By Sean Neary, Director – Neary Consulting
On 21 May 2021, the long-running matter of Glencore v Federal Commission of Taxation fizzled to a low profile conclusion when the High Court of Australia refused the Commissioner’s application for Special Leave to Appeal on the basis that the matter rested purely on its facts. With no question of law to review, the High Court declined to hear the matter. With the final appeal exhausted, the taxpayer’s win at the Full Federal Court stands, handing a significant loss to the Australian Taxation Office in its campaign to use the transfer pricing provisions to increase the tax take from multinational groups.
This article examines the decision in the Full Federal Court and what it means for transfer pricing practice, notably:
The functional analysis as the foundation for all transfer pricing thinking;
Addressing the correct statutory question;
Choosing the right expert witnesses; and
Perfect use of imperfect evidence in comparability studies.
All transfer pricing reports need to start with a functional analysis, which documents the functions performed, assets employed and risks assumed by each party to the international related party dealings. In this case, Cobar Management Pty Ltd (“Cobar”) was an Australian resident company, wholly owned by Glencore International AG (“Glencore”). Cobar owned and operated an underground copper mine in (unsurprisingly) Cobar, in central-western New South Wales. Cobar sold 100% of the production of the mine to Glencore during the 2007 to 2009 years under review, for prices the Commissioner claimed were too low. At issue is whether the validity of the amended tax assessments issued to Cobar by the Commissioner.
Cobar was mining underground stopes of copper at a depth of between 1,400 and 1,500 meters. Once the stopes were blasted, ore was transported to a primary crusher located at a depth of 980 meters. The crushed ore was transported to the surplice for milling, where it was ground into a slurry. The slurry was pumped into flotation cells, where different minerals were skimmed from the cells and dried. The skimmed and dried material is copper concentrate, which is the product that is being sold by Cobar. Depending on the mine, copper concentrate ranges from 10% to 50% copper.
The transfer pricing method selected was the comparable uncontrolled price (CUP) method, using an adjusted CUP. The CUP in this instance is the price of London Metal Exchange (LME) traded copper. LME copper is A-grade copper (99.95% purity), traded in 25 tonne lots. The copper concentrate as sold by Cobar is a long way from LME copper, so significant adjustment is required. It is the pricing of that adjustment to the LME “CUP” that is a matter in dispute. That adjustment takes the forms of the Treatment Charges and Refining Charges (TCRC) levied by the smelters that transform the copper concentrate into LME copper. The TCRC is the primary component of the adjustments to the CUP that form the matter in dispute. Other components include freight and insurance adjustments.
Cobar entered into an offtake agreement with parent company Glencore for 100% of production for the life of the mine. This allowed Cobar to limit the functions performed, with Cobar at no stage having marketing or logistics capability. By agreeing to take 100% of production, Glencore also assumed significant risk.
The next step is an appreciation that the functional analysis isn’t static. Whilst the core functions, assets, and risks of each party remain largely consistent over time, economic circumstances in each year of income still had an impact. Whilst Cobar did have a life of mine offtake agreement, the terms only covered the Base Tonnage of the first 100,000 wet metric tonnes. Production above that level would be at “mutually agreed” terms. With the copper price spiking to historic highs from 2006, Cobar was seeking to maximize production by pushing above the Base Tonnage. At the same time, the mine faced cost pressures, including ventilation difficulties from operating at 1,500m depth, a shortage of skilled labour, and drought limiting water availability. Cobar was also a small player in global terms, with annual production from the Cobar mine equating to only one or two days production at the BHP-controlled Escondida mine in Chile. The court considered all these facts as being relevant to the taxpayer at the time of entering into a revised contract with Glencore.
Contracts Under Review
If the production and marketing of copper sound complex, certainly the contractual arrangements for offtake agreements are to match. All contacts mentioned start with the LME price, making deductions for TCRC, insurance, and freight. Later contracts also included adjustments for price participation, the optionality of quotation periods, and back pricing. Whilst the CUP in terms of the LME price was uncontroversial, the matter rested on the adjustments made to that CUP.
The Cobar offtake agreement with Glencore was entered into from mine commencement in 1999 and included TCRC based on the Japanese benchmark and one quotational period, meaning the LME price was set at the price in the month following the month of production.
The 1999 contract was replaced with a further agreement in 2004, introducing two significant changes. First, the single quotational period was replaced with each of the two classes having three quotation period options as follows. That is, on an annual basis Glencore could choose the pricing to be based on any of:
Production – being the month prior to, the month of or the month following production; or
Shipment – being the month of arrival at the shipment port, two months after or three months after.
The introduction of multiple quotation periods at Glencore’s option clearly passed the pricing advantage to the purchaser. Refinements made to a 2006 version of the agreement introduced “back pricing”, being the ability for the purchaser to nominate the quotational method with some degree of hindsight.
Further changes were made in 2007, significantly allowing Glencore greater optionality by electing to choose the pricing structure on a shipment by shipment basis (as opposed to applying optionality to all shipments within a year under the earlier agreement). The agreement also introduced price participation, being an increase or decrease in TCRC as a proportion of the movement in LME price.
The above is a condensed summary of the contractual conditions only. Whilst there were various changes to the pricing mechanism, on balance the increasing optionality and back pricing were found to favour Glencore, as a foreign purchaser of the Cobar copper concentrate.
