Cheap Oil Inc, a company incorporated in the US, is the parent company of a wholly owned subsidiary incorporated in Australia. The Australian subsidiary in turn has a wholly owned subsidiary incorporated in the US.
Due to the group's overall credit rating and with a guarantee from the US parent company, the US subsidiary borrowed funds from third parties at an interest rate of 1%. The funds are lent to the Australian company at 9%, which the group argues to be the arm's length interest rate for the Australian subsidiary. Under the tax structure of the group, the interest income received by the US subsidiary from the Australian company is not subject to taxation in the US or anywhere else. In addition, the interest payments to the US subsidiary are allowed under the thin capitalisation regime in Australia.
Answer the following questions:
1. What are the transfer pricing issues arising from the transaction?
2. Should the Australian subsidiary be allowed to deduct interest expenses at 9%?
3. If you answer to question 2 is no, how should the transfer pricing rules work to address this tax avoidance loophole?