By Sean Neary, Director – Neary Consulting

The Federal Court’s decision on 17 December 2021 in Singapore Telecom Australia Investments Pty Ltd (STAI) v Commissioner of Taxation provided a significant win for the Australian Taxation Office (ATO) with respect to the interest rate applying on international related-party loans. With the decision likely to have been core Christmas reading for many of our subscribers, this article examines the finer points of the case and the implications for taxpayers.

Optus Acquisition

The matter originated in 2001 when the Singapore Telecom group said: “Yes” to the acquisition of “Optus” (or, more precisely Cable & Wireless Optus Ltd). The transaction flow was complex, with SingTel acquiring some C&W shares directly and providing a loan used by C&W to finance a share buyback. The result was SingTel having acquired 100% of C&W for $14.2 billion.

Related Party Loan

The complexity of the acquisition appears to have had flow-on effects, with the SingTel group shortly thereafter undertaking a restructure such that STAI acquired 100% of Optus for consideration of $9b in shares plus an international related party loan of $5.2b. Importantly the loan wasn’t directly for the acquisition of C&W, but the Court characterized the loan as being the provision of vendor finance in the subsequent restructuring. The key terms in the original from 28 June 2002 were:

·         Principal of $5.2b;

·         Unsecured;

·         A term of ten years; and

·         An interest rate of the one-year Bank Bill Swap Rate (BBSW) plus 1%, with the result multiplied by 10/9 (to put the effective cost of interest withholding tax onto the borrower).

At this point the SingTel group had Optus within the preferred corporate structure and with all the billions in the right places. Everyone was presumably happy, until someone decided the group could do better.

Amendments

Doing better with respect to international-related party loans requires balancing interest withholding tax against the tax-deductibility of interest expense. In ordinary circumstances, the benefit of the tax deduction at the 30% corporate tax rate exceeds the cost of the 10% interest withholding tax (meaning higher interest rates are more tax effective for inbound loans to subsidiaries of foreign multinationals). However, the reverse applies when the borrower is in a tax loss. That’s because the immediate cost of the 10% interest withholding tax is considered to be a higher cost than the eventual 30% benefit of the tax deduction in the future when the carry forward tax loss is utilised. The SingTel group found itself in the latter position, with the significant investment in expanding the Optus telecommunications network putting STAI into tax loss.

Faced with the above, the loan terms were subsequently changed by three amendments as follows:

·         A First Amendment was ignored by the Court as being immaterial to the case;

·         A Second Amendment dated 31 March 2003 increased the interest rate by adding a premium of 4.552% on top of the original rate; and

·         A Third Amendment dated 30 March 2009 moved from a floating rate based on the BBSW to a fixed rate of 13.2575%.

The Second and Third Amendments also contained terms providing for deferral of interest until STAI reached defined profit and cash flow benchmarks. The impact of these changes would have been to avoid interest withholding tax during years when STAI was in tax loss, whilst incurring higher interest deductions in later years when the carry forward losses were extinguished. In short, the impact would have provided for optimal balancing between the interest withholding tax and tax-deductibility of the interest expense (by not incurring withholding tax until such time as the company could benefit from the interest deductions).

The ATO conducted an audit of STAI, issuing amended assessments that disallowed the higher interest cost under the Second and Third Amendments. The taxpayer’s appeal was the matter before the Court.

SingTel’s Case

The case swung on the respective benchmarking analyses to ascertain the arm’s length interest rate on the loan. The taxpayer’s case assumed the loan was unsecured and without benefit from a parent company guarantee (also referred to as the “orphan” approach in the earlier Chevron case). The taxpayer’s experts then conducted a “debt capital markets” (DCM) approach. This approach firstly gave the taxpayer a hypothetical credit rating using the Standard & Poor’s and Moody’s rating criteria and found DCM loans between independent parties with similar ratings. The taxpayer contended that the interest rates on those similar loans showed the Second and Third Amendment rates to be within the arm’s length range.

Court’s Decision

The Court held against the taxpayer for the following reasons:

·         The taxpayer incorrectly based the benchmarking analyses on the circumstances of the taxpayer at the time of the Second and Third Amendments. At those times STAI had incurred substantial losses due to the investment in telecommunications infrastructure and was also cash flow negative. The correct circumstances to apply were those applying at the time the original loan was granted.

·         The provision of vendor finance wasn’t sufficiently comparable to the independent party loans in the DCM analysis.

·         The conditions of the loan were so commercially unrealistic that no parties dealing at arm’s length would have agreed to such terms. For example, if STAI never reached the profit and cash flow benchmarks, no interest would have been payable over the term of the loan (a term to which no independent lender would agree). Conversely, if STAI reached the benchmarks earlier than anticipated, then the substantially higher interest rate would apply for the whole of the remaining loan term (a condition to which no independent borrower would agree).

·         Pure transfer pricing is about pricing – that is, determining the interest rate that would have applied had the loan been between independent parties. As the terms of the related party loan weren’t commercially realistic, the Court firstly varied those terms and then asked the question as to what the interest rate should be for a loan between independent parties with those amended terms in place.    

·         The Court looked at the way S&P and Moody’s consider implicit and explicit parent company guarantees, ultimately determining that an explicit guarantee would have been provided (thus rejecting the orphan approach per Chevron, without specifically using that terminology).

Overall the Court held that the arm’s length interest rate was that applying in the original loan. STAI was therefore considered to have received a “transfer pricing benefit” under Division 815, with the Court upholding the ATO decision to deny interest deductions totaling $894 million over the 2010 to 2013 income years.

Implications

Implications for transfer pricing practice going forward include:

·         Transfer pricing cases are becoming more tightly focused as more cases pass through the courts. As a guide, only five witnesses appeared before the Court. The likely implication is that the ATO, taxpayers and the courts are all becoming more familiar with presenting arguments under the arm’s length principle.

·         With the amounts at stake, the witnesses are becoming more specialized. No general transfer pricing experts were called, with those who did appear to have specialized expertise in applying S&P and Moody’s credit ratings and/or benchmarking expertise within DCM.  

·         The transfer pricing matters coming before the courts are for billions of dollars in related party loans and with the taxpayer and the ATO a considerable distance apart in terms of what constitutes an arm’s length interest rate. Smaller transfer pricing disputes aren’t presently coming before the courts.    

·         Both the Chevron and STAI decisions have implied parent company guarantees in support of related party loans, resulting in substantially lower interest rates than if the Australian subsidiary had been considered on a stand-alone basis.  

If you have any questions in relation to international tax or transfer pricing, please contact Sean Neary at sean@nearygroup.com.au or (+618) 6165 4900.