The Full Federal Court upheld the taxpayer's earlier win and held that (bar one aspect) the consideration paid under a related party agreement was within an arm's length range.
Typical of many transfer pricing issues, the background facts and the issues engaged are complex. Further detail of the background to the case and the lower court decision can be found in our previous article. This update highlights some of the key points from the appeal decision.
The Glencore decisions provide an indication of how transfer pricing issues will be approached by the courts and the type of evidence and commercial considerations that can be influential in their resolution. This is particularly relevant at the present time given that transfer pricing continues to be a key focus area for tax authorities, both in New Zealand and internationally.
The decisions also address important transfer pricing related issues such as the Commissioner's ability to infer or disregard contractual terms and the extent of the influence of the OECD's transfer pricing guidelines.
The facts – in summary
CMPL, an Australian entity in the Glencore group, sold 100% of the copper concentrate produced from its mine to its parent, GIAG. In 2007, CMPL and GIAG entered into a revised “price sharing" agreement, under which a deduction was taken from the copper price for treatment and refining charges (TCRCs) fixed at 23% of the relevant “copper price". The “copper price" was determined by reference to the official London Metal Exchange cash settlement price averaged over a month-long “quotational period". The agreement also provided GIAG with “quotational period optionality with back pricing". That involved the option to choose which quotational period the relevant copper price would be averaged over, for example the month prior to shipment or the month of shipment. The back pricing element was that (at least) one of those quotational periods was known to GIAG when it made its choice, for example the month prior to shipment.
The Commissioner amended the taxpayers' assessments on the basis that the consideration paid to CMPL under the agreement was not arm's length. The Commissioner's arguments were based primarily on the contention that arm's length parties would not have agreed to the “price sharing" or the “quotational period optionality with back pricing" terms.
Evidence in a transfer pricing context
As with other recent transfer pricing decisions, the factual and expert evidence put before the court was extensive. The taxpayer and the Commissioner produced experts at trial who gave evidence on various aspects of the copper market, such as its volatility, various participants' risk profiles, and common terms in offtake agreements. The taxpayer also produced a number of contracts between arm's length parties as evidence of the arm's length nature of the various contract terms contested by the Commissioner (in particular, the price sharing and quotational period optionality with back pricing terms). The various types of evidence and the Court's approach to it is outlined below.
The Court focussed primarily on the evidence of two expert witnesses (one for the taxpayer, and the other for the Commissioner). The experts, who often differed in what arm's length parties would have agreed to in a copper offtake agreement, served to inform the Court of the “range of arm's length" outcomes which could arise in a copper market context. The Court referenced the fact that the Commissioner and the Commissioner's expert had different opinions on what would be arm's length in pricing the TCRCs as further evidence of there being a range of arm's length outcomes available.
The experts both impressed on the Court that, for independent parties, the price selected within the range would depend on that particular party's appetite for risk in a highly volatile market. This approach is encouraging and shows a willingness to accept a range of possible arm's length outcomes within that hypothetical independent party analysis.
Contractual examples – comparables
A number of contracts between independent parties including quotational period optionality or price sharing terms were produced as evidence. Only one of the contracts exhibited both terms. The Commissioner argued that these contracts were not comparable due to various factors such as the time the agreements were entered into and the amounts of copper being transacted under them.
The Court accepted that many of the differences raised by the Commissioner were material and lessened the evidentiary value of the contracts as true comparables in benchmarking the contract in question. The contracts were nevertheless found to be useful in confirming that the various terms existed in agreements between independent parties in the copper mining market and that the price sharing percentage was within a range of commercial outcomes found in independent transactions.
Lay or factual evidence
No evidence was given by the taxpayer as to the circumstances leading to CMPL's entry into the agreements (or certain amendments to the agreement) or to CMPL's subjective risk appetite.
The Court noted that it would have been beneficial to have heard from a factual witness from the taxpayer on the circumstances giving rise to entry into the relevant contracts and the matters taken into account in setting the terms, rather than relying only on expert evidence. This is on the basis that an independent expert will not have first-hand experience of the commercial context and background as to why those particular terms of the agreement at issue were agreed. Exclusive reliance on expert evidence risks speculation which could be avoided with more direct factual evidence.
Arm's length “consideration" or “conditions"
The lower court found that the Commissioner could not depart from the actual contractual terms entered into by the parties in assessing whether consideration was arm's length. Relevant to the particular issues engaged in the case, the lower court determined that the Commissioner could not substitute the methods by which the parties agreed to determine the price (quotational period optionality with back pricing and price sharing) with a different pricing approach.
However, the majority of the Full Federal Court held that the relevant Australian domestic transfer pricing rules permitted the Commissioner to substitute the agreed pricing methodology for a different one which he considered resulted in a better assessment of arm's length consideration for the transaction.
The relevant domestic regimes used the terms arm's length “consideration" and “conditions" in different iterations. The Full Federal Court determined that both terms could be interpreted to include pricing formulas or methodologies. The Court found that it is open to the Commissioner under the terms of the relevant provisions to substitute the terms of the contract which go to define the price as part of the Commissioner's assessment of the arm's length “consideration" or “conditions". It would then be for the taxpayer to defend the actual terms as arm's length.
