Why you should care about Chevron

By in Opinion

Businesses in Australia – even if you don’t have complex international financing arrangements – need to care about the Chevron decision.

Every corporate group undertakes related party transactions and the tax laws are littered with rules that try to deal with them. Trading stock, sale of depreciable assets, market value substitution provisions and remuneration of associates are some examples, but there are many others.

The tax issue in Chevron may well be transfer pricing, but the case provides real insight into how the ATO, and the Courts, approach dealing with tax outcomes of non-arm’s length related party transactions.

What is Chevron about?

In Chevron, the transaction was an intercompany loan. The tax dispute centred around the interest rate. Chevron applied a 9% interest rate on the basis that the loan was unsecured. However, Chevron had been able to raise the money for the loan at an interest rate of just 1.2%.

They now face a tax bill in excess of $1 billion after the Full Federal agreed with the ATO that the interest rate was excessive.

A key takeaway for all businesses is how the ATO and the Court approach determining an arm’s length interest rate for the loan.

Chevron had diligently identified the terms of the loan and had sought expert advice as to the appropriate interest rate to apply to a loan made on those terms.

In the view of the ATO and the Courts, this missed a critical step. Before considering the arm’s length price for a transaction, what is necessary is to consider the arm’s length terms for the transaction itself. If unrelated parties would not have undertaken the transaction on its terms, it is pointless to try and determine an arm’s length price for that transaction.

The Chevron arrangement involved the making of a substantial loan for a five-year term, but without financial covenants and without the provision of security. An unrelated party would have required both financial covenants and adequate security. The evidence indicated that the Chevron parent company would have provided a guarantee and would not have charged a fee to its Australian subsidiary to do so. The appropriate transaction to price was therefore a five-year loan, with financial covenants and supported by a parent company guarantee. The interest rate on this loan was well below the 9% being used by Chevron.

What do businesses in Australia need to be considering?

Clearly if you are transacting with overseas related parties, this case has direct application. For transactions between Australian entities, if there is a tax impact, then the same principles apply.

Take as an example transactions involving research and development activities or intellectual property.

It is not unusual for one member of a corporate group to contract another to undertake research and development activities on its behalf. A service fee may be paid, often calculated on a cost plus basis, with the margin being relatively limited. Some instances are even less formal, with a manufacturer or distributor of a product doing things which enhance the product, but not being recognised or rewarded for that work.

In other cases one party will develop intellectual property and then will transfer ownership (through a sale, an exclusive perpetual licence or otherwise) to an associate. A value will be struck for the transaction, but for IP that is yet to be commercialised, this value rarely provides the seller with a significant profit or upside.

These types of transactions are driven by a range of factors, with tax consideration being one of them. The focus, from a tax perspective, has historically been on ensuring that the transactions is priced at a market value. If an independent valuer concludes that the current value of the IP is approximately the same as the costs incurred to develop it, then that is the market value and the tax consequences (or lack thereof) are just a natural outcome of the transaction.

The decision in Chevron would question this. Having invested the time and effort to develop IP, would a business be prepared to sell it to a third party before its commercial potential has been realised in a transaction where the business generates little (or no) profit? Potentially not.

There are numerous other related party transactions where a similar issue could arise. If the transaction is between related parties and it has a material tax impact, merely pricing the transaction at a market value may not be enough. There’s a threshold question that needs to be addressed – would unrelated parties actually do this transaction? If they wouldn’t, then the pricing of the transaction needs to be adjusted to reflect the impact of the non-arm’s length terms and conditions.

The Chevron decision has been appealed to the High Court. If the High Court rules in the ATO’s favour, expect a lot more scrutiny of non-arm’s length transactions. Even if the High Court overturns this decision, it is clear that the ATO is focused on tackling inappropriate tax outcomes from non-arm’s length transactions, so all business will need to carry out extra diligence.


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