, maintained, protected and exploited?

Australia puts transfer pricing to the test

The shift in focus from contractual form to economic substance has led to growing calls from tax administrations for information on taxpayers’ global value chains. Notwithstanding this trend, recent case law developments in Australia continue to emphasise the importance of intercompany contracts and their key terms.

Picture: Thomas Ickeringill CA.

“Recent case law developments in Australia continue to emphasise the importance of intercompany contracts and their key terms.”

In landmark cases involving Chevron and SingTel, which owns Optus, the question was whether the interest paid on intercompany loans was arm’s length (as required by transfer pricing law), having regard to the contractual terms and surrounding circumstances.

In the 2017 Chevron matter, this included the fact that a US$2.5 billion (A$3.7 billion) intercompany loan to develop gas fields off Western Australia was unguaranteed, unsecured and lacked operational or financial covenants. It had a 9% interest rate.

In the 2021 SingTel case, a 10-year A$5.2 billion loan between two wholly owned subsidiaries of Singapore Telecom Australia Investments (STAI) was unguaranteed and coupled with a range of contractual amendments not considered to be commercially rational.

Those amendments included retroactively treating accrued interest as not having accrued, setting a higher rate of interest contingent on profit benchmarks being met, and moving from a floating to a fixed interest rate. The loan agreement went through three amendments and had a final interest rate of 13.2575%.

In both of these cases, the taxpayers were unsuccessful in the courts. The Full Federal Court agreed with the Tax Commissioner that the conditions and interest rates applied to these internal loans didn’t reflect what would have happened between unrelated parties operating at arm’s length.

That meant tax deductions for interest payments – in SingTel’s case almost A$895 million over four years – were denied.

However, the 2020 Glencore judgment went differently.

In that case, a Swiss related party paid the owner and operator of an Australian mine an agreed price for copper concentrates for three years, and pricing risks were partly transferred to Switzerland. The authorities had to consider whether this arm's length, contractual pricing methodology was commercially rational.

In this instance, the taxpayer won the case. The Court decided that the actual pricing terms between the two related entities were ones that might have been expected between independent parties in the copper sector.

Interpreting OECD guidelines in Australia

Looking at these cases, we can make a number of uniquely Australian observations.

First, although Australia's transfer pricing provisions should be interpreted consistent with the OECD guidelines, it is only to the extent the guidelines are relevant. Given their highly generalised language, Australian courts remain sceptical of the practical utility of the guidelines when interpreting domestic Australian law.

Second, when taxpayers are assessing if their intercompany pricing is arm’s length, they need to ask whether the underlying contractual terms would be considered commercially rational.

This could be viewed as an anti-avoidance overlay to transfer pricing. If an important intercompany contractual term cannot be observed in the open market, the taxpayer will face evidentiary challenges.

Third, even if market evidence is imperfect, it may still be relevant.

A taxpayer need not show the intercompany pricing would necessarily have been achieved at arm’s length: that would be setting the evidentiary bar too high. All it needs to show is that the relevant transfer price was consistent with a range of commercially acceptable arm’s length outcomes.

Finally, the arm’s length test is not performed in the abstract. The Australian tax-paying entity is a member of a multinational group, with the same objective attributes of that group. What is an objective attribute is a question of fact, but courts have endorsed the potential relevance of parental affiliation and group lending policies in the context of intercompany loans.

These observations highlight the importance of robustly drafted intercompany contracts. It is strongly advisable that such contracts are supported by market-based evidence of the overall profit outcomes and that key terms are commercially rational.

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