Australian Federal Court dismisses ATO appeal In Glencore transfer pricing case

In a unanimous decision last Friday, the Australia Full Federal Court dismissed the ATO appeal in the Glencore transfer pricing matter (except in relation to freight expenses in 2009). A single judge of the Federal Court had already found in favour of Glencore last year ( Glencore Investment Pty Ltd v Commissioner of Taxation of the Commonwealth of Australia [2019] FCA 1432).

Background

The years under review and the increase in income in each year were:

• 2007, AUD49,156,382
• 2008, AUD83,228,784
• 2009, AUD108,675,756

Transfer pricing decisions in Australia are extremely important because of their infrequency and because of the significant changes to our domestic rules with the introduction of Division 815 in 2012. It is also a topic that the Commissioner defends ferociously, and the lack of decided cases (particularly in relation to the post 2012 provisions) has, until recently, made taxpayers reluctant to use the courts to resolve disputes. This important judgement adds to the decisions which give taxpayers good guidance on how the Australian courts will approach such matters. This should give taxpayers more confidence in turning to the courts as arbiter to resolve disputes.

This decision is also significant because the bench included two members who were viewed as amongst the most eminent tax barristers in Australia prior to their appointment to the Court (Steward and Thawley JJ). In addition, Steward J  was in recent weeks elevated to the High Court of Australia.  This judgement then takes on additional importance as an insight into the thinking of one of the newest members of our High Court.

The Court delivered two judgements. A joint judgement of Middleton and Steward JJ. The other, by Thawley J., agrees with their conclusions, but expresses a different view on the operation of the Act and OECD guidelines.

The joint judgement notes that the parties were largely agreed on what were the facts, and what was the relevant law. It said however that “the real contest before us was as to which expert’s opinion should be preferred” (at para 16).

Essentially, the matter concerned intra group arrangements for the sale of copper concentrate. The group member which was the actual seller is referred to as C.M.P.L in the judgements. The first arrangement was entered into in 1999, and pricing was set based on the Japanese benchmark TCRC’s (an amount for agreed costs) and specified only one quotational period, (being the reference time used to set prices). The costs and pricing formulas used by the parties varied over time, but changes made with effect from the 2007 year triggered the dispute. In the years under review TCRC’s were set at 23% of the copper price, which had the effect of sharing risk between the parties. The purchaser was given an option to select quotational periods on a shipment by shipment basis, rather than annually. It could select between two classes of arrangement, each having an ability to select one of three quotational period options on a shipment by shipment basis at a later time. The result of this approach was that the purchaser had knowledge of the average price in at least one of the quotational periods available to be selected, prior to each shipment.

On appeal, the Court unanimously found that the judgement of the Court below should remain, and that the taxpayer had proven the pricing under the agreements was arms length, apart from the basis of calculation of freight charges in the 2009 year.

The relevant provisions of the Income Tax Assessment Act varied over the years in question. Two sets of provisions were relevant, Division 13 (which now only has limited relevance for most taxpayers) and Subdiv. 815-A. The relevant principles in both sets of provisions were felt by both courts to be similar enough for the same analytical principles to apply (apart from some reservations expressed by Thawley J.).

We see two key areas of guidance for taxpayers in the judgement. The first is the issue of whether the Commissioner could set aside the actual decision to make the changes to the pricing arrangements in 2007, on the basis that an arms length party would not have made such amendments. The second is the selection and use of witnesses.

The role of a Court of Appeal

In exploring these issues, the Court discusses (at para 142 et seq) the role of an appeal court in such a transfer pricing dispute. Glencore commenced these proceedings with an appeal to the Federal Court when it was dissatisfied with the Commissioner’s objection decision. On the Commissioner’s appeal from the decision of Davies J, the Full Federal Court had wide powers. Including the power to take fresh evidence. To be successful the appellant Commissioner had to show error in the primary Judge’s decision. But the Court has long accepted that the Judge at first instance has a unique advantage in being able to see witness testimony first hand and to see the way the evidence unfolds as the case is argued. Although the Appeal Court must still, by definition, form a view on the conclusions that should be drawn from the evidence.

The Court was critical of the approach to the appeal, pointing out that the Commissioner had essentially invited a review all of the proceedings at first instance and suggested to the Appeal Court that it form its own view on the issues. This was done through a process of taking the Court through the evidence below in great detail. This was said to amount to thousands of pages of documents and thousands of lines of transcript. It is clear the Court expected a more focused approach to the appeal (see especially the comments in para 102).

The primary judgement contains an elegant example of the operation of the burden of proof in Australian taxation appeals. The Commissioner’s witness had opined that the “quotational period optionality clause” alteration in 2007 left no risk to the buyer and that an arms length taxpayer would seek consideration for agreeing to it. The taxpayer’s witness disagreed. The Commissioner said that the taxpayer had failed to prove what the correct situation was, and therefore failed. The Court agreed with the Court below that the evidence of the Commissioner’s witness should be discounted and that of the taxpayer preferred. With the result that the taxpayer had sufficient evidence. The Court went further to say that the taxpayer was not required to directly negate each assertion by the Commissioner. If the taxpayer’s own evidence was positive and sufficient, then that was enough.

