Arm’s length for good.

In a 23 October 2015, an inter-company loan transaction between 2 related entities, one in Australia and the other in US were ruled by the Australian Tax Office (ATO) as a transaction not on arms’ length and created for tax advantage. The Courts ruled in favour of ATO and a 25% penalty of what was deemed to the shortfall is levied on the transaction.

An Australian entity, Australia Holdings Pty Ltd (CAHPL) engaged in an inter-company loan arrangement with Chevron Texaco Funding Corporation (CFC) lending CAHPL the AUD equivalent of USD2.5 billion on an unsecured basis for 5 years at an interest rate of AUD LIBOR + 4.14% under a Credit Facility agreement. CFC borrowed the funds through an issuance of USD commercial paper with a credit guarantee provided by Chevron Inc, the ultimate parent of the group at below USD LIBOR (approximately 1 to 2%).

The key point in issue is that CAHPL cannot substantiate that the transaction is at arm’s length and therefore the payment of interest at 4.14% above USD LIBOR is not excessive. And that this excessive interest payments under the said loan arrangement is prima facie done for the purpose of claiming excessive interest deduction against CAHPL income in Australia.

Interesting facts of the case:

  • An employee of CAHPL under cross-examination, did not disagree that the total interest paid at that point in time of 8.97% was “unsustainable” from the viewpoint of CAHPL.
  • Unrealised high pricing of the loan to CAHPL with no consideration of provision of any collateral, guarantee or credit enhancement as in other usual loans, which would reduce the interest rate payable under the loan arrangement.
  • CFC was not taxable in the US on the interest income
  • CFC generated profits from the interest differentials and onwards paid dividends to back to CAHPL, which were exempt from tax in Australia
  • CAHPL in turn paid dividends to its shareholder

The facts and events subsequent to the loan arrangement seems to indicate a scheme benefit for claiming high interest deduction in one entity in a high tax regime with the benefit accruing to another related entity in a low tax or nil tax regime. The said scheme benefit is then recycled back to the same entity and paid out in the form of dividends which again is exempt from tax.

It is therefore important that taxpayer keep all transfer pricing arrangement relevant and contemporaneous. A few takeaway points in to note:

  • the substance and conduct of the related parties must be consistent with an appropriate transfer pricing methodology
  • normal credit related factors should be considered in the pricing including credit rating, provision of security etc
  • Choice of currency or the impact of transactional foreign exchange risk on loan principal and interest repayment

Similarly, IRAS subscribes to the principle that profits should be taxed where the real economic activities generating the profits are performed and where value is created. Where related party transactions are not at arm’s length, IRAS may adjust the profit of the Singapore taxpayer as it deemed necessary to reflect the arm’s length results just as in the above case where ATO manually adjusted the related party transaction amount.

In Singapore, IRAS recommends that taxpayers adopt the following 3-step approach to apply the arm’s length principle in their related party transactions:

Step 1 – Conduct a comparability analysis to It identify situations or transactions undertaken by unrelated parties that are comparable to the situations or transactions between related parties.

Step 2 – Identify the most appropriate transfer pricing method and tested party

Step 3 – Determine the arm’s length results