Australia: Crossing the line in cross border finance arrangements – what you need to know post Chevron decision

On 21 April 2017 the Full Federal Court of Australia handed down its decision in what has been described as the most significant tax case ever litigated in Australia: Chevron Australia Holdings Pty Ltd v Commissioner of Taxation. The decision is the first to provide any real guidance on the intra-group pricing of debt by multinationals and has received significant attention both internationally and here in Australia.

The Chevron Decision

The key question in the Chevron case and subsequent appeal was whether the 9% interest rate charged on a $2.5 billion loan by a US (Delaware) Chevron subsidiary to Chevron Australia was consistent with a genuinely "arm's length" arrangement, particularly when the Delaware entity had sourced the loan funds at the much lower rate of 1.2%.

The 3 judges of the Full Federal Court unanimously found that the arrangement was not "arm's length" and that Chevron had used the intra-group loans as a means of shifting profits offshore and avoiding tax in Australia. The decision leaves Chevron facing an enormous tax bill, estimated to be in excess of $340 million in tax, interest and penalties on this particular financing arrangement alone.

The Financial Review reported that the Chevron ruling "marks the onset of a new, more aggressive approach by the ATO" and the ATO has itself issued statements saying that the decision "has direct implications for a number of cases the ATO is currently pursuing in relation to related party loans, as well as indirect implications for other transfer pricing cases".

The ATO's PCG 2017/D4

As part of the new approach informed by the Chevron decision, the ATO has now issued Practical Compliance Guideline 2017/D4, which sets out details of the ATO's compliance approach to the taxation outcomes of cross-border financing arrangements entered into between related parties. PCG 2017/D4 is set to come into effect on 1 July 2017 and the key concepts are unlikely to change in between now and then.

PCG 2017/D4 applies to any financing arrangement entered into with a related party that is not a resident of Australia, whether the relevant debt funding arrangement is inbound or outbound.

The ATO intends to use the framework set out in PCG 2017/D4 to differentiate risk and tailor its engagement with taxpayers according to: the features of their particular financing arrangements; the profile of the parties to the arrangement; and the choices and behaviours of that particular corporate group.

PCG 2017/D4 outlines an assessment framework in the form of a risk matrix allowing taxpayers to self-assess the level of tax risk associated with their financing arrangement. Under this matrix, the transfer pricing risk associated with each financing arrangement is to be assessed with regard to a combination of quantitative and qualitative indicators including:

  • pricing of the debt relative the cost of referable debt;
  • leverage of the borrower compared to the group;
  • interest cover ratio compared to the group;
  • the headline tax rate in the lender's jurisdiction;
  • the currency in which the debt is provided; and
  • the presence of any 'exotic' features of the arrangements

The indicators feed into a scoring and risk zone system, where a score of:

  • 0-4 = a 'Green Zone' result, meaning the arrangement is regarded as low risk;
  • 5-10 = a 'Blue Zone' result, meaning the arrangement is regarded as low to moderate risk;
  • 11-18 = a 'Yellow Zone' result, meaning the arrangement is regarded as moderate risk;
  • 19-24 = a 'Amber Zone' result, meaning the arrangement is regarded as high risk; and
  • 25 or more = a 'Red Zone' result, meaning the arrangement is regarded as very high risk

Click here to access the risk matrix in full within PCG 2017/D4.

What does it mean for an Australian taxpayer that is part of a multinational group that has cross-border financing arrangements in place?

It should be noted that the concepts set out in PCG 2017/D4 will not apply to cases where:

  • there is a financial institution within the group;
  • there is an Australian resident securitisation vehicle within the group;
  • the financing arrangement is a form of Islamic Finance, or
  • the Australian taxpayer is eligible to use the simplified transfer pricing record keeping options

Smaller taxpayers will now need to determine whether they qualify for the simplified transfer pricing record keeping regime, or not, before assessing whether they need to apply the PCG 2017/D4 risk assessment matrix. To be eligible for the simplified record keeping regime, an entity must fit into one of the 8 safe harbour categories set out in the ATO's Practical Compliance Guideline 2017/2. Each category has its own specific criteria for eligibility so it is crucial that contractual documentation is put in place to support eligibility to any category that is claimed.

If you are not entitled to any of the 4 exemptions from the PCG 2017/D4 transfer pricing framework, but your financing arrangement is rated as being low risk (or Green Zone) under the risk matrix, then you can expect that the Commissioner will not apply any compliance resources to review the taxation outcomes of your arrangement, other than to fact-check your self-assessment of the appropriate risk rating.

If your financing arrangement falls outside the low risk category (meaning that it falls into the Blue, Yellow, Amber or Red Zones and not the Green Zone) you can expect that the Commissioner will monitor, test and/or verify the taxation outcomes of your arrangement. The higher the risk rating, the more likely your arrangement will be reviewed.

In addition, the higher the risk zone that you fall within, the greater the expectation by the ATO that you will have high quality documentation in place to evidence the arm's length nature of your arrangements.

The message is clear that the ATO is, quite sensibly, intending to focus and concentrate its compliance efforts and resources on international related party dealings that pose the highest risk of not complying with the transfer pricing rules or other relevant provisions.

However the message is also clear that, in all cases, it will be essential to have contemporaneous contractual documentation in place to support the outcomes of your self-assessed transfer pricing risk profile by showing that you have taken the ATO's issued guidance into account. Doing this will significantly lessen the chance of any underpayment determination and/or the chance of any penalties being applied by the ATO if (or when) your cross-border debt financing arrangements are subsequently audited.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

Kemp Strang has received acknowledgements for the quality of our work in the most recent editions of Chambers & Partners, Best Lawyers and IFLR1000.

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