13 June 2017

Pricing of intercompany loans may receive different tax treatment in view of recent case

A recent judgment of the Federal Court of Australia may impact how tax authorities worldwide look at intercompany loan pricing. Companies should look critically at existing group financing structures and determine whether their pricing can be upheld if the test introduced by the Australian court is applied.

The Australian Federal Court decided in appeal on a transfer pricing case concerning Chevron. The case involved an Australian tax payer, but the approach taken by the court may have a much wider impact.

CAHP, an Australian company, is a 100% subsidiary of CVX, a US company. It borrowed AUD 2.5 billion from its US subsidiary CFC. CFC in turn had borrowed these funds in the commercial paper market under a guarantee issued by CVX. Due to CVX’s guarantee, the cost of borrowing for CFC was LIBOR. The loan to CAHP was priced at LIBOR+ 4.14%. 4.14% reflects the mark-up typically paid by a borrower of poor credit quality for an unsecured loan. CVX did not charge a guarantee fee.

Chevron chose this group funding structure to optimise its after tax results. Interest paid was deductible at CAHP’s level, whereas the net income received by CFC was not taxable in either the US or Australia.

The question the court had to answer was whether the loan between CFC and CAHP was at arm’s length. In determining this, the transaction had to be tested against a comparable transaction. No internal comparable transaction – an unsecured borrowing from an unrelated party – was available. So CAHP took the position that the loan should be compared with that of an independent company borrowing in the market (“an external comparable”). If independent (not part of a group), the pricing of an unsecured loan would have been Libor+ 4.14%.

The court ruled that CAHP’s position should not be compared with a stand-alone company, but with a company that is part of a group and where the group has a policy to borrow at the lowest cost possible (the reason why CVX guaranteed the issued commercial paper). So interest due by CAHP on the intercompany loan should have been at the same (or a lower) price level as the cost of CFC’s borrowing in the market. The court thereby disregarded the actual transaction undertaken, for which external comparables existed, and replaced it with a different transaction. According to the OECD Transfer Pricing Guidelines this should only be done in exceptional circumstances; an example of this would be where “arrangements made differ from those that would have been adopted by independent enterprises behaving in a commercially rational manner”.

As to the question of whether CAHP should have paid a guarantee commission to CVX, the court ruled in favour of CAHP because there was no evidence of any likelihood of Chevron charging a fee for such a guarantee.

 

In court cases on transfer pricing, it is not uncommon to refer to cases in other jurisdictions, especially where these deal with the interpretation of OECD Guidelines. This “part-of the-group” approach may therefore be quickly embraced by tax authorities around the globe, as it is a perfect fit with the OECD’s actions to combat Base Erosion and Profit Shifting (BEPS).

The decision may have an impact beyond the incidental loan without a guarantee. A similar approach could be taken where a group would normally pledge assets to the lender in an external borrowing situation; the benchmarking against an unsecured loan could be seen as irrelevant. The pricing of the intercompany loan should then be set at the level of a loan with securities.

The part-of-the group approach could be applied as well to outside lending. When you think of inter-group transactions – where a group company acts as manufacturing entity (in effect, a contract manufacturer) for the group, and all the commercial and inventory risk is removed from this contract manufacturer – the pricing then leaves little margin for the contract manufacturer. Should the comparison here be made with a contract that would normally be entered into with a non-related party? If such a contract would not remove risks from the manufacturer, should the intra-group transaction be replaced by terms and conditions of a typical third-party contract (and be priced accordingly)?

The High Court in Australia has been asked to review the case on appeal, and therefore nothing is final yet. However, existing transfer pricing policies may not only be subject to challenge under BEPS, but could also face the scrutiny of judges who take views that differ from the traditional view on how transfer pricing principles are applied. From this perspective, it may be advisable to look whether any specific intra-group financing arrangements are at risk.

We would like to express our thanks to Marco Adda, transfer pricing partner of our partner firm Bonelli Erede, for his contribution.