Written By: Matthew Hemmings – Corporate Finance
Within the practice of transfer pricing, intercompany loans are among the most tricky and vital for multinationals. They are used to centralize their treasury and long-term financial needs to ensure cost-efficiency when borrowing on the market. Parent, or mother, companies may borrow in less expensive ways than their subsidiaries, and they can offer their group guarantees to reduce bank counterparty-risk charges.
However, when pricing the intercompany loan to the subsidiary, the method to be chosen is not simple.
The so-called arm’s length principle relies more on common sense and subjective analysis of the markets collected by finance teams than on precise mathematical definition:
- at cost without margin could be contested by the tax administration of the parent company’s country;
- at cost that would have been charged on the market to the subsidiary if it had borrowed alone, without its parent’s help, also could be contested by the tax administration of the subsidiary’s country.
A go-between is often calculated by financial teams, like a mark-up for the mother company taking into account a certain level of counterparty risk and also country risk. But no strict international calculation applies. And regulators are now more and more likely to contest those operations. Most international organizations have announced that 2017 will be the year during which they focus on intergroup financial transactions, cash pooling and loans being at the top of those transactions.
The stakes are high for multinationals, as we can see from the recent judgment made by the Australian Federal Court on the Chevron case.
The Australian Taxation Office (ATO) made a claim against US oil giant Chevron for A$269 million, based on a loan of $2.5 billion concluded in 2004 between the Delaware-based company and the Australian entity that funded the acquisition of Texaco Australia. The ATO argued that the Delaware company borrowed on the market at a rate of 1.2 percent but lent to the Australian company at 9 percent. This 9-percent rate would have applied on the market for the Australian company if standing alone, without any guarantees from the US company. Chevron, which was sentenced to pay A$180 million in arrears of taxes, a $45 million fine and at least $44 million interest, appealed. But the Federal Court of Australia recently rejected its appeal. The last possible step for Chevron is to appeal at the Australian Supreme Court level.
The ATO victory is raising lots of questions: At first, based on Chevron’s size, a much larger $42 billion loan has been booked to fund development of its North West Shelf gas facilities in Australia, involving similar internal debt financing, albeit with a far lower interest rate charged. Secondly, for all the oil companies exploiting Australian gas and oil platforms, the ATO may use this result to collect a huge amount of tax.
Beyond the loan issue, there is another reason for the ATO’s anger.
The explanations given by Chevron made the ATO feel that by setting the conditions of the loan, Chevron really wanted to optimize the tax impact rather than simply optimize the financial conditions for the Australian entity. And on top of that, in December 2016, a Tax Justice Network analysis of ATO data showed that for the second year running, Chevron had paid no corporate tax. Chevron certainly paid other types of tax, such as social and royalty, but not income. And no tax was paid in the US for this operation, as Delaware is listed among the corporate tax havens.
And according to the ATO, many of the oil companies in Australia are in this same situation. An ATO transparency report on multinationals for 2014-15 showed that more than 35 percent of the largest public companies and multinational entities paid no tax in Australia during the most recent financial year on record. Among them, oil companies were numerous.
The landscape is far from being set today with this case; lots of questions remain on which methodology to choose.
The ATO has recognized the need for clarification and declared that it will shortly release “detailed guidance to help companies with related party loans comply with Australia’s transfer pricing rules”. But the strengthening of Australian rules has continued since the years under consideration in the Chevron decision; one can cite the Multinational Anti-Avoidance and Diverted Profits Tax laws. And, referring to the transparency report published, the ATO can also now tackle the rental charges of oil companies, as the Petroleum Resource Rent Tax (PTRR) decreased sharply in 2015.
The sums at stake are in the billions for Australian tax authorities. The fight will be a tough one.