September 12, 2019

By Ruth Butter & Stefan Sunde at TP EQuilibrium AustralAsia

The Federal Court of Australia on 3 September issued its much-anticipated judgment Glencore Investment Pty Ltd v Commissioner of Taxation of the Commonwealth of Australia [2019] FCA 1432, herein referred to as the Glencore decision.

First, the Court found that the Commissioner of the Australian Tax Office had misapplied the provisions of Division 13 and Subdivision 815-A of the Income TaxIncome Tax is a direct levy imposed by governments on the income generated by individuals, corporations, and other entities within a specific jurisdiction. It serves as a major source of revenue for governments and funds various public expenditures, such as infrastructure projects, healthcare, education, national security, and welfare programs. The tax is generally calculated as a percentage of the taxable...Tax AssessmentA tax assessment is a formal determination made by a tax authority to calculate the amount of tax an individual or entity owes. It is a comprehensive evaluation based on financial records, declared income, expenses, deductions, and any applicable tax laws or regulations. Tax assessments may arise from routine self-assessments by taxpayers, or they may be conducted by revenue authorities... Act. As such, Davies J then found that the transfer priceTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of... paid by Glencore’s Swiss head office for copper concentrate, purchased from Glencore’s CSA mine in New South Wales fell within an arm’s length range. The amended assessments issued by the Commissioner for the 2007, 2008, and 2009 income years were ordered to be set aside.

The decision is beneficial to taxpayers at large, setting clear restrictions on the ability of the Commissioner to re-cast the actual transaction and substitute alternate contractual terms. Controlled transactions must be assessed under arm’s length analysisA Comparability Analysis is an essential framework in Transfer Pricing used to evaluate whether the conditions of a transaction between related entities (such as subsidiaries of the same multinational enterprise) are consistent with the arm’s length principle. The arm’s length principle requires that intercompany transactions reflect terms that independent entities would negotiate under comparable circumstances, ensuring that multinational corporations (MNEs)... in the form and substance which they were agreed, as opposed to an alternate reconstruction that may be informed with the benefit of hindsight.

The writers caution however that because the case was heard under the now-lapsed regime of Division 13 and Subdivision 815-A, there is no guarantee that the case will provide unchallenged precedent for matters under the current Subdivision 815-B regime.

This article sets out the key themes considered by Davies J in reaching her judgement.

What is the statutory test and how should it be applied?

Both Division 13 of the Income TaxIncome Tax is a direct levy imposed by governments on the income generated by individuals, corporations, and other entities within a specific jurisdiction. It serves as a major source of revenue for governments and funds various public expenditures, such as infrastructure projects, healthcare, education, national security, and welfare programs. The tax is generally calculated as a percentage of the taxable...Tax AssessmentA tax assessment is a formal determination made by a tax authority to calculate the amount of tax an individual or entity owes. It is a comprehensive evaluation based on financial records, declared income, expenses, deductions, and any applicable tax laws or regulations. Tax assessments may arise from routine self-assessments by taxpayers, or they may be conducted by revenue authorities... Act 1936 and Subdivision 815-A of the Income TaxIncome Tax is a direct levy imposed by governments on the income generated by individuals, corporations, and other entities within a specific jurisdiction. It serves as a major source of revenue for governments and funds various public expenditures, such as infrastructure projects, healthcare, education, national security, and welfare programs. The tax is generally calculated as a percentage of the taxable...Tax AssessmentA tax assessment is a formal determination made by a tax authority to calculate the amount of tax an individual or entity owes. It is a comprehensive evaluation based on financial records, declared income, expenses, deductions, and any applicable tax laws or regulations. Tax assessments may arise from routine self-assessments by taxpayers, or they may be conducted by revenue authorities... Act 1997 are applicable, and were considered by Davies J. However, as stated in her judgement, the common objective of the legislation is to ensure taxpayers’ fiscal obligations for domestic tax purposes are based on the arm’s length equivalent dealing of the actual transaction entered into [48].

Davies J articulated the two statutory questions directed by provisions as [324]:

First, whether there has been non-arm’s length dealing, or whether the conditions differ from those which might be expected between independent enterprises. An affirmative answer establishes the pre-condition to permit an adjustment to an amount equivalent to an arm’s length amount.

Second, if that pre-condition exists, whether the consideration was greater than or less than an arm’s length amount, or was there a causal relationship between the non-arm’s length conditions and profits not accruing to the taxpayer.

Davies J addresses the questions as different inquiries. Accepting that a non-arm’s length dealing may have an arm’s length consideration [49], determining arm’s length consideration therefore requires a ‘hypothetical’ for the purpose of determining an arm’s length amount. The appropriate hypothetical is an arrangement that was not affected by the lack of independence and lack of non-arm’s length dealing [172].

What is the appropriate ‘hypothetical” comparable for the purposes of pricing?

The fundamental issue here centres on what the ‘starting point’ should be for determining the hypothetical arrangement, for the purposes of determining an arm’s length amount. 

The Commissioner submitted that it was necessary to work out what contractual terms independent parties might have agreed to, and in doing so concluded that different terms from those actual terms would have been agreed between the parties. The Commissioner sought to re-cast the terms of the actual agreement to a different (“benchmarkBenchmarking, within the context of transfer pricing, refers to the process of analysing and comparing financial and economic data from independent companies to establish a fair and arm’s length price for controlled transactions. It is typically conducted using databases that provide details about comparable companies and transactions. The objective is to determine whether the terms and conditions of intercompany transactions...”) pricing mechanism. In support of his case, the Commissioner submitted that the hypothetical transactions should not be constrained by the actual terms of the agreement, and that the actual pricing mechanism adopted by the parties should therefore be replaced with an alternate pricing mechanism [30]. 

The taxpayer submitted that the starting point should be the actual agreement entered into by the parties. The taxpayer’s case rested on evidence which showed that the terms governing pricing in the actual agreements were terms that existed in contracts for the sale of copper concentrate between independent market participants, and thus could be expected to be found in an agreement between the relevant hypothetical parties. The taxpayer further submitted that the task of the court was to determine whether, based on the actual terms of the agreement, the level at which the actual pricing mechanism was set was within an arm’s length range [29].

Davies J re-iterated that it is only appropriate to disregard actual structure of the transaction in the exceptional circumstances [314], and even then, restructuring should still align with what can reliably be hypothesised as comparable to the actual dealing [317]. Davies J considered that the economic substance did not differ from the form of actual agreement, and there was no suggestion of tax considerations shaping the terms of the actual agreement.

As a result, Davies J rejected the Commissioner’s contention that appropriate hypothetical was a pricing mechanism that differed from the actual pricing mechanism [322]. The Commissioner’s approach also relied heavily on hindsight, a practice firmly rejected by Davies J.

Davies J also made reference to the Cameco case [325], citing “the traditional transfer pricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of... rules must not be used to recast the arrangements actually made… except to the extent necessary to properly price the transaction by reference to objective benchmarks”.

The outcome of the court decision appears to align more closely with the OECDThe Organisation for Economic Co-operation and Development (OECD) is an international organisation comprising 38 member countries, established to foster economic growth, trade, and development on a global scale. Founded in 1961, the OECD provides a forum for governments to collaborate, share policy experiences, and develop solutions to common economic challenges. The OECD's core mission is to promote policies that improve... guidance than the Commissioner’s position.

What is comparable?

The taxpayer put forward numerous examples of offtake agreements between independent mine producers and traders, for the sale of the same product as the actual transaction here. The taxpayer did not contend that any of the agreements were directly analogous to the tested transaction.

The taxpayer submitted that as the pricing terms in actual agreement were observable in third party agreements and as there was nothing to suggest the parties were acting other than in a commercially rational manner, the agreement that should be hypothesised for the purpose of determining arm’s length pricing was the actual one that contained those pricing terms [311].

The Commissioner pointed to contractual differences, timing differences and differences in the broader circumstances of the parties to those contracts as undermining their comparability to the actual transaction [253 – 306]. The Commissioner concluded that no one of the contracts was a true comparable transaction that would allow a conclusion as to what might have been expected of a producer, with the characteristics of the taxpayer at that time [308].  As a result, the Commissioner argued that the actual pricing terms should be set aside and replaced by pricing terms that might reasonably have been agreed between independent parties, arguing that such would have sold the product on different pricing terms and a different pricing structure.

Davies J found that the examples did have probative value as illustrations of contracts between independent market participants for the product and demonstrated that the pricing mechanism and quotational period terms were standard in contracts for the product in the relevant years [307]. Further, Davies J accepted the taxpayer’s submission that the example agreements, holistically, demonstrated that the terms at issue could and had been agreed between independent participants in the market at that time, and therefore might be expected to operate between independent parties [308].

Relevance of the Chevron decision

Interestingly, both the taxpayer and Commissioner submitted that the Chevron decision supported their competing positions, an issue Davies J invested heavily in a detailed examination of [36].  

Davies J highlighted that the actual characteristics of the taxpayer must serve as the basis in the comparable agreement [42], and the comparative analysis, except in the case of the exceptional circumstances [40]. Davies J further noted that the hypothetical is “not of an abstract agreement between abstract parties” but should be based on the form of the actual transaction entered into [41, 314]. 

Davies J outlined that the appropriate hypothetical was on the basis of, first, an independent buyer in the position of the trading entity, acquiring the whole of the producer’s output for the life of the mine and providing logistical and marketing support to the producer; and second, an independent seller of the product in the position of the producer, selling all its output for the life of mine to an independent buyer, and with no need for a marketing department or logistics expertise [172].

In the Chevron case, it was noted that the terms of the loan diverged from terms that might be expected between independent parties acting at arm’s length [29]. Conversely, in this case, the terms governing the pricing in the actual agreement were terms that existed in contracts for the sale of copper concentrate between independent market participants.

To what extent is hindsight appropriate?

Davies J re-iterated that the use of hindsight is not appropriate.  She noted that it is irrelevant whether or not the taxpayer was profitable in the relevant years, since the statutory questions must be answered by looking at the events at the time the pricing was entered into [244].  Any analysis of whether the taxpayer would have earned more under a differently structured pricing mechanism involves hindsight [327], and as such is irrelevant for comparison to the actual results of the taxpayer [332].

Discharging the onus of proof

The Commissioner argued that the evidence did not demonstrate that an independent producer might be expected to agree the actual terms at that time. As a result, the Commissioner advanced an alternate hypothetical agreement, based on a different pricing structure and pricing terms [31, 32]. Meanwhile, the taxpayer argued there was no basis on which to disregard the actual pricing terms [33].

With regards to the onus of proof, Davies J disagreed with the Commissioner’s contention, stating that in order to discharge onus of proof, the taxpayer does not have to prove that, if acting at arm’s length, it might reasonably be expected to have adopted the actual terms that it did adopt [333].

Davies J went on to state that neither Division 13 nor Subdivision 815-A require an enquiry into the commercial prudence of the non-arm’s length contract actually entered into. She re-iterated that any requirement to consider whether an arrangement is commercially rational is only in relation to the second exceptional circumstance where structure is not explained by normal commercial conditions. 

Whilst noting that it was not necessary to consider the commerciality of the arrangement [342], for completeness, Davies J later set out the taxpayer’s (seven) reasons, which she accepted as satisfactory evidence that the actual terms were not irrational and might reasonably be expected to agree, at that time, to the terms it did [385 – 394].

Reliance on the testimonies of expert witnesses

Davies J also offered observations on the role of the expert witnesses. In this case, the outcome did not ultimately rely on finding the evidence of one expert more persuasive or reliable that another. However, Davies J observed that each of the mining industry experts included expression of opinions on matters outside their specialist knowledge and re-iterated that the role of the expert is to provide independent assistance to the Court by providing objective and impartial opinion on matters within their specialist knowledge. Further, she re-confirmed that it is not the role of the expert to act as advocate for one party or another, nor to express views on matters outside their own expertise [402 – 404].

The opinions of expert witnesses were dismissed where the questions asked of them did not direct them to address the correct statutory questions [326]. Here, the starting point for the expert witnesses engaged by the Commissioner was an enquiry into whether the price, terms, and conditions would have been different, and so their consequential analysis was based on an assumption of re-casting the actual terms of the agreement [61, 215 – 242].

However, industry expert witnesses individually and collectively remained key to providing understanding of the (copper concentrate) industry market norms relevant to pricing structure [67 – 92] and prevailing industry conditions [93 – 103].

What does this case not provide guidance on?

This case provides welcome clarification, confirmation and re-iteration of the basic principles of applying the arm’s length principleThe Arm’s Length Principle (ALP) is a cornerstone concept in international taxation and transfer pricing. It requires that transactions between related parties, such as subsidiaries or affiliates within a multinational enterprise (MNE), mirror those that would occur between independent entities under similar circumstances. This principle ensures that each entity within an MNE is compensated fairly and transparently, based on the..., and is clearly and comprehensively referenced, citing prior case law, OECDThe Organisation for Economic Co-operation and Development (OECD) is an international organisation comprising 38 member countries, established to foster economic growth, trade, and development on a global scale. Founded in 1961, the OECD provides a forum for governments to collaborate, share policy experiences, and develop solutions to common economic challenges. The OECD's core mission is to promote policies that improve... guidance and the objectives of the relevant Australian tax legislationTax laws form the backbone of any nation’s revenue system, setting the rules that govern how individuals and corporations contribute financially to support government functions. These laws define the types of taxes, the applicable rates, and the regulations regarding payment and compliance. They also outline the rights and obligations of taxpayers, ensuring a balanced and fair approach to funding public....  However, the time periods at issue (being the income taxIncome Tax is a direct levy imposed by governments on the income generated by individuals, corporations, and other entities within a specific jurisdiction. It serves as a major source of revenue for governments and funds various public expenditures, such as infrastructure projects, healthcare, education, national security, and welfare programs. The tax is generally calculated as a percentage of the taxable... years 2007 – 2009) fall under the Division 13 and Subdivision 815-A regimes and, as a result, the extent to which this case might act as precedent for the application of Subdivision 815-B remains unclear.

In this case, Davies J accepted evidence which provides a ‘point of reference’, which is ‘illustrative’ of or which is relevant as an example of agreements that demonstrate individual elements of pricing. The difficulty in identifying directly comparable arrangements is recognised, and this case appears to take a practical and logical approach to addressing this difficulty. Arguably, one such data point should be sufficient to demonstrate that particular terms might have been entered into by independent parties.  However, it remains to be seen where the balance lies with regards to the weight of such ‘points of reference’ required to overcome an absence of direct comparables.

– -Ruth Butter and Stefan Sunde at TP EQuilibrium AustralAsia