The case was heavily fact-driven, with the Federal Court stating, “the real contest before us was as to which expert’s opinion should be preferred”. The ATO’s key expert was Mr Marc Ingelbinck, an individual with an immaculate pedigree as former Vice President of BHP’s Base Metals Group. He had overall responsibility for the marketing of all BHP’s concentrate, including copper (noting BHP was the largest global supplier of copper concentrate during his tenure). Mr. Ingelbinck’s evidence focused on his corporate experience. Whilst he had seen quotational period optionality, he had never seen an optionality clause as “liberal” as in the Cobar agreement. He was scathing of the changes in contractual terms across the various agreements, noting there appeared to be no “quid pro quo” to Cobar for the concessions granted to Glencore. He specifically stated the agreement to switch to price sharing in 2007 was “irresponsible”. He stated that an independent seller presented with such an agreement would have answered with a simple “thanks but no, thanks”. His view presented with gravitas, considering his statute as overseeing sale negotiations within the largest global supplier of copper concentrate. Supported by Mr. Ingelbinck’s views, the ATO position was that the agreement that was in place prior to 2007 constitute the arm’s length price.
The taxpayer’s expert was Mr Richard Wilson, from specialist mineral consultancy Brook Hunt. Mr Wilson presented with impressive academic qualifications, having graduated from the Royal School of Mines, Imperial College London and, amongst other achievements, had worked his way up to being Managing Director of Brook Hunt since 1996. However, the Commissioner took issue with the reliability of Mr Wilson’s opinions, noting he had never directly negotiated a contract for copper concentrate, never worked for a mine, never traded copper concentrate, and never worked for a smelter. A poor match against Mr Ingelbrinck, it would appear.
However, there was more substance to Mr. Wilson than initially met the eye. Consulting is a tough game, with everyone challenging your views. Mr. Wilson and Brook Hunt knew what they knew – and avoided what they didn’t. For example, Brook Hunt published monthly, quarterly, and yearly price forecasts for multiple base metals, but never forecast the spot price (on the basis that the spot price is too volatile to predict). Mr. Wilson produced a list of 16 contracts between independent parties for the sale of copper concentrate, all of which contained some form of price optionality. Whilst he’d never sat at the head of a negotiation table, his ability to produce reliable, public information on the pricing arrangements for copper concentrate was impressive. It was Mr. Wilson’s view that the optionality and back pricing clauses within the Cobar agreement were within the arm’s length range as defined by the comparable sample of agreements between independent parties.
The Statutory Question
Having reviewed the evidence, the court turned to the application of the facts to the law. One of the greatest fears of any consultant is getting an answer wrong. So it must have been horrifying to the Commissioner’s team, having spent a decade in dispute with the taxpayer, when the found held they had asked the “wrong question”! That is, the Commissioner defined the arm’s length price as that contained in the 2006 agreement. Mr. Ingelbrinck had opined that Cobar should have said “thanks but no, thanks” to the 2007 agreement, thus imputing amended assessments to revise pricing back to that which applied in prior years. However at no stage did the Commissioner state why the earlier agreement reflected an arm’s length arrangement, only that it was better for Cobar than the agreement that followed.
The Court, however, found the statutory question to be addressed was whether the agreement that was in place between 2007 and 2009 was within the arm’s length range. Under transfer pricing guidelines that required a search for comparable arrangements between independent parties. Regardless of what the Commissioner pointed out Mr. Wilson hadn’t achieved during his life, what he achieved, in this case, was the provision of a sample of 16 comparable contracts between independent parties. The ATO challenged the validity of the sample but never presented an alternative.
The detail got worse for the Commissioner. During cross-examination, Mr. Ingelbrinck had acknowledged that the 2007 agreement may have been arm’s length had it been in place from the beginning. In his view it was the transition from a more advantageous contract to a less favorable one was conduct not reflective of an arm’s length dealing. However, the Court found the arm’s length test to be an objective one under which the taxpayer must identify an arm’s length range from an examination of dealings between independent parties. What parties may or may not have negotiated isn’t part of the statutory test. Further, the Court found the earlier agreement would have only been of limited usage due to the lack of pricing detail once Cobar’s production increased beyond Base Tonnage. That is, retaining the earlier agreement wasn’t an option.
Whilst the comparable contracts identified by Mr. Wilson were imperfect as comparables, importantly all 16 contained elements of price optionality. Whilst the decision is loose in terms of precisely how and where Mr. Wilson felt the Cobar agreement was positioned within that range, at least Mr Wilson asked the right question and produced a benchmarking analysis as required under transfer pricing guidelines.
Implications for Transfer Pricing Practice
The loss to the Commissioner was considerable, with the ATO having raised $241 million in amended assessments resulting in $72.3 million in tax plus $20.4 in shortfall interest. In my view, the implications for transfer pricing practice include:
The primacy of the functional analysis as the foundation upon which the selection and application of methods is built;
Benchmarking is required at the core of any transfer pricing analysis;
The “negotiation approach” of having a former senior executive saying “an independent party simply wouldn’t agree” didn’t carry the day;
From the above, external consultants (used to being challenged and thus supporting all opinions with data) proved far more effective; and
All tax cases are ultimately decided by properly addressing the relevant statutory question.
For those looking for broader life meaning within the decision, perhaps the words of Romanian-French playwright Eugene Ionesco are instructive:
“It is not the answer that enlightens, but the question.”
If you have a tax or transfer pricing question, please contact Sean Neary on email@example.com or (+618) 6165 4900.