In a New Zealand context, previous iterations of New Zealand's transfer pricing provisions have focussed solely on determining the “arm's length amount of consideration". As a result of the BEPS related amendments to New Zealand's transfer pricing regime, the provisions now require identification of the “arm's length conditions" independent parties might be expected to have agreed as well as the “arm's length amount of consideration" payable under them.
The influence of the OECD transfer pricing guidelines
The Full Federal Court also considered the role of the OECD's transfer pricing guidelines in determining whether the Commissioner was permitted to substitute the pricing methodologies under the relevant domestic transfer pricing provisions. The majority considered that the OECD's statements of “abstract principle" were in contrast to the “discipline and rigour" undertaken in the drafting of domestic legislation. As such, the majority considered that they would not be of much assistance to applying the domestic legislation in the context of this case.
In contrast, New Zealand's transfer pricing regime is more prescriptive as to the importance of the OECD transfer pricing guidelines. Our transfer pricing regime now specifically refers to and requires that certain methods and approaches set out in the transfer pricing guidelines be applied when determining an arm's length amount for a transaction.
Practical considerations in applying the “arm's length" analysis
The Full Federal Court commented on a number of factors which should be taken into account in conducting an arm's length analysis.
A difficult factor, which the Court considered, was the extent to which features and attributes of the particular parties can be carried over into an independent party analysis. The Court concluded that the relevant features of the Australian subsidiary, CMPL, would include only the objective attributes of CMPL which could affect the transaction (e.g., the size of the mine, its costs of production), and not those factors which relate to CMPL's related party relationship with the Glencore group (e.g., the broader group's risk policy).
The Court commented that the parties to the dispute could support their position as arm's length by referring to what an independent party “might have done to address risk in the objective circumstances of the copper concentrate market at that time selling either to an independent trader or smelter". A related factor accepted by the Court was that a taxpayer is not under an obligation to “maximise profitability at the expense of all else" and may agree to terms which mitigate risk.
Relatedly again, the Court directed that the statutory tests should not be applied narrowly as “predicting how independent parties dealing at arm's length with each other would price a wholly controlled transaction is a difficult and complex issue." This is an appropriate acknowledgement of the difficulty of arriving at precise outcomes in applying an arm's length analysis to complex commercial arrangements.
Based on the evidence given by the experts, the Full Federal Court accepted that the pricing methodologies put forward by both parties could be found in various agreements between arm's length parties. The differences between the methodologies represented the different commercial decisions that could be made by parties, based on various considerations such as appetite for risk.
In respect of the “price sharing" element of the arrangement, the Court accepted the opinion of the taxpayer's expert witness that independent parties possessing the objective factors of the taxpayer might reasonably have been expected to agree a price sharing clause which fixed the TCRCs at 23%. It also accepted that the TCRC calculation methodology put forward by the Commissioner's expert was within an arm's length range as “this is a case where reasonable minds have reasonably differed within a range of commercially acceptable arm's length outcomes".
Quotational period optionality
The Commissioner argued that arm's length parties would have agreed to a discount for CMPL to the TCRCs deducted from the copper price in exchange for the quotational period optionality. However, the Court accepted that quid pro quo for quotational period optionality with back pricing was uncommon, there being only one contract which put a specific value on the back pricing optionality. The Court accepted that the taxpayer had sufficiently discharged its onus of proof as to the arm's length nature of the term.
This decision indicates that the Australian courts are sympathetic to the difficulties that can arise in carrying out the arm's length analysis and intend on applying transfer pricing provisions with a level of flexibility and pragmatism. The Court here providing that “[b]y nature, transfer pricing is not an exact science… It was a sufficiently reliable choice and accorded with common sense. In that respect, 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."
A related point is the Full Federal Court's approach to the burden of proof. Consistently with the comments above, the Court did not require the taxpayer to refute positive claims by the Commissioner that independent parties would have done something different – whether that be negotiate a reduction in the fixed offtake rate or to reach an agreement that did not contain all of the various pricing terms and methodologies in the transaction under review. It was enough that the taxpayer's evidence defended the actual terms and pricing as being within a reasonable range of commercial possibilities between independent parties. That approach to the practical satisfaction of the onus is important and may be of significance in a New Zealand context now that the onus of proof sits with the taxpayer in transfer pricing matters.
We note for completeness that the Australian Commissioner's application for leave to appeal to the High Court of Australia has been declined.
Other significant transfer pricing decisions
Prior to the release of the Glencore judgment on 6 November 2020, another significant transfer pricing case was decided by the Federal Court of Appeal in Canada, Her Majesty the Queen v Cameco Corporation (2020) FCA 112. Similarly to Glencore, the Court in Cameco dismissed the Crown's appeal in favour of the taxpayer. The decision in Cameco turned on an issue of interpretation of the relevant transfer pricing provisions as the factual findings of the lower court were not appealed by the Crown.
As in Glencore, the Court in Cameco provided that the relevant transfer pricing provisions posited an objective test; it is a determination as to whether two arm's length parties would have entered into the transaction, not as to whether the taxpayer and an arm's length party would have entered into the transaction (the latter being the interpretation argued by the Crown). Unlike in Glencore, the Court in Cameco did not provide guidance as to whether objective features of the taxpayer which could influence the transaction should be taken into account in the arm's length analysis.
If you have any questions about the matters raised in this article please get in touch with the contacts listed or your usual Bell Gully adviser.
This publication is necessarily brief and general in nature. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.