By Chris Kinsella CA & Stephen Jones. Banner image: Justin Sullivan / Getty Images.

The Chevron decision, handed down by the Full Federal Court on 21 April 2017, was a watershed moment for taxpayers and for revenue authorities in Australia and around the world.  

The decision has received an unprecedented level of media attention, with some commentators describing it as the most important tax case ever. So, what are the key learnings for taxpayers and their advisers?  

The case concerned the application of Australia’s “former” transfer pricing provisions to the interest charged on the A$ equivalent of a US$2.5b loan from a wholly-owned US-based subsidiary to Chevron Australia Holdings Pty Ltd (CAHPL). Specifically, the court had to decide whether the interest rate charged exceeded the arm's-length rate.  

The assessments in dispute were based on transfer pricing determinations made under Division 13 of the Australian Income Tax Assessment Act 1936 (for the five years in question) and under Division 815-A of the Australian Income Tax Assessment Act 1997 (in respect of the last three years). Although both of these provisions have now been repealed, the Chevron case highlights the difficult statutory interpretations that arise in transfer pricing disputes. The case also highlights complex matters of evidence including how to ensurw expert opinions are admissible, probative and reliable.  

The decision of the Full Federal Court is a strong one for Australian Tax Commissioner Chris Jordan. There are important lessons arising for multinationals involved in cross-border financing and those questions are not limited to an Australian tax context. There has been considerable interest from overseas jurisdictions in the issues discussed in this case.  

Arm’s-length principle

The reason this case is so important internationally is that transfer pricing legislation in most jurisdictions (and specifically those countries that are members of the OECD) is based on the concept of the arm’s-length principle.  

The arm's-length principle is set out in Article 9 of the OECD Model Tax Convention and is broadly reflected in Division 815-A and, relevantly, its replacement Division 815-B (the current Australian transfer pricing provisions).  

After setting out the commentary on Article 9 contained in the1995 OECD Guidelines, Allsop CJ concluded that:  

The test in s 815-15(1)(c) based on Art 9 is a flexible comparative analysis that gives weight, but not irredeemable inflexibility, to the form of the transaction actually entered between the associated enterprises. A degree of flexibility is required especially if the structure and detail of the transaction has been formulated by reference to the group relationship and a “tax-effective” outcome (even if, as here, one that is not said to be illegitimate). The form of that transaction may, to a degree, be altered if it is necessary to do so to permit the transaction to be analysed through the lens of mutually independent parties.

This approach was central to the analysis that followed, not only under Division 815-A, but also in relation to Division 13.  

The application of Division 13

Chevron argued that the court had to price the interest on the basis of the agreement actually entered into. The court rejected this on the following basis:  

Division 13 reflects a fiscal policy that parties who are not dealing with each other at arm's length… should be treated as if the consideration given by them for property… as if the property had been acquired under an agreement between parties who were independent and were dealing with each other at arm’s length.  

The reasonable hypothesis called for under Division 13 is that at arm’s length CAHPL would have obtained a guarantee from its parent, which would have allowed it to obtain the lowest cost of funding.

Guarantee fee

Pagone J accepted CAHPL’s alternative submission that the hypothetical acquisition would need to assume that CAHPL had paid a guarantee fee to its parent had some force. However, there was insufficient evidence in the case as conducted to warrant the conclusion that a fee might reasonably be expected to have been paid by CAHPL.  

The judge therefore left open for a future case the possibility of pricing into the transaction the cost of providing a guarantee.  

Evidence of bankers

The Full Federal Court rejected CAHPL’s expert banking evidence because the banking experts had been asked to price the loan on the basis of the actual agreement entered into and on the basis that CAHPL was a stand-alone company. Their evidence was not directed to the correct statutory question.  

The court held that, “the model upon which s. 136AD(3) is based presupposes, in other words, that there exists a comparable agreement able to be compared with the actual agreement under which the consideration for the comparable agreement was not affected by the parties not being independent and not having dealt with each other at arm's length.  

As a stand-alone company, severed from the financial strength of its ultimate parent and corporate group, CAHPL could not secure a loan for an amount equivalent to US$2.5b at the rate obtained by its subsidiary with a guarantee from the ultimate parent.  

The court rejected CAHPL’s construction that section 136AD(3) required pricing a hypothetical loan which a hypothetical CAHPL could obtain from a hypothetical independent party on the assumption that the hypothetical CAHPL had the attributes of the actual CAHPL but was otherwise independent. The court held that to apply s136AD(3) in that way would be unrealistic and contrary to its purpose.  

Independence and the “orphan theory”

The Full Federal Court rejected Chevron’s “orphan theory”. The essence of the orphan theory is that CAHPL should be assessed as a stand-alone entity shorn of all affiliation to its parent. On this point Justice Pagone, with whom Allsop CJ and Perram J agreed, said at para 130:  

The prediction of what might reasonably be expected is not to be undertaken upon the hypothesis submitted on behalf of CAHPL that it was not a member of the Chevron group or, in the language sometimes used in this context, as if it were an orphan. To do so would be to distort the application of Division 13 and fundamentally undermine its purpose of substituting as a comparable a real-world, arm’s-length consideration, that consideration which could predictably have been agreed between them on the hypothesis that they had been independent and dealing at arm’s length.  

The court endorsed what Commissioner Jordan submitted, that while the relationship between the borrower and lender needs to be disregarded and the borrower and lender need to be treated as independent, it is not the case that a consequence is that the ownership of the borrower needs to be disregarded.  

This point is important in the circumstances of this case as the credit strength of Chevron in the US was far superior to the credit strength of CAHPL as a stand-alone, meaning that if CAHPL were a stand-alone, its borrowing cost would have been higher.  

Division 815-A

Given the court found for the Commissioner on the basis that the assessments were supported by the Division 13 determinations, its comments on Division 815-A were strictly incidental.   Nevertheless, the comparison which Article 9 required to be undertaken is akin to that contemplated by Division 13. The object is to determine whether conditions actually prevailing between relevant enterprises differed from those that might be expected to operate if they had been independent and had been dealing wholly independently with each other.

Chevron had challenged Subdivision 815-A on the basis of its retrospectivity. But the court held that Subdivision 815-A does not impose an arbitrary or incontestable tax. The court decided that the mere fact that a person may not be aware, at an earlier point in time, what the criteria of liability might consequently be, is not sufficient to make the legislation arbitrary or incontestable in the sense considered in High Court authorities. 

Validity of the Division 13 determination

The court held that CAHPL did not prove excessiveness by showing error in the making of the determinations. Section 175 of the 1936 Act meant the error did not affect the validity of the determination and was within “due making” within the meaning of the conclusive evidence provisions. The error did not go to substantive liability.    

Chris Kinsella CA is a partner in Minter Ellison's Tax Controversy team. Minter Ellison acted as solicitor for the ATO in the above case. Kinsella has over 30 years experience consulting to leading Australian corporates and financial institutions in relation to Australian income tax matters.  

Stephen Jones is a member of Minter Ellison's Tax Controversy team and specialises in providing taxation advice and tax litigation services. Prior to entering private practice, Jones worked in the Australia Taxation Office (ATO) as a senior officer in the Appeals and Review Group.