It's been described as the most significant tax case ever litigated in Australia. The Australian Tax Office is pursuing Chevron over a $US2.5 billion ($3.7 billion) inter-company loan. Immediately at stake is roughly $340 million in taxes, penalties and interest on the 2003 loan.

But that's not the half of it. Since 2003, Chevron has borrowed $43 billion to finance its part of the Gorgon and Wheatstone LNG projects.

If the full bench of the Federal Court finds in favour of the ATO, Chevron may be on the hook for a whole lot more than $340 million.

Not only that, a decision against Chevron will require every multinational company in the country to re-examine its transfer pricing arrangements, particularly as they relate to inter-company loans.

The dollars involved are huge. About 2600 companies claimed $14.5 billion in interest deductions on loans from related parties overseas in 2014, according to ATO data.

If Chevron's transfer pricing was invalid and thus the company claimed excessive interest deductions, how many of these arrangements might also be questioned?

"The Chevron case is probably the most significant Australia has ever seen for a couple of reasons," Greenwoods & Herbert Smith Freehills managing director Tony Frost says.

"There are large amounts of tax and penalties involved, and implications for other similar projects. But the outcome will tell us, for the first time, how the courts interpret the law for the pricing of debt used by multinationals. There have been surprisingly few court decisions around the world on this subject, which means it is being watched closely internationally."

Under pressure

The Chevron case also marks the onset of a new, more aggressive approach by the ATO, which has come under pressure from politicians desperate to be seen as tough on multinational tax avoidance. Observers say the ATO has half a dozen more transfer pricing cases lined up ready to go once the Chevron verdict is in.

As the Corporate Tax Association notes, the situation is made more complex and uncertain by the incoming diverted profits tax, which will be available to the Tax Commissioner when related-party transactions occur with countries that have a headline rate below 24 per cent.

That means loans from the UK to Australian subsidiaries, for example, could be caught in the diverted profits tax net. If the US rate drops to below 24 per cent, as President Donald Trump and the Republican Congress would like, the US will also be caught. Together the two countries account for about 45 per cent of all direct investment into Australia.

A quick look back at the basics. When one part of a company sells goods or services to another part of the same business, the price at which that transaction occurs is called a transfer price. Transfer pricing laws require such transactions be conducted at arm's length. That is, as if there was no relationship between the two parties. This is to prevent profit shifting.

In the simplest of terms, the Chevron case is the transfer price of a loan. In 2003, Chevron Funding Corporation (CFC) in Delaware borrowed $US2.5 billion at an interest rate of between 1 and 2 per cent and on-lent the money to Chevron Australia (in Australian dollars) at rate of between 8.8 per cent and 10.5 per cent."

The ATO said those terms were not at arm's length and alleged the arrangement generated excessive interest deductions, slashing the amount of tax Chevron owed in Australia.

Not only that, the deal produced a two-way dividend windfall. By the time the loan facility was wound up, CFC had shipped the profit on the loan – about $2.6 billion – back to Australia as dividends. In Australia these dividends were categorised as US earnings and so not taxable.

Rare public comments

Chevron rejected the ATO's view and the case went to court. The parties argued in court for five weeks, which according to a paper by University of Sydney professors Richard Vann and Graeme Cooper was "almost unprecedented in Australian tax litigation".

The judgment ran beyond 200 pages. "It cost us $10 million in out-of-pocket expenses for expert witnesses, legal counsel, etcetera, let alone the time of people inside the ATO," Commissioner Chris Jordan told a parliamentary committee in rare public comments about the case last year.

"There were something like 11 legal counsel for both sides [and] in excess of 12 expert international opinions."

In late 2015, the Federal Court handed down a decision affirming the ATO's position. It is important to note that Federal Court judge Alan Robertson said Chevron did not engage in any illegal activity or tax avoidance and the arrangements were not a "sham".

Chevron appealed and hearings of a full bench of the Federal Court were held for several days in February and March. It will be several months before a result is known.

KPMG Australian Tax Centre leader Grant Wardell-Johnson says the federal government may already be working on a back-up plan in case the ATO loses.

He says Australia could follow New Zealand by introducing a cap on interest rates for related-party loans, which would future-proof against another Chevron case.

The NZ government proposal involves amending thin capitalisation rules to limit to a "reasonable" level the deductible interest rate on related-party loans from non-resident subsidiaries to an NZ borrower.

"We consider that such a cap is the best approach to ensure that the interest rate on related-party loans is roughly in line with the interest rate the borrower would agree to with a third-party lender," says a discussion paper released last week.

"We consider that such a rule would also reduce or eliminate costly disputes over what an appropriate interest rate is under standard transfer pricing."

Testing an old regime

The NZ proposal is not for a hard cap of uniform numerical value. Rather, a limit would be determined by the interest rate a multinational parent could obtain when raising senior unsecured debt.

"This proposed rule would therefore anchor the deductible interest rate on intra-group debt to multinational's actual cost of debt," the paper says.

Wardell-Johnson says one of the key questions in the Chevron case is whether the Australian business could be characterised as an orphan or identical twin at the time of the loan. Was it an orphan and therefore independent of the characteristics of its multinational parent and unable to borrow at investment grade interest rates? Or was it an identical twin whose credit rating reflected that of the parent and should therefore be able to secure more favourable terms than 9 per cent? If the answer is twin, Chevron is in trouble.

"The question Treasury will be asking is whether Australia can let very high interest rates happen," Wardell-Johnson says. "This will go through the courts but in my view if the ATO loses it, the Australian Treasury will change the law, possibly as early as in the May budget to at least cover itself from this year."

Clayton Utz partner Niv Tadmore said the Chevron case was, in fact, testing an old transfer pricing regime which has since been updated to include what is called subdivision 815B. That meant the issue had a long way to play out still.

"These rules are so new that they have not been before the courts yet," he said. "It is early days so no one can tell if the general trend here will be settlements or courts, although I believe it will be the former."