The first topic: the decision to agree to changes

The Commissioner’s argument, the Court said, was “why would a party in the position of C.M.P.L. have agreed to such a debilitating change of terms” in February 2007. The Court rejected this approach saying it was the wrong question (from para 166). 

The Court endorsed the finding in the Court below that the Act and the Transfer Pricing Guidelines required the arms length principle be applied to the transaction actually undertaken. With limited explicit exceptions where substance differs from form, and where the arrangements differ from those that independent enterprises would have adopted (the so called “reconstruction exceptions” in the OECD commentary). Thawley J. differed on this point. He believed (from para 245) that the transaction being priced should differ from that the parties actually entered into in a wider range of circumstances.  Otherwise related parties might insert clauses into agreements that result in a distortion of what arms length parties might do. In the end he accepted that the taxpayer had shown that the particular agreement here was one which independent parties might reasonably be expected to enter into.

Ominously for the Commissioner in future, at para 153 the reconstruction exceptions in the OECD commentary were said to have been written in language which is “very highly generalised and is frustrating opaque”, and in any event “only a guide”. A clear preference was expressed for the domestic statute, with an observation that the Guidelines “may not be of much real assistance”. There is a clear echo of the OECD language in the so called reconstruction provisions of Subdiv. 815-B of the ITAA (815.130). It will be interesting to see how effective those provisions are. They do, however, contain simple steps for taxpayers to take to ensure that they fall outside their scope.

The Court concluded from para 154, that in fact the Commissioner has the power, where a price under an agreement is specified as a formula, to replace it with a different formula where arms length parties would have used the different formula. And that the task is to identify only those clauses of an agreement “actually defining the consideration received”. While the task was acknowledged to be difficult in some cases, there is no power to alter clauses which “are not seen as defining the consideration received”. This includes clauses which “may indirectly bear upon price”. This conclusion was one which Thawley J disagreed with in his judgement.

The Court identified the process as requiring the identification of the critical facts of the situation that would be used for determining the profile of the arms length parties whose price decisions would be critical. This did not require a party who was identical to the taxpayer, merely one whose critical characteristics were found in the taxpayer. So in this case, for instance, the type of mine and presence in the group was relevant, but the actual risk appetite of C.M.P.L. (on which there was no actual evidence) was not. But, evidence of what an expert might consider reasonable in the circumstances, taking into account the experts evidence of how an arms length party might assess risk, was permissible.

This is coupled with an explicit acknowledgement of why the arms length price might be expected to be expressed as a “range”.

The taxpayer’s evidence was sufficient for the Court to be satisfied that the arrangement was one which arms length taxpayers might enter into, and that the price paid was in an arms length range.

The result is a judgement that reflect considerable flexibility around a transfer pricing conclusion.  Overlaid with an acknowledgement that in the end it is the taxpayer who has the onus of proving what the correct answer is, and who must provide the court with evidence to support its argument.

The Court accepted that there was evidence that accepting the 2007 change meant the profits of the Australian company would reduce.  But said that the statute did not ask the question whether an arms length party would have accepted the change. It instead asked whether the resulting consideration in the later years was less than the arms length consideration in those years.

The second topic: the selection and relevance of witnesses

In argument much had been made by the Commissioner of the lack of precise comparable agreements. The court, however, found that while there were important differences which had not been adjusted for, they remained important “reference points” and acted as a sounding board for the opinions of the experts that the taxpayer’s arrangements were ones that an arms length party might enter into.

Interestingly the court gave greater weight to the taxpayer’s expert (Mr. Wilson’s) evidence, partly because he was seen to have diverse experience that traversed the entire copper concentrate market.  The Commissioner’s expert had experience as a trader selling to smelters. Which was seen as more narrow. The Commissioners expert’s evidence was also discounted because the Court formed a view that part of his evidence was perhaps based on an incorrect assumption.

The judgements of both Courts contain detailed and useful examinations of the use made by both parties of their witnesses, the importance of the examination of these witnesses and the distinction between lay and expert witnesses.

Conclusion

There are comments throughout the judgement that are directly encouraging to taxpayers engaged in a transfer pricing dispute in Australia. In particular at para 203 the Court said“…the Court must take care not to make the task of compliance with Australia’s transfer pricing laws an impossible burden when a revenue authority may, years after the controlled transaction was struck, find someone, somewhere, to disagree with a taxpayer’s attempt to pay or receive arm’s length consideration”.

The judgements give us valuable insights into the selection of key witnesses to support changes to transfer pricing, or to defend existing arrangements.

They also give us more clarity about how to identify the precise parts of any arrangement which must be priced, and how to go about pricing them. And about the correct way to frame the questions given to an expert as we do so.

The decision suggests that the transfer pricing provisions will not be the main focus when making a decision to change existing arrangements (other than to make sure the new arrangements are also priced within the appropriate range). But the judgements hint that other attacks might occur. Thawley J, at para 272 points out that the Commissioner’s case has echoes of Part IVA about it, but that the point was not taken.

Today, there is also a real need to take care that the DPT provisions of the Act are also considered when changing arrangements.