Contributed by David Bond, Partner and Julian Pinson, Partner, Greenwoods & Herbert Smith Freehills
The Full Federal Court upheld the decision of Davies J at first instance finding that the price sharing and quotation period optionality elements of the copper concentrate pricing were arm’s length. However, the calculation of the freight allowance was not arm’s length and accordingly, the appeal was allowed on this issue.
The taxpayer’s expert evidence of how independent parties operated in the copper concentrate market, and its examples of third-party copper concentrate sale contracts were important in establishing that the pricing was arm’s length.
The decision of the Full Federal Court provides guidance on the role of OECD Transfer Pricing Guidelines, how to identify the hypothetical transaction, and the role of experts and comparable transactions.
Facts of the case
The case considered the sale of copper concentrate by Australian subsidiary Cobar Management Pty Ltd (seller) (CM) to Glencore International AG (buyer) (GI), a Swiss related company.
Copper concentrate pricing is generally based on the London Metal Exchange (LME) price for refined copper less discounts for Treatment Costs and Refining Costs (TCRC). Prior to 2007, CM and GI had agreed to price their copper concentrate sales based on the LME copper price and agreed benchmarks for TCRCs.
In 2007 there was uncertainty in the copper market in relation to both copper prices and TCRCs. CM and GI agree to amend the off-take agreement so that the price of copper concentrate was calculated as 23% of the copper reference price on the London Metal Exchange. Evidence was led that this pricing mechanism would reduce CM’s risks from volatility in both copper prices and TCRCs but might also reduce its sales revenue.
The Commissioner argued that this new pricing mechanism was not arm’s length and applied the transfer pricing rules in Div 13 and Subdiv 815-A to issue amended assessments. These amended assessments substituted the copper concentrate price that would have been received under the previous pricing mechanism.
Original Federal Court appeal (Davies J)
Glencore’s appeal to the Federal Court was first considered by Davies J and she decided in favour of Glencore for the following reasons:
- The transfer pricing analysis should generally be based on the form of the actual transaction between the associated enterprises.
- The 1995 OECD Transfer Pricing Guidelines were relevant to applying both Div 13 and Subdiv 815-A. In particular, transactions could only be reconstructed in the exceptional circumstances detailed in the Guidelines. CM’s copper concentrate sales did not fall into these exceptional circumstances.
- The use of hindsight was not appropriate, and it was irrelevant to the transfer pricing enquiry whether different pricing options actually resulted in different financial outcomes.
- The third-party offtake agreements tendered by Glencore provided evidence of arm’s length prices between miners and traders, even though these agreements were not perfectly comparable.
Full Federal Court appeal (Middleton, Steward, and Thawley JJ)
The Commissioner appealed to the Full Federal Court, which dismissed the appeal (with the exception of the freight charge adjustment) but on different grounds to Davies J. The Full Federal Court included a majority judgment from Middleton and Steward JJ and a minority judgment from Thawley J. The minority judgment agreed with the majority decision but for different reasons.
OECD Transfer Pricing Guidelines
- The majority were hesitant to use the OECD Transfer Pricing Guidelines (and in particular the two exceptions) in applying Div 13. They described the language of the Guidelines as “very highly generalised and is frustratingly opaque”. They contrasted the general principles discussed in the OECD Guidelines to the greater discipline and rigour that is usually found in domestic legislation.
- The majority also held that Subdiv 815-A obliges the Court to determine whether an entity has received a transfer pricing benefit consistently with the Guidelines, but only to the extent they are relevant. The majority held that given the generality of the comments in Guidelines they may be of limited assistance in applying Subdiv 815-A.
Reconstruction under Div 13
- Davies J had focused on whether the Commissioner could reconstruct the terms of the offtake agreement. In contrast, the appeal majority held that the Commissioner had not sought to reconstruct the terms of the offtake agreement but had merely sought to adjust the consideration.
- The majority held that the concept of consideration for the offtake agreement was “at least wide enough to include a pricing formula or some other methodology for the determination of price”.
- The majority also commented that it must be very seriously doubted whether the Commissioner is authorised under Div 13 to ignore or reframe those other clauses of the agreement which do not define the price payable.
- However, Thawley J (minority) considered that there was scope for the Commissioner to reconstruct the terms of a related party contract because otherwise it was open for related parties to dictate the consideration by implementing a transaction which might not reasonably be expected to have been agreed by independent parties.
Reconstruction under Subdiv 815-A
- The majority decided that the question of whether the Commissioner could reconstruct a transaction when applying Subdiv 815-A “is a question for another day”.
Reconstruction under Subdiv 815-B
- None of the judges considered the applications of Subdiv 815-B which includes an express statutory power to reconstruct a related party transaction in certain circumstances.
Steps to identify the hypothetical contract
The majority identified seven considerations relevant to identifying the hypothetical contract:
- Only attributes or features which affect consideration are relevant.
- Only the objective attributes or features should be included in the hypothetical. This will include the circumstances of the mine and the copper concentrate market in 2007.
- Considerations which arise from the non-arm’s length relationship should be excluded. In this regard, CM’s actual attitude to risk from transactions with GI would be coloured by the fact that they are related parties. Instead, the attitude to risk of an independent entity can better be established from expert evidence as to how market participants approached risk.
- Identification of arm’s length consideration can take into account how an independent party (in CM’s circumstances) might have managed risk. That independent party could legitimately adopt a more conservative approach to risk so long as it was commercially rational to do so, and an independent party might reasonably be expected to have done so. There is no obligation to maximise profitability at the expense of all else.
- There can be a range of arm’s length outcomes.
- What controls the range of acceptable arm’s length outcomes is the concept of what might (not would) reasonably be expected.
- A degree of flexibility and pragmatism is required in the face of practical difficulties in finding reliable evidence. Common sense may be more useful than long complex expert reports.
The majority held that the comparability differences in the third-party offtake agreements identified by the Commissioner reduced the probative value of these agreements but did not negate them entirely. The agreements demonstrated that price sharing of 23% was not out of the market.
Arm’s length consideration
The majority found in relation to each element of the consideration under the offtake agreement as follows:
- The 23% price sharing formula was arm’s length consideration, based on 23% being the midpoint of the historical range from a survey of offtake agreements with price sharing formulas, and taxpayer’s expert evidence the formula was rational and commercial.
- The quotation period optionality was arm’s length consideration as the Barminco third-party contract contained a materially identical quotation period optionality clause, and there was no persuasive evidence to displace this evidence.
- The freight allowance based on the costs of transporting the copper concentrate to India, which was the most expensive destination, was not arm’s length as only a small number of cargos were shipped to India and there was no evidence as to why India was chosen.
OECD Transfer Pricing Guidelines
- It is interesting to note the reduced focus on the OECD Guidelines even in the context of Subdiv 815-A, which specifically requires the assessment of whether an entity has received a transfer pricing benefit consistently with these Guidelines. The majority held that transfer pricing outcomes are determined by the words of the Australian transfer pricing legislation and not by OECD frameworks.
- Subdiv 815-B also includes a requirement that arm’s length conditions be identified so at to best achieve consistency with the Transfer Pricing Guidelines. Based on the comments of the Full Federal Court, it would appear that the words of Subdiv 815-B will have much greater weight than those of the Transfer Pricing Guidelines.
Defending a transfer pricing position
- The Court acknowledged the practical difficulties faced by both the taxpayer and the Commissioner in finding reliable evidence in a transfer pricing case, and the task of compliance with Australia’s transfer pricing laws should not be made an impossible burden.
- The ability of the taxpayer to tender both expert evidence of how independent parties operated in the copper concentrate market and example of third-party copper concentrate sale contracts was vital in supporting their transfer pricing position.
- For many related party transactions, evidence of a third-party market may not be available. In this case, the taxpayer will be required to search for evidence to support the position that its related party contract (including both its terms and pricing) is consistent with industry practice, and that the transactions are rational and commercial.
- This suggests that a transfer pricing position will be strengthened by adding to the usual benchmarking analysis evidence that the terms and pricing of a transaction are commercial.
- The Federal Court did not consider the application of Subdiv 815-B and accordingly the question remains as to how the courts will interpret these Subdiv 815-B provisions, and in particular the reconstruction provisions.
- However the Federal Court’s comments about the importance of the actual contract between the related parties as the starting point for the transfer pricing analysis, may suggest that the Commissioner’s view that Subdiv 815-B includes a broad reconstruction power may not be sustained.
This article was originally published on the Greenwoods & Herbert Smith Freehills website and has been reproduced with